Arch-Watford: The sweet relief of a miserable ending?

On Friday last week, Watford Re announced it had reached a definitive agreement to sell itself to sponsor company Arch for $31.10 a share.

The news comes after a period of bid speculation, with at least one confirmed public bidder – Enstar – asking for the company to engage and disclosing an indicative offer of $31, and at least one more reported as having been privately rebuffed.

Now, there are plenty of reasons one could argue why this particular outcome may be preferable to Watford’s investors than continued uncertainty. The Watford and Arch release points to a 74% gain for shareholders from the undisturbed share price on 8 September before bid speculation began in earnest. The companies’ release also highlights the “speed of execution” relating to due diligence from a known counterparty.

This is all well and good. But ultimately, the deal will need to be approved by a majority of Watford’s shareholders. Though Arch and its executives own around 15% of the company, that advantage may be mostly balanced out by the 9.1% ownership of Enstar (which is unlikely to enjoy being given the public run-around) and 2.5% of Capital Returns (which has already expressed dissatisfaction with both the process and the price). Notably, Arch did not announce any other indicative support from other major shareholders that is common in these type of predictably contested affairs.

There is an old German saying that that goes something like: ”A miserable end is better than misery without end”.

This may ultimately be the calculus facing Watford’s longest tenured shareholders who invested in the company at $40 a share back in 2014, and will be forced to crystalize a miserable ending in the form of a permanent loss on capital if the deal closes – an underperformance to the S&P500 during the same period of ~135%.

Now, there are plenty of reasonable things you can say in support of the deal, as noted above. Additionally, any criticism of Arch needs to be tempered against the extra-contractual support it has provided to the company without explicit payment since its foundation, including various operating costs, implicit ratings support, and explicit back-stopping of its debt and preferred shares offerings.

Arch has also consistently disclosed the control-nature of its relationship with Watford to minority investors, explicitly designing the contracts governing the relationship to be bullet-proof, and has clearly meant for the company to be inseparable from Arch from an operating perspective. Indeed, it is worth remembering that Arch consolidates Watford's results.

That said, there are several points worth making against the deal.

First, the offer price is strange. And whatever the intent, it comes across as bad optics at the least.

It is honestly hard to understand what on earth led the company to take the public indicative offer from Enstar, add a dime, and announce a definitive deal. Perhaps the proxy will eventually provide more detail that justifies this, but the optics look pretty bad at face value. This is the corporate M&A equivalent to bidding a penny more than your competitor on The Price Is Right after they’ve guessed. Even if well-intentioned, it risks seeming like petty point settling more aimed at Enstar than paying independently-sourced fair value to long suffering shareholders and partners.

Additionally, it should be noted that Enstar explicitly stated it may be able to increase its offer following due diligence. One can reasonably debate whether you think this is likely or not, but it should mean that putting ten cents on top of their indicative offer should not be seen as superior to any available best and final offer.

Second, it is not at all obvious why Watford’s shareholders need “certainty” with any urgency.

Arch and Watford can make lots of credible arguments about why the deal with Arch represents the best deal for shareholders. For example, the Watford board may view an Enstar approach as non-credible given its inside knowledge of its illiquid investments, iron-clad service contracts, and other factors that complicate a run-off by a third party. It can also point to the speed of any due diligence with Arch given they are known quantities to each other, and the relatively low execution risk.

That said, it’s not at all clear that Watford’s shareholders are in any urgent need of certainty, nor does there seem to be any trigger that makes a rapid deal preferable to taking a few extra months to run a transparent auction including all interested parties.

One could argue that Watford may miss out on underwriting deals while its ownership remains uncertain, but given its value-destroying track record of underwriting results, this should be welcomed by investors as a way to free-up capital for a higher return strategy of buybacks.

Indeed, it is curious language, as from the outside at least it seems the party most likely to be worried about certainty is Arch in terms of its communications with its trading partners.

Without any urgency on a need for certainty or “speed of execution”, it is hard to understand why the board has not engaged with other interested parties to at least solicit other offers to maximize the price paid to shareholders.

Indeed, it is hard for anyone to argue any offer represents fair value – let alone the best possible deal – when refusing to even go through the process of soliciting bids from avowedly interested buyers. And if it really is a fair value price, a transparent and inclusive M&A auction would have proved this point.

The fact someone chooses not to do so typically says more about what they really think fair value is than the offer price does – regardless of what they can pay a banker to sign off on in a proxy.

Third, this should be a red flag for corporate governance in Bermuda more broadly.

Another point worth noting is what the state of play at Watford says about corporate governance issues in Bermuda and what this should imply for equity valuations.

Watford’s board has a strong defense for its actions in the fact that under Bermuda law it does not have to simply maximize the price paid but do what is in the best interest of the company – including multiple stakeholders.

Furthermore, Bermuda firms’ constitutional documents and by-laws typically include extensive anti-takeover protections favorable to incumbent management. These include staggered boards, board power to issue ‘blank cheque’ preference shares, supermajority shareholder approval requirements for amending governing documents, shareholders’ inability to act by written consent, advance notice of shareholder resolutions, etc.

Perhaps for these reasons, hostile bids are rare in Bermuda. Some of the notable exceptions include Validus’ offer for IPC Re in 2010 through a variety of transaction structures offered, Endurance for Aspen in 2014, and Exor for PartnerRe in 2015.

Many of these are present in Watford, but have been consistently disclosed to informed investors.

In the Watford case, Arch’s position is further strengthened under Bermuda law by the fact that its two appointed directors on the Watford board can participate in the meeting and vote despite having interest in the proposed transaction.

Nevertheless, if Watford’s board can hang its hat on corporate governance laws in Bermuda to not worry about maximizing shareholder value when running the company, this is a powerful argument that investors in the sector in general should be wary of Bermuda-based companies and apply a valuation discount relative to US-peers. Though Bermuda-based Arch is not exactly seen as a likely M&A target, there is still a strange aspect of shooting oneself in the foot from an optics perspective.

Finally it should be noted that this miserable ending for Watford’s long-term shareholders represents a significant gain to Arch’s.

A final point is worth making. Arch can make pretty solid arguments that Watford has been explicitly designed to be inseparable from its sponsor company.

For all the noise around activism and run-off, this is really just the inevitable conclusion once it was put into play (albeit at an unknown price). It is also understandable that Arch’s board and management may well feel aggrieved at being forced to do this, and to want to defend its own equity investors against having excess value extracted from a situation where Enstar tries to take Watford “hostage” and shame the company into paying a price beyond fair value to protect its trading partners.

But whatever justifications you can make, one cannot get away from the very simple fact that long term third party investors in Watford have done terribly while Arch has done very well. On the one hand, Watford has been near the very bottom of the P&C universe in terms of value creation (even excluding valuation issues)…

…And on the other hand, regardless of this performance, Arch has consistently extracted a stream of fee income that entirely pays back its initial investment on a gross basis. Combined with the ~$150mn gain on bargain purchase anticipated, the company could have generated a ~20% CAGR on its $100mn investment in 2014 (excluding prefs and debt).

Now, the illustrative example above is hypothetical and extreme. The actual result net of costs associated with the fees bring this down somewhat, and the relative expense burdens in the ceding commissions complicate this picture and make a precise answer unknowable. Similarly, any third-party money used in this transaction will dilute the final gain. And the return on debt and prefs would lower the overall RoI.

However, it is clear that Arch has done considerably better than its investor-partners, and indeed likely better than any other available investment opportunity it had in 2014 at the beginning of the soft market.

Now it is reasonable to note that Watford’s performance could very well have been different had underwriting results not been linked to some of the worst years in recent history. Even then, it is fair comment to note the company has outperformed even some traditional (re)insurance peers in some years. Furthermore, investment returns more in line with expectations would have presented very different results to long-term investors.

However, whatever portion of “bad luck” is attributed to the timing of the investment, it is worth noting the sponsor company did not share in this misfortune. This should serve as a reminder that these type of “soft-market plays” are explicitly designed to arbitrage naïve capital further from the risk. Indeed, if this was not so, and this was an optimum pairing of risk and capital, companies could easily manufacture it on their own balance sheets. Arch’s “heads I win, tails you lose” outcome with Watford should serve as a stark reminder that alignment of interest does not come from a modest amount of skin in the game, but a weighing of the competing and conflicting interests.

Now there is nothing wrong with any of this this per se. That’s capitalism. And there are plenty of well-respected and high returning companies out there with a reputation for ruthlessness – ironically Enstar is one of them!

That said, this type of approach can come with an implicit cost in reputation that can lead to explicit costs over time, including through cost of capital, ability to raise more third-party funds, and levels of trust with existing and potential trading partners. Indeed, part of the reason run-off companies like Enstar can be more sharp-elbowed with trading partners is that they tend to be involved in more “one-shot games” from a game theory perspective rather than “repeated games” like live companies.

Warren Buffett has famously said companies get the shareholders they deserve based on how they treat their stakeholders and run the business. Arguably, the same applies for third-party capital providers and joint venture partners. The key question for Arch is whether the reputation hit in the near term is worth the implicit costs – if any – that emerge over time relating to its treatment of its investor-partners in Watford.