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Published 1 September 2015
M&A has a cycle, just as underwriting does. When M&A is booming, prices tend to rise and value tends to decrease. The market can fall victim to a fear of missing out: the media reports deal activity and so shareholders start to expect it to be on their company’s agenda, CEOs begin to measure their success against the size of the latest deal and the investment banks call with increasing urgency.
We have entered that phase where rigorous and objective valuation can start to give way to looser multiples of earnings and it becomes difficult to resist speculation: ‘The value will come from synergies’ or ‘We will do more with less’. The reality is very different: it pays to remember that somewhere between 70% and 90% of acquisitions fail to deliver the value expected by the buyer. If investment discipline is not maintained then the deals start to destroy value, not create it. It is essential to evaluate each potential target methodically, by reference to a sound valuation model and on the basis of thorough due diligence. Integration must also be planned with the same relentlessness and attention to detail.
Solvency II has made valuing an insurance company for an acquisition more complex than before. When evaluating an acquisition CFOs now need to run at least two financial models – one based on International Financial Reporting Standards (IFRS), or Generally Accepted Accounting Principles (GAAP) for their shareholders and the analysts, the other based on Solvency II capital and technical provisions for the PRA.
It might be wondered why this is new. The PRA and its predecessors have for years been gatekeepers to UK insurance sector M&A: no acquisition or even substantial minority investment can happen without the regulator’s approval under Part XII of the Financial Services and Markets Act 2000 (FSMA).
The PRA must apply statutory criteria in deciding whether to approve a change in control (sections 185-186 FSMA) but these criteria are drafted widely enough to give the regulator a significant degree of judgement in deciding whether to consent to a transaction going ahead. Notwithstanding other factors, historically approval has (unsurprisingly) been withheld unless a buyer can demonstrate how the target will meet its individual and group capital requirements post completion.
What has been less obvious over the years, particularly to prospective investors from outside Europe, is that the regulator will, where it thinks necessary, interpret sections 185 and 186 FSMA to require target insurance companies to be overcapitalised as a buffer against the basis risk inherent in new ownership.
Some commentators (and some CEOs) maintain that integration is unnecessary, pointing to private equity (PE) portfolios as proof. This in our view misunderstands the way PE firms manage capital, putting representative directors on the boards of their portfolio companies to drive a relentless common focus on returns. It also ignores that, unlike most PE acquisitions, M&A in the re/insurance market always involves buying a significant amount of duplicate infrastructure.
If that is not dealt with, and quickly, then shareholder value evaporates: to give a real-life example, few things kill synergy like maintaining 19 general ledger systems.
In fact, something that has gone relatively unnoticed in 2014/15 is the quiet integration of the Lloyd’s and Companies’ Market operations of several insurance groups previously run on a decentralised basis. This will not only generate cost savings and capital efficiencies, it will enhance the leadership of senior management and prevent group subsidiaries from cannibalising each other in a fight over common lines of business. This is a trend we expect to see accelerated in future insurance market M&A.
Now Solvency II has changed the basis on which insurers must demonstrate their financial position to the regulator. Previously, insurers and prospective buyers could demonstrate their solvency using IFRS or GAAP in the same way as they calculated their annual accounts. However, Solvency II requires insurers’ technical provisions, reinsurance balances and own funds to be calculated differently from the accounting rules for published accounts.
Any capital surplus identified in the target by a sharp-eyed buyer is likely to look smaller under Solvency II, and smaller still when considered against the PRA’s stated views on capital extraction. Perhaps more significantly, regardless of IFRS, if the Solvency II calculations demonstrate a shortfall against the target’s Solvency Capital Requirement or Group Capital Requirement post completion, the PRA will want to see additional funds invested to bring the target back up to, or indeed over those requirements before it will consent to the buyer acquiring control. Buyers unfamiliar with the Solvency II requirements (and there are plenty of non-EU investors looking at London Market targets) may be in for a shock when they bring their proposals to the regulator.
As if that were not enough, in our experience the PRA is unlikely to allow buyers facing a regulatory capital shortfall in their acquisition target, or elsewhere in their group to rely on transitional measures that would otherwise allow insurers more time to reach their capital compliance requirements. The regulator’s approach seems to be that if you’ve got the capital to contemplate an acquisition, you should first use that capital to comply with Solvency II.
In the early stages of the M&A cycle, if a buyer has to make good a solvency deficit there is simply a net reduction in the gain that the target’s shareholders make from the deal, as the buyer would spread its available capital between filling the gap and paying for the shares.
At the point in the cycle where M&A becomes a seller’s market, however, buyers seek to use additional capital to fill the gap, as sellers resist attempts to lower the price and there is no shortage of substitute buyers. The insurance market is at or almost at that point in mid-2015.
These conditions can lead buyers to stretch themselves financially in making acquisitions. Previous acquisition cycles have been fuelled by corporate buyers seeking debt finance in the capital markets; this in turn fed cycles of refinancing legacy acquisition debt. Current market conditions suggest that leverage for the latest M&A boom will come from private equity and pension fund investment. In that regard it was very interesting to see the innovative deal that Fairfax announced almost immediately after its acquisition of Brit, to divest close to one-third of its newly acquired holding (in some ways more redolent of a banking sub-participation than a conventional joint venture).
None of this is to deny that there are opportunities in M&A for those with an eye for value, nor to reject leverage as a means for converting those opportunities into profitable gain: both will continue in the short term. It is, however, a caution against the risk of an M&A spiral. Finding value will become increasingly difficult as prices rise and integration will become harder as the number of potential targets reduces.
The takeaway for acquisitive insurance groups, and for their General Counsel, is that the valuation of M&A targets must now be combined with capital planning and corporate structuring. Buyers should seek to optimise all relevant Solvency II positions before and after the acquisition, if necessary raising capital or sub-participating the deal, provided that doing so leaves enough value in play to make a difference to the buyer’s shareholders. ‘Synergies’ and other intangibles will only deliver value if ruthlessly pursued.
Where does this leave the hard-pressed CEO or CFO facing bonus-chasing bankers, activist shareholders and relentless commentary from analysts? When the time comes to do a deal in the London insurance market, they can count on world-class support in navigating these dangerous waters. The EC3 postcode is to insurance, reinsurance and broking what Silicon Valley is to the tech industry. This small corner of the City can supply expertise in corporate finance, legal, accounting, actuarial, risk management and taxation, all tailored to international insurance.
Specialist advisers know what matters to your business and focus on it, reducing your time to market, enhancing your due diligence with experienced insight and supporting your post-acquisition integration with an understanding of how your company and your market work. Those are advantages no generalist can match: innovative, insurance-focused professional support is essential to the London Market’s vision for the future.
It will be tempting to buy at all costs as pressure from the media and analysts builds, but investment discipline is crucial. The corporate world well beyond the insurance market is littered with examples of M&A that have failed, usually when boards have abandoned once well-thought out plans and financial models. Inevitably, we will look back in five years’ time and question some of the deals that have made headlines in recent months, but statistically only 10-30% of them will have delivered or exceeded the value anticipated by the buyer.
ACE – Chubb
Willis – Towers Watson
Tokio Marine – HCC Insurance
Exor – PartnerRe
XL – Catlin
Fairfax – Brit Insurance
RenaissanceRe – Platinum Underwriters
Hyperion – RK Harrison
Willis – Miller Insurance Group
Qatar Insurance Group – Antares
Hamilton Insurance Group – Sportscover Underwriting and Kinetic Insurance Brokers
Nick Gibbon, Clive Garston, Bridget Salaman
Craig Dickson, Toby Vallance