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Summary

  • ACP Re has agreed to buy Tower Group International, Ltd. for $2.50 in cash per share.
  • Shareholder meeting to vote on proposed merger is scheduled for August 6, 2014.
  • Unique risk arbitrage situation with 14%+ upside in less than one month.

Background

On August 6, 2014, Tower Group International, Ltd. (NASDAQ:TWGP) will hold a special shareholder meeting to consider approval of the merger proposal between TWGP and ACP Re, Ltd. The deal has been on shaky ground ever since it was first announced on January 3, 2014, and with that, trades at a significant discount to the deal price of $2.50 per share.

(click to enlarge)

Business Description

TWGP is a provider of property and casualty insurance products and services in the United States. Through its insurance company subsidiaries, TWGP provides personal and commercial insurance for small to medium-sized businesses through its network of retail and wholesale agents across the country.

Signs of Trouble

On August 7, 2013, the Company announced that it was delaying the release of its financial results for the second quarter of 2013 due to issues, "relating to the estimate of its loss reserves and, primarily due to the integration of the Canopius Bermuda merger, its allocation of goodwill and certain tax accounts." This announcement resulted in a decline in its stock price of 24% to $16.41 and began the precipitous decline in TWGP's business and share price.

By October 7, 2013, TWGP announced that it would increase its loss reserves by approximately $365 million, primarily for accident years 2009 through 2011 in its commercial insurance lines of business, including workers' compensation, commercial multi-peril, commercial auto and other liability lines.

Included in the press release was a statement that the Company had retained JP Morgan as its lead financial advisor to review a range of strategic alternatives with the Board. By the close of trading on October 8, 2013 the stock had fallen to $4.39 (down 80% since the beginning of August earlier in the year).

Merger Details

While the announcement of strategic alternatives was made in October 2013, the Company began to privately explore strategic alternatives in August 2013. By October, JP Morgan had reached out to 71 potential strategic counterparties regarding a strategic transaction.

As the Company looked to make a deal, the underlying fundamentals of the business continued to deteriorate with the Company announcing on November 14, 2013 that it would restate its financials for 2011 and 2012 in light of the previously announced reserve increases. Furthermore, the Company noted that there was substantial doubt about its ability to continue as a going concern.

By the end of December 2013, the Company was downgraded to B (Fair) by A.M. Best (the Company had been rated A- back in August), which further limited the ability of the Company to write and renew existing business.

On January 6, 2014, the Company announced a merger agreement between TWGP and ACP Re, Ltd., a Bermuda based reinsurance company whose controlling shareholder is AmTrust Financial Services, Inc. (NASDAQ:AFSI). The terms of the merger was for $3.00 per share in cash and included standard conditions. Explicitly stated was that, "the merger is subject to the non-occurrence of any material adverse effect on Tower, as well as the absence of any insolvency-related event affecting Tower."

While the stock initially traded at a marginal discount to the deal price, the stock continued to slide over the ensuing weeks. By late-April 2014, ACP Re indicated that it could no longer go forward with the merger given the continued deterioration of TWGP's business. With few options available, the Company had little choice but to renegotiate. On May 7, 2014, the Company announced that it had amended its merger agreement with ACP Re to lower the cash consideration from $3.00 to $2.50 per share, and removed a significant number of conditions related to the material adverse clause that had originally been part of the deal. The only material clause remaining concerns TWGP's solvency (see Other Points section).

On May 13, 2014, the Company announced that it received an unsolicited letter from Eurohold Group and Euroins Insurance Group proposing to enter into a stock-for-stock deal that would value TWGP shares at $3.75 per share. The Company quickly dismissed this offer as inferior to the agreement with ACP Re given timing issues and the difficult nature in closing a trans-border deal.

On June 26, 2014, the Company sent a letter to ACP Re indicating that the Company sensed that ACP Re believed an "Insolvency Event" had occurred, which would allow ACP Re to terminate the merger agreement due to issues with the Company's Massachusetts subsidiary that required a $3 million contribution from TWGP. The following day, ACP Re confirmed its intention to comply with its obligations as specified under the merger agreement.

Opportunity - 14.3% upside in less than one month (171.6% annualized)

With the deal expected to close within a week or two after the shareholder vote on August 6, 2014, investors have significant upside as shown below:

  • Current Price - $2.17
  • Deal Price (discounted back @ 6%) - $2.48
  • Upside - 14.3%

Risks

The obvious risk here is that the deal is terminated. As the Company currently has a negative tangible book value and its business has deteriorated significantly, equity investors should anticipate a total wipeout if the deal does not close. As such, this position should be considered risky and position sizing is critical.

Conclusion

While risk arbitrage situations have become little more than higher risk money-market alternatives, there are some situations that still provide investors with attractive returns. In the case of TWGP, it is clear that shareholders will vote in favor of the deal (particularly given the alternative) and given the already agreed upon reduction in deal price and removal of key conditions, the deal with ACP Re looks like it will go through. There is certainly significant downside in this situation; however, investors are sufficiently compensated for the risk they are underwriting.

Other Points

While some investors may point to the significant short interest (19.8% of float currently) as a major negative and indication that the deal will not go through, many of the shorts are just hedgers. The Company has $150 million in 5.00% convertible bonds due September 15, 2014. As of this writing, the bonds were trading at $92.00, implying a yield-to-maturity of 81.9%. As many fixed income investors are hedging their positions in the bonds with equity, the short interest level has become artificially inflated. For investors who are able to, I recommend looking at the bonds, which offer a lower upside versus the equity, however, are less likely to be wiped out in the event the deal is terminated.

Additionally, in speaking with the Company, the only meaningful financial condition remaining is for TWGP to maintain its risk-based capital scores above regulatory thresholds, which the Company believes will be in line at the time of the deal closing date.

Source: A Towering Spread: Tower Group International, Ltd. - 14% Upside

Additional disclosure: I am long TWGP. I may change or exit my position (buy or sell shares) without updating this article and without informing the Seeking Alpha community.