Special Situation Investment...Demutualization
Ever since reading Joel Greenblatt’s You Can Be a Stock Market Genius several years ago I have been a huge fan of investing in spin-offs. From time to time if I’m trying to procrastinate, I’ll surf around the web looking for information on planned spin-offs. I found one today that has piqued my interest, but it’s a little different than the straight splits of public companies that I normal find.
The spin-off that I found is actually a planned IPO by a non-listed company. I’m normally not a huge fan of IPOs…with one big exception, conversions of mutual insurance companies to public corporations.
Such conversions often offer investors the opportunity for huge gains. I first became aware of this phenomenon while reading about the famous investor David Einhorn in the book Fooling Some of the People All of the Time. I need to dig my copy of the book out to find out exactly what he said, but in short Einhorn made a passing reference about how he loves investing in these situations.
When I read that money can be made on such conversions, I set about to figure out why. Here’s what I learned. Mutuals are insurance companies that are owned by policyholders rather than public shareholders. Insurance companies often start out as mutuals and decide that they want to go public in order to fuel future growth. The conversion process actually has a name…demutualization.
A few weeks ago I stumbled upon an article on this subject that contains a fantastic description of how the process works:
Mutual Conversions – A Secret Hiding Place of Stock Market Profits:
In order to understand why mutual conversions offer such an attractive area for uncovering inefficiently priced opportunities (and hence tend to be a secret hiding place of stock market profits), it is useful to quickly walk through the mechanics of a mutual conversion in order to more fully understand why this is so.
When a mutual insurance company converts, it goes from being owned by its policyholders to being owned by a holding company which, in turn, is owned by the general public. The conversion process usually starts with a subscription offering, through which the policyholders, employees, officers, and directors of the institution in question are given the right to buy shares, typically for $10 each, in the new holding company. If there are any shares remaining after the subscription offering (and often there are not) the remaining shares are usually then offered first to people in the local communities that the insurance company serves, and then to the general public.
The key aspect for investors to understand here is that not only do shareholders of the newly public company have a full claim on the IPO proceeds (as is typical), they also receive a claim on all the pre-conversion market value at no cost. Unlike any other type of initial public offering, in a mutual/thrift conversion there are no prior shareholders; all of the shares in the institution that will be outstanding after the offering are issued and sold on the conversion, so the entire existing value, as well as the cash raised in the recent IPO, will belong to the post- conversion shareholders. If you’re unfamiliar with mutual/thrift conversion, you may want to go ahead and re-read this paragraph one more time.
Again, the conversion proceeds are added to the pre-existing capital of the institution, which is indirectly handed to the new shareholders without cost to them. When describing the favorable arithmetic of thrift conversions and the reasons why investing in thrift conversions can offer such compelling investment opportunities for bargain hunting investors, Seth Klarman stated that “In a real sense, investors in a thrift conversion are buying their own money and getting the preexisting capital in the thrift for free.” Peter Lynch put it a little differently, once remarking that from the perspective of the IPO investor, this was equivalent to buying a house, moving in, and finding the seller had left the sale proceeds in the house for the buyer to keep. Indeed!
Source: The Penn Miller Holding Corporation – A Classic Low-Risk, High-Return Special Situation With A Turnaround Twist
Pretty cool, huh. OK, enough background info. Let's talk about the spin-off that I alluded to earlier. Liberty Mutual Group, the fifth largest property and casualty insurance company in the United States, recently announced that it plans to spin off 20% of its Liberty Mutual Agency subsidiary in a small, $100 million IPO.
Liberty Mutual Agency (LMA) is the second largest writer of property and casualty insurance through independent agencies in the United States, and the tenth largest writer of such policies in the country (based on 2008 data).
LMA offers a variety of commercial and personal property insurance to small and mid-size businesses and individuals. The company operates a small contract and commercial surety bond business (sort of like derivative or credit default swap bets in the form of insurance rather than an unregulated free-for-all) nationally.
In 2009, LMA wrote $10.1 billion in net premiums ($4.6 billion commercial / $4.7 billion personal) through around 13,000 independent agencies. Over the years LMA has grown significantly through acquisitions, including the its 2007 purchase of Safeco and its 2006 purchase of Ohio Casualty.
I suspect that LMA plans to grow by acquisition in the future as well. In its recently filed S-1, the company cited an interesting statistic. It said that the property and casualty insurance market is still very fragmented, with approximately 57% of the policies issued in 2008 being written by companies other than the industry’s top ten largest. LMA should be able to use the proceeds from its IPO to acquire some of the 550 smaller players in this segment, or to grow its business organically by stealing market share from smaller, less efficient operators.
LMA has been growing rapidly over the past several years, going from $4.4 billion in net written premiums in 2007 to $6.7 billion in 2008 and $10.1 billion in 2009. Like many companies, LMA reported a net loss in 2008, -$564 million. However, it was solidly profitable in 2009, reporting just over a billion dollars in net income.
While insurance premiums in general have been very soft lately, LMA has managed to improve its combined ratio (a measure of profitability for insurance companies, anything under 100% means that their underwriting activity is profitable) to 93.6% in 2009, from over 95% in both 2007 and 2008.
The transaction is under review by the SEC. Liberty Mutual expects the review process to be finished some time in the third quarter. The new Liberty Mutual Agency stock will trade under the ticker symbol LMA.
The question is:
As a partial spin-off rather than a full-fledged demutualization, does the Liberty Mutual Agency IPO still represent an excellent investment opportunity?
The answer is…I don’t know, but I’m trying to figure it out and I have several months to do so. Whether or not this is an attractive investment will probably become more apparent when additional details about the IPO are made public in the coming months. I’d love to hear others’ thoughts on this situation.