The Validus diaspora reaches ProSight
On Friday, ProSight announced that it had agreed a sale to an acquisition vehicle led by Jonathan Ritz, which had backing from TowerBrook and Further Global, confirming this publication's scoop from earlier in the day.
M&A involving insurers tends to be a marathon not a sprint, but that was taken to its extreme here with talks that stretched back at least as far as September last year – perhaps fittingly for a business which owners Goldman Sachs and TPG have been trying to exit since at least 2017.
The cash deal values the business at $586mn, or $12.85 per share. This was 10.4% below the closing price the previous day, driving the share price down by 10% in Friday's trading.
But the price was substantially inflated by bid speculation after Inside P&C's September story, with the takeout price 42% above undisturbed – leaving some special situation investors nursing losses.
The deal is certain to go through given that the company is ~75% owned by Goldman and TPG.
By raising the money to buy ProSight, Ritz – best known as the former head of Validus' US insurance arm – continues the remarkable progress of the diaspora of Validus' ex-management team to senior positions elsewhere in the sector.
This includes Jeff Consolino and Ed Noonan, who are running "re-cap" Core Specialty; Peter Bilsby, who has become CEO of a revamped ERS; Lixin Zeng, who has launched ILS fund Integral; and Jeff Clements, who is poised to head up new launch Ark Bermuda.
Ritz will have a number of advantages after he parachutes in as CEO:
First, market dynamics are favorable, with catching the right point in the cycle crucial to winning in specialty insurance.
P&C rates turned in Q1 last year and have sequentially accelerated through the third quarter of last year (see below), with Q4 pricing data expected to show continued momentum.
D&O, umbrella/excess casualty and cat-exposed property have shown particularly strong momentum, with rates in E&S markets also stronger than in standard lines. There are increasing signs that workers’ comp – long a laggard on rates – is also in the early stages of a turn.
Alongside price increases, underwriters are tightening T&Cs, increasing retentions and compressing limits – all of which is likely to help drive improved performance.
Sources in the US E&S market believe that absolute rates are reaching levels in many years where strong underwriting results – assuming a normal cat load – will be delivered in 2021. Senior sources have said that good specialty players could achieve accident-year combined ratios in the low 90s or high 80s in 2021.
The market has also seen relatively little new capital arrive – with around $1.5bn of external equity raises – reflecting higher barriers of entry relative to Bermuda and the London market.
The E&S market is also continuing to see significant increases in submission (Kinsale said +25% in Q3) as admitted markets drop business as part of de-risking efforts, with insurers also seeing increased flow from limit compression from E&S writers.
Second, the entry multiple is favorable and significantly below historic takeout premiums for specialty insurers, creating scope for significant multiple arbitrage on exit.
A crucial piece of the private equity model in insurance is driven by a cheap entry multiple and a rich exit multiple, with the returns available to carriers in any given year unable to drive the 15%-20% returns expected by PE.
Buying ProSight at a multiple of around 0.9x book value – 0.92x Q3 book value – creates the room for significant value creation via floating or selling the business at a premium.
As well as being modestly priced in absolute the terms the acquisition is also being executed at a significant discount to historic takeout multiples for US specialty insurers, which tend to be in the range 1.5x-2x.
Ritz and TowerBrook will be looking to present ProSight as a member of the cohort of successful US specialty insurers on exit, with most of that group trading at multiples of between 1.2x and 2x book (excluding outliers Kinsale and RLI on the high side, and Argo on the low side).
Third, the deal with Enstar around the prior-year reserves takes out one of the biggest downside risks around a P&C transaction.
One of the central challenges to successfully executing M&A in P&C insurance is correctly estimating the appropriate reserving levels of a target company and pricing for that in the deal.
There is likely even greater cause for concern at this point following a long soft market and mean reversion around loss cost inflation. And the true picture has been further complicated by the way in which the pandemic has distorted claims activity and the reporting of claims over the last year.
Ritz and TowerBrook have curbed the risk of significant adverse development through a two-part legacy deal with Enstar. This includes a ground-up loss portfolio transfer for a portfolio of discontinued workers' comp and excess workers' comp business and an adverse development cover for a diversified mix of general liability business.
Enstar said that ProSight would cede $500mn of net loss reserves, with an additional aggregate limit of $250mn provided.
Fourth, with hardening cycles time limited, speed-to-market is crucial and by buying into an existing business Ritz will gain instant exposure to hardening rates.
I have previously said that the US E&S start-ups are racing the soft market, with 2019 in retrospect the optimum year to launch either a new underwriting venture – or to reboot an underperforming franchise.
The window of opportunity is still open in this regard, with 2021 widely predicted to be another year of positive rate momentum, and by buying an existing business Ritz will gain access to an immediate flow of premiums.
Although, Ritz and his PE backers have a number of the necessary conditions in place to succeed, the inescapable fact remains that ProSight is a turnaround and turnarounds are challenging in insurance.
The business has failed to establish a track record of generating strong underwriting returns, with its performance tending to cluster around or just better than breakeven, except for a weak 2015/16. Investment has been the bigger driver of profitability, with yields of over 3% in 2018, 2019 and in the year to date.
The business has relied on financial engineering with relatively high leverage across a number of measures, utilized to juice returns.
The ratio of NWP to average equity peaked at 2.27x in 2018, although it then fell substantially in 2019 and again in the first nine months of 2020. Its ratio of assets to equity peaked at 6.6x in 2018 – well ahead of peers – and is still running at just under 5x.
During the past close to five years, the business has generated a fluctuating RoE performance with two years of major negative returns, followed by a major bounceback in 2018 and two years of single-digit returns thereafter.
The business also operates as a program specialist, with underwriting delegated to what is believed to be around 60 program managers and MGAs. That means that the key value creating enterprise of the business is largely handled by other firms.
A key early decision for Ritz will be the degree to which ProSight looks to build its own in-house underwriting teams.
The best proof of the lack of franchise built by management to date is the fact that Goldman and TPG have been looking to exit since at least 2017, and to get their money out have ultimately had to agree a deal at a discount to book value.
The valuation ultimately underscores the amount of work in front of Ritz and his PE backers.