From a buyer perspective, the business has a long-established and reasonable sized (but still digestible) US specialty franchise.
That sector is hot right now, with substantial tailwinds around rates, business flows and (although it may be starting to pick up now) recent loss trends.
And from an investor perspective, the business has been mismanaged for so long that a cash exit and some kind of control premium probably looks like an acceptable outcome.
While for the board and the management team, a sale at a respectable multiple would bring the curtain down on its well-catalogued troubles, which may provide some relief.
Activist investor Ron Bobman has, of course, skilfully made this case. We assume Voce Capital, the firm’s largest shareholder with 9.4%, has decisively done the same behind the scenes, although it hasn’t broken through the surface. (Certainly ahead of Argo’s decision being made public, it had called round the market extensively to canvass the prospects for a sale.)
But having spent some time with the kind of bankers who would typically pick up buy-side mandates on an asset like this, there are a lot of idle dealmakers, suggesting the sale may not be as straightforward or lucrative as the above analysis suggests.
There are two primary reasons for this.
First, Lloyd’s is highly out of favor, and the perception exists that anyone buying the group will have to clean up Argo Syndicate 1200, which is believed to represent over a third of net assets.
There is a widespread view that this would require a) putting the syndicate in run-off; b) a tricky divestiture; or c) substantial remedial work. Which is to say that Argo’s syndicate is acting as a kind of poison pill.
The business put up a 94.4% combined ratio last year, against a 93.5% market average. I am always sceptical of underperforming businesses that put up a single year of good results when they really need it (as others are).
But source information from multiple parties that have had visibility of Syndicate 1200 suggests the widespread view may be wide of the mark. Doubtless, it was a weak Lloyd’s business in 2017 – but a lot of remedial work has been done since, and that work has been done against the backdrop of huge Lloyd’s market tailwinds.
Second, as astutely highlighted by the Inside P&C Research team, there are real question marks around the balance sheet – with even a 5% adjustment in overall reserves equivalent to (another) $100mn hole.
Balance sheet risk is probably the number 1 concern for P&C carriers looking at M&A, and the $132mn Q4 charge will be a red flag for potential acquirers.
Multiple sources have said that Argo brought a ~$1bn legacy transaction for its US insurance arm to the market last year, which was not subsequently consummated. (Argo declined to comment on this information.)
The charge was taken subsequently but it skewed to the run-off portfolio, driven by the construction defects book.
With a hungry legacy market that swallows all kinds of liabilities it probably shouldn’t, the absence of a deal will prompt questions around what else could come out of Argo’s US insurance back book. The legacy market is not in the habit of passing up redundant books.
In recent earnings calls, Argo repeatedly stressed the rigor of its reserving process including a feedback loop between actuarial, claims and reinsurance operations, as well as its use of internationally recognized third-party actuarial firms. It also pointed out on its Q4 call that its carried reserves were above the central estimate of the the actuarial firm, giving Argo “more confidence” in its position.
The price problem
So while the initial read may be “someone will pay up for US specialty” you find that the requirement for a counterparty is an acquirer who is willing to execute difficult M&A, and a company that is willing to run the reserving risk – or pay for an adverse development cover to manage it.
Which narrows the field substantially.
The latter point also brings you to the third and final challenge, which is not something that will put off buyers - but a challenge for the board and investors.
Argo is currently trading at trading just ahead of stated book value and 1.17x tangible book.
Having closed at $43.35 on Friday, there could be ~$5-$6 of bid spec in the price, perhaps a little more.
Nevertheless, you still need to find a substantial premium versus the current trading price for shareholders, probably 20% or more. This points to 1.25x stated book, and 1.4x tangible book.
Throw in some reserve deficiency and you could be creeping up to 1.3x book, and pushing towards 1.5x tangible. (Each bidder would take its own view of the reserves when weighing its bid.)
This is too expensive for a pure private equity buy-in, with anything above 1.25x making the math close to impossible – although some PE may well opportunistically look in case the board is determined to sell at the market-clearing price.
That valuation is also too high for a strategic bidder thinking about the value unlock from cost and capital synergies. All of which is to say, you have to be a strategic that really wants the platform to do this deal, and believe there is franchise value there.
The runners and riders
Let’s bring this analysis into the real world.
The Europeans: It is hard to see Zurich wanting a clean-up asset despite its growth ambitions in US wholesale (it is growing nicely organically anyway). It is hard to see what this does for Allianz, a parsimonious bidder too. Axa is a top 10 player in US specialty already, and has had more than its fair share of issues as a result of specialty P&C M&A.
US commercial lines: Chubb, meanwhile, has been growing very rapidly on its own in the E&S market – why dilute what it has when it could just look to take additional share? Other large cap US commercial names are possible. Argo would be a bite-sized move into E&S for Travelers, but it is hard to see why it would move for a relatively challenged name. Such a move would look like a Hartford-Navigators deal, something that has found little favor with investors. AIG is in the midst of an IPO of its life business, and may still want to sell Validus afterwards. The timing is wrong even if the talk is that CEO Peter Zaffino has M&A ambitions.
US specialty: Running through the scaled specialty names does not shake out any candidates. Each of WR Berkley, American Financial Group and Markel has scope to grow organically, and would be unlikely to want to dilute what they have and pay up for a franchise they don’t need.
Class of 2020/21: Vantage spent a long time looking for a scale-up US specialty deal, perhaps making it the likeliest name here – but having now done the work on an organic build, Argo feels like an expensive pivot. Jeff Consolino and Ed Noonan are always looking for M&A opportunities, but are likely to view this as too messy when Core Specialty is probably within a year of an IPO. And, after all, the business was built out of a deal with StarStone where it insisted on a carve-out of London which is not on the cards here. It seems likely ERS will stay in its lane given Aquiline already backs a US specialty franchise. Conduit, meanwhile, is a reinsurance business.
Bermuda: The Bermudians all seem unlikely acquirers. Arch has focused outside of traditional P&C with mortgage and trade credit, otherwise looking for more keenly priced fold-ins (eg Barbican). RenaissanceRe has been very plain it doesn’t want to be an insurance company. Everest Re does when it comes to growth – but its focus is international, and the direction of travel organic. After its u-turn on the reinsurance sale, it would be a bold move from Axis to think about doing a pretty dilutive M&A transaction at this stage.
International: Tokio Marine is looking for its next major deal, but it will not want a lower quality asset given its riches in US specialty. If Mitsui Sumitomo is in any way close to being past its Amlin scars, you could see it as an acquirer of Argo. But that is a big if. And you have to think when it ultimately decides on an international deal it will buy something safe, which points to an A1 franchise. Sompo International meanwhile is in the midst of a reorganization, as Brian Shea places his stamp on the business – and while they may have been quieter than one would expect on the M&A front, you wonder if the timing would be right. Intact just said it had upwards of $1bn of dry powder to do a deal with US specialty, an attractive area, and has a track record of difficult M&A – but bankers remain skeptical it will make a move on Argo.
European reinsurers: Munich Re has certainly thought about US insurance deals, and looked at OneBeacon when Intact bought it, giving it a degree of plausibility as a suitor. Swiss Re CorSo seems unlikely to pursue a deal while it is still trying to cement its turnaround. Scor also has ambitions in US insurance, although it is questionable whether it has shareholder backing for a dilutive transaction. With the HDI Global Specialty divestiture in November last year, Hannover Re has clearly indicated it wants to focus on reinsurance.
Mutuals: Mutuals can be a bit of an M&A wildcard. Liberty Mutual remains acquisitive and lacks the same constraints as a stock company, so could be another name worth considering. Nationwide has shown an interest in M&A and strategic deals like Geneva Re, although not on this scale. American Family, meanwhile, has its specialty play in Bowhead.
Financials: White Mountains is about to have $1.8bn of proceeds from its sale of NSM, bringing Argo within reach. But Ark aside, it has tended to look for more keenly priced assets. With CPPIB seeking to sell out of Ascot, and private equity strategies heavily focused on non-balance sheet assets right now, a Canadian pension fund acquirer for Argo looks like a far-fetched scenario.
So between Munich Re, Liberty, Mitsui Sumitomo, White Mountains, Travelers, and perhaps Intact, there is a list you can start to build. But you have to eke it out. This is not going to be the CFC process…
Goldman Sachs is good at what it does. And ultimately you only need one bidder to get a deal done, and one naïve bidder to get a good price. But Goldman is going to have to work for it. It’s not a slam dunk sale.
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