This comes after insurance specialist investor Ron Bobman kicked off an activist campaign aimed at Watford arguing for a strategic review and likely liquidation to address its woeful business performance and valuation.
At that time, my colleague Adam McNestrie argued Arch was well positioned to secure the transaction as – and I am summarizing – most potential buyers would see a protracted M&A fight as unattractive if the inevitable result would be a Price is Right “plus $1” bid from Arch. (You can read his much more eloquent argument in full here, as well as more background detail on the potential deal.)
As I was driving near across the country at the time, I was unable to feed in a few additional thoughts. In short, while the path outlined by Adam may be the most likely, I do not agree that it is inevitable as reported. I see various wrinkles that could yet lead to any transaction with Arch proving less smooth than they might like. I outline four below.
The first is simply the potential for an “embarrassment factor”.
Recall, we argued that the success of Voce’s activist campaign against Argo was essentially due to its effective use of “activism through embarrassment” – surgically exploiting the space that existed between the board members' (limited) sense of shame and their legal liabilities as fiduciaries. This helped up-end a conventional wisdom that held activism insurance was too complicated due to the de facto support and pro-management conservatism of rating agencies and regulators (as indeed initially appeared to be the case with Argo vs. Voce).
There is similar scope for a motivated activist to make life awkward for various folks involved related to the relationship between Watford and Arch. In particular, the more the focus is on Arch and its conflicts of interests, the more incentivized the sponsor company may be to take a hit on winding up the relationship. Similarly, external pressure on board members to represent the interests of Watford investors and not Arch could prove effective given their legal liability.
Of course, this is multi-dimensional and complex stakeholder management, but Arch has a tricky path to navigate maintaining its strong reputation with the investment community, regulators, and existing and potential counter-parties. Indeed, the emergence of this bid should be seen as some evidence that the company has decided to take an acute PR hit with its bid versus a potential chronic embarrassment should a protracted activist campaign emerge, with the potential for more investors to jump on the bandwagon.
The second is the fate of Watford’s liabilities to Arch.
To most potential alternative bidders, Watford would likely be seen as a box full of assets and liabilities, with perhaps a free option on a platform and some licenses. Crucially, it is worth remembering a large portion of those insurance liabilities ($800mn plus out of ~$1.8bn) are essentially due to Arch for retroceded business where Arch will have to pay the claims to its counterparties then claim the money from Watford.
Of course, if Arch has designed Watford well (e.g. to protect its own interests and not Watford’s investors), the mechanisms and contractual obligations may limit the ability of a new owner to play hardball in the typical run-off model.
Indeed, it is worth noting that close to two thirds of Watford’s assets are pledged as collateral in various trusts, including over $1bn as pledged underwriting collateral. This may make this vulnerability less acute. That said, there is still some scope for a hostile actor with control to make life more difficult for Arch than it might like across the multiple buckets of balances due, including through legal challenges that would exacerbate the embarrassment factor mentioned above.
Third, there is scope to play hardball on the underwriting contract.
Some have argued that Arch will have a clear run at Watford because it is worth more to it than to anybody else.
This argument seems to be a bit confused. Some appear to argue that Arch controls the business value of Watford and therefore there is no value available to a third party bidder. This seems misplaced for a transaction that would likely be entirely about liquidation value – not its going concern valuation which the market currently rates at pennies on the dollar.
Others argue the exact opposite – that Watford’s new owners would have no ability to cancel its underwriting arrangement with Arch that runs through 2025 without providing 24 months notice – leaving it vulnerable to accepting business it doesn’t want.
Again, there seems scope here for a party willing to play hardball to make this less clear cut. Subject to the constraints around assets in trust and pledged as collateral, an aggressive counterparty could seek to decapitalize Watford and transfer sources of value into different entities in such a manner that would make it an unappealing counter-party for Arch.
Fourth, there is also the Enstar wildcard.
Recall, run-off specialist Enstar is currently Watford’s number-three shareholder with a ~5% stake. Though it has publicly stated its investment was purely due to its view on valuation, it is worth noting at least that there is a strong incentive for the company to try and extract a higher price from Arch if it thinks the offer made does not approach its view of intrinsic value in liquidation.
In this way, the existence of a counter bidder in an auction could extract a better price from Arch, even without intent to ultimately exercise control. Of course, this is a dangerous game of chicken, and would likely mean any stalking horse bid would need to have a substantial margin of safety built in while capturing as much as possible of the potential valuation-unlock and synergies generated in a buy-in from Arch. But at the very least it should be seen as a potential wildcard.
One final point is worth making around the implications for the industry beyond Watford and Arch.
With the market having now witnessed the spectacular collapse of Maiden Holdings and current valuation-linked crisis at Watford, the fate of these sponsored vehicles seems unattractive to say the least.
Current iterations that were launched as contemporaries of Watford but had the good sense to avoid the scrutiny of publicly listed equity include Chubb’s ABR Re, launched in partnership with BlackRock in 2015, and Axis’ Harrington Re, launched in 2016 with Blackstone – both of which have performed poorly similar to Watford according to regulatory filings (see table below).
Three points are also worth making here, and remembering long after the dust has settled on this latest gambit only a soft market could love.
The first is that these vehicles are set up for failure. Though framed as creating value by matching risk and capital in a different way, it should not be forgotten that the sponsor company has the ability to manufacture the exact same outcome for itself, should it consider it likely to generate an attractive outcome. Arbitraging a “lower cost of capital” is almost always going to end badly for those willing to accept lower returns while having an asymmetric understanding of the risks ceded and assumed. It is the insurance equivalent of finding a schmuck to join your poker game.
The second is that at a time of crisis – inevitable if you accept the premise above – the sponsor company will always act to protect the interests of the mothership and not the investors in the sponsored company – and that arguments that rely on the skin in the game of a modest minority interest should be laughed out of town. Indeed, even in good times, the value of its stake needs to be weighed against the NPV of the value it is extracting through fees.
The third is that the minority interest of the sponsor company and any boilerplate corporate governance protections for investors should be weighed against the level of de facto control the sponsor company has as the provider of premiums.
That said, capital markets have short memories. It is a pretty safe bet that the “new and improved” third generation will come off the manufacturing line as soon as the next soft market hits – with old problems solved and new ones ingeniously concealed.
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