The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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To the external eye M&A deals can often seem quite dull. A short legalistic stock exchange announcement from one side is, perhaps, followed by one from the other. A few weeks later you may notice a similar exchange, with announcements that look like they have been copied and pasted. Then they might move into due diligence.

Eventually, a bid might be recommended. And when a number of seasons have come and gone the shareholders might actually approve it and the regulator rubber stamp it.

But, under the suface there is a world of power struggles, jostling egos, multi-million pound capital gains, eccentric investors, press leaks - and all of this beneath the veil of secrecy that keeps others in ignorance.

So, what does happen? How does it work? If I want to buy a listed Lloyd's insurer how would I go about it? And when the veil is lifted, what do you see?

First of all, you realise that M&A can only be understood within a context. Deals are not isolated affairs and they do not take place solely for idiosyncratic reasons particular to the buyer and the seller: they are structurally conditioned too. There is always a bigger M&A picture.

At the moment a number of wider environmental features make M&A an attractive option. "We are entering a golden period for M&A," one corporate adviser told IQ. "Fear of doing deals is giving way to greed."

Fighting fears
The factors counteracting the fears - or companies' risk aversion - include burgeoning surplus capital and a bleak rating environment, alongside meagre investment returns, the historically low valuations of (re)insurers and the regulatory uncertainty provoked by Solvency II. These factors make M&A an attractive proposition, or perhaps a seductive panacea, which is perhaps saying no more than at the moment that executives feel they have little - or at least less - to lose.

"Even with due diligence you can never be certain what you're buying, without it you will have only the faintest idea"

Greed is eternal, but that is no reason to discount it. There will always be executives looking to conjure a deal that transforms their company's fortunes, just as there will always be management with an instinct to sell when it feels it has taken a business as far as it can. And these two instincts are strengthened by the growing sense that the days of small- and medium-sized quoted Lloyd's insurers are numbered.

At the moment, there is some new greed in town. One source talked about the catalysing effects of "the new money" hovering on the fringes of the sector. After falling into disfavour with traditional investors fleeing the challenges outlined above, trading multiples have fallen and private equity (PE) has scented an opportunity to buy into a non-cyclical business that it can use to hedge exposure to the business cycle.

The quarry
Far more deals are contemplated at one level or another than ever make their way into the public domain. There is a whole industry based on M&A and it isn't content to sit and wait for deals to come to it. PE funds and (re)insurers will be visited periodically by investment bankers speculatively touting takeover targets - usually without the permission of the company in question.

Some boards are more active in scouting the market for opportunities themselves alongside their retained advisers. Normally, it is through one of these two methods that a company with the wherewithal and inclination to acquire will fix its attentions on a takeover quarry.

"The game normally starts with an opportunistic approach," one corporate adviser at the heart of M&A activity on Lime Street in told IQ. Which is to say that this touting and scouting process takes place until a company appears in the crosshairs of a would-be acquirer that fits the profile and would likely be available for a price that allows the deal to remain accretive.

At this point a flurry of activity will take place behind the scenes. Management on the buy-side and its corporate advisers will undertake a so-called "side-by-side" analysis. They will calculate the combined top-line of the two companies and attempt to model the volume of premium that will be lost when the businesses are combined.

Synergies will also be modelled. These will include cost synergies (buildings, back-office staff, senior management), capital synergies (diversification benefits, reduced financing costs) and hedging synergies (outwards reinsurance spend, currency hedging). An analysis of the damage to both businesses caused by the period of uncertainty attaching to a major M&A will also have to be undertaken.

The buyer will then need to work out the premium to net tangible asset value - otherwise known as the frictional costs - that it is willing to pay. A price range will be determined and a walkaway price etched in stone.

Hangers-on
Board level management is involved in these calculations, but external corporate advisers undertake the heavy lifting. The public exposure of these advisers is normally restricted to a byline at the bottom of stock exchange announcements, but they are the masters of the M&A process.

It is the advisers who will make the initial takeover approach. Sometimes, advisers will approach shareholders for discreet conversations ahead of an official approach, but fund managers dislike this tack as it makes them an insider and prevents them from trading in the stock until the bid interest is made public. More often, the advisers will approach the sell-side company and arrange a preliminary meeting with their opposite numbers. The chairmen will often undertake initial meetings as well.

One slightly jaded corporate adviser told IQ that in that first meeting "you watch two completely self-interested advisers working out at what price the deal can be done". There is a community of interest between both the buy-side and sell-side advisers, because both are remunerated by commission calculated on the deal price, he added.

And these opinions are quite widely held. "I think there is a massive conflict of interest," one Lloyd's CEO told IQ.

And even those who dismiss these ideas are critical of the mega-remuneration picked up by the advisers.

Another Lloyd's CEO commented: "They charge a hell of a lot of money. It's daylight robbery."

It's war
Once the attack side has disclosed its intentions, a struggle commences. The sell-side management may be amenable or hostile to a deal, but the board has a fiduciary duty to its investors to maximise shareholder value. And at the same time the buy-side management is trying to pull off a coup without overpaying and without forfeiting the support of its own shareholders (if it is a public company).

During this tug-of-war over a public company the shareholders' attitude is key. Overwhelmingly, the Lloyd's insurers are owned by a relatively small collection of fund managers representing asset management companies like Invesco, BlackRock and Legal & General. Through their advisers, both sides will canvass and counter-canvass these fund managers, making the case for and against the deal, arguing over the valuation of the company and, in fact, replaying on a smaller scale many of the negotiations taking place between the two sides.

However, the fund managers are active participants in the game too, and will often give conflicting accounts of their views depending on their audience.

One Lloyd's CEO burned by his interactions with fund managers told IQ: "The fund managers talk to both sides. It's like Labour, the Conservatives and the Lib Dems in an election knocking on the door and asking 'who are you going to vote for?' And you tell each of them you are going to vote for them because you don't want to have to talk to them."

Some of this struggle can get ugly. According to one corporate financier there are "certain weapons of defence" that companies that do not want to be sold can employ.

Most involve "behind the scenes stuff, quiet assassination". Bids can be rubbished to analysts, the expertise of the opposing management can be called into question and the deal can even be taken public via a willing journalist.

If the deal does go public, things get immeasurably more complicated. Some approaches will even be predicated upon the deal remaining secret during negotiations. In those cases, if the deal goes public the buyer walks. There are, however, other problems associated with publicity. The biggest is uncertainty. Staff are destabilised by the possibility of a deal - they start to look around for escape routes and opportunistic headhunters are only too happy to provide them for the most talented.

Meanwhile, management loses focus on running the business day-to-day as its time and energies are sapped by negotiations, the analysis and the investor roadshow meetings.

Price is everything
Good negotiations are based on trust and successful deals can only be made between companies that have compatible cultures. Nevertheless, the most important thing is the price. In essence, the whole takeover exchange is a power struggle between one side that wants to force the price down and another that wants to force it up.

"Strictly speaking, if it's a cash offer, so long as you get a good price for your shareholders you've done your job," one Lloyd's CEO explained. Preliminary analysis and post-approach analysis will invariably centre on price. One corporate adviser said: "Advisers right from the beginning will be asking themselves: 'what's the killing zone?'" In the killing zone you have a price that is likely to result in a sale (or a kill).

Time and again the negotiations are compared to games of strategy. "There is an element of poker in it," one adviser told IQ while another said: "A lot of it's about momentum. It's a mega game of chess."

Price negotiations are undoubtedly an art. IQ was told that if a bidder enters with an offer of roughly 75 percent of the implied asking price they will typically end up having to pay more than a bidder that enters at 90 percent. That is one of the tricks on the buy-side.

On the sell-side it is an acknowledged truth that you
reject the first offer. Another nugget of sell-side wisdom is that due diligence is a favour that has to be bought. "Once you've opened the books at a price you're never going to get more than that," said a Lloyd's CEO involved in M&A negotiations last year.

Fairytale ending
Once negotiations reach the point where it seems that a sale of one sort or another is going to happen, there is another option open to the defensive side: they can cast themselves on the mercy of the 'white knight'. This is a mythical character who rides to the rescue of companies in the throes of unwanted takeovers at the hands of rapacious villains. And another reason to make the deal public on the sell-side is to flush out any potential white knights.

"Once it goes public it is likely that one or two white knights will appear out of the woodwork," according to one adviser. This process can also take place privately. In the latter case corporate advisers will work very much like headhunters, drawing up a list of suitable bidders and going to them to solicit an approach.

No hostility
The boards of the sell-side companies are more powerful in the insurance industry than elsewhere. Their trump card is their ability to withhold due diligence. There are businesses where M&A transactions can be carried through without due diligence but insurance is not one of them.

One corporate adviser said: "You have to get to a point of agreement. Insurance hostile takeovers do not happen. Ultimately you have to get an agreement because going hostile means you're not going to get access to the books. It's dangerous, you shouldn't do it."

Before you take over a Lloyd's insurer you need to spend a lengthy period poring over the target's books, decoding their arcana and talking to key staff about the dirtiest secrets. Employment contracts need to be examined, incurred but not reported examined and reserving placed under the microscope. Insurance companies - particularly specialty insurance companies - are complicated and opaque structures. Even with due diligence you can never be certain what you're buying, and without it you will have only the faintest idea.

Comparison of M&A deals to war is widespread among the professionals. However, perhaps because of the "hostility problem" in insurance, there is also a gentlemanly school of thought that holds that decency and trusting relationships are the secret of good deal making. "Trust is key. Make sure people like you. Go and see them and make them like you," one corporate adviser insisted. "It's exactly like courtship." There may not be advisers to suit every budget, but there are advisers to suit every inclination - sharks and gentlemen are both available.

Even when the two sides emerge from the struggle with an agreement, the M&A race is far from over. An agreement with the sell-side company's board is merely an agreement on its part to recommend the terms of a deal to its shareholders, which still need to give their approval.

For this reason, negotiations with the sell-side board will typically take place in tandem with discussions with the major shareholders. But even if a consensus has been reached on a sale price, it will take weeks and probably months for all of the necessary approvals to be collected.

And alongside this process - often retarding it, in fact - is the drawn-out struggle to get regulatory bodies to give the deal the green light.

'Zombie company'
Throughout this period the target is a "zombie company". The offeror is unable to get its hands on the takeout firm and so the latter continues to lurch around and ape the forms of a living company under a lame-duck management. Staff are unsure whether a deal will eventually go through and are in the dark on their future, and this inevitably disrupts their work. Underwriting and risk management become lax.

Staff always resign during this period, which is one of the reasons why M&A specialists often insist that two plus two in this business can equal three.

One corporate adviser told IQ: "Essentially you're buying a house that not only won't be maintained but where people will throw parties for six months before you get it."

Even this, though, is only the deal. Getting it done is important, but it merely gives the offeror the chance to exploit the opportunity that it saw before its approach. Afterwards, it has to find a way to realise the benefits that motivated the bid in the first place.

Takeovers are costly and disruptive exercises and they can only truly be said to have justified themselves if a success is made of the integration process. As such, it can be years before a big takeover can be judged a success or a failure.