It probably did not come as a huge surprise to most observers that Watford Re’s stock market debut came at a discount to book value. This publication has not been alone in long predicting this outcome.
But the sheer magnitude of the discount at near 36 percent at one point was significant and likely gives pause to numerous privately held companies with comparable business models eyeing a potential liquidity event, as well as any would-be start-ups.
Given the well-publicised challenges of the first generation of hedge fund reinsurers, a public listing for Watford was always going to be an important test of investor demand for the second generation of total return vehicles.
In many ways, the Watford model was put together in response to the explicit concern from both rating agencies and investors that hedge fund reinsurers were not viable due to their challenges in reliably accessing quality business in an over capitalized market.
One solution at the first generation was to pay up for name recognition among its underwriting talent, notably at Third Point Re which hired well-regarded former Chubb executive John Berger as its CEO and figure head.
With the rating agencies acting as de facto gatekeepers to the sector, the solution from the new generation like Watford was to address the access-to-business problem by partnering with a carrier rather than competing against them.
Given the superior investment returns, in theory the firms should be able to engineer a true win-win scenario by expanding the pie of earnings and splitting the synergies in some negotiated form, albeit at the cost of more risk.
There is much to be said for this view. However, the new model is not without its own complications.
The first, and easiest to manage, is the potential for conflicts of interest. The partnership model only works in so much as the access to business does not come at the discretion of the underwriting manager. In this scenario, the manager could select against its partner and send its lower-quality business to the fund. This can be managed by various alignment of interest mechanisms.
The second, however, is more complicated. Though the partnership model solves the access to business in the short run, in the long run it is simply swapping one problem for another. That is, that the hedge fund reinsurer becomes entirely dependent on its carrier partner.
This dependency can be solved to some degree with long-term contracts that at least give certainty from a business planning perspective. In the case of Watford, the underwriting partnership with Arch covers five years with a two-year cancellation notice.
However, this is extremely difficult for equity investors to value. Beyond an investor's view on real book value, any premium paid above this is essentially valuing the cash flows generated by the underwriting partnership – and, perhaps, the potential for third-party business eventually.
This is because an investor can theoretically access the same investment portfolio directly using comparable financial leverage to engineer the same results. This is problematic for three reasons.
First, in any fundamental valuation approach that relies on discounting cash flows, most of the value comes not from the forecasted period’s cash flows but in the terminal value – typically estimated as a perpetuity with a stable growth rate.
For investors, it is tough to value cash flows that largely rely on a single contract that could be cancelled at the discretion of a counterparty. However long you think you can forecast out the relationship, at some point you have to assume the relationship will end. You simply never own the customer or the associated cash flows.
This doesn't lend well to a perpetuity model with stable growth.
The second is a rare “term of trades” issue in favour of the reinsurance market. There is only a finite number of highly regarded reinsurance carriers versus a high number of funds that would likely be interested in partnering with someone like an Arch. This gives the underwriting manager leverage to periodically re-negotiate contracts to their advantage that puts a cap on potential upside to the funds.
Finally, the current challenges at Maiden – arguably the closest public comparable due to its dependence on it original sponsor company AmTrust Financial – shows the risk of an undiversified reinsurer relying on just one cedant.
Put simply, the new hedge fund re model substitutes uncertainty on the quality of business for uncertainty for the duration of the access to business. And though there may well be value creation in the model, it is just hard to price a finite contract and option to periodically renew as a perpetual equity security.
As such, Watford’s lacklustre debut should come as no small surprise, and will likely act as a handbrake on new capital formation for similar vehicles that rely on private equity money and a financial model that assumes listing at a premium.