Tower Group: An Arbitrage Opportunity With A Potential Annualized Return Over 100%
May. 7, 2014 8:48 AM ET
Disclosure: I am long TWGP. (More...)
Summary
Tower Group currently trades at a 26% Discount to the $3 Takeover Price.
Merger with ACP Re, an affiliate of AmTrust Financial, is Expected to be Completed by mid-September 2014.
If the Merger is Completed at $3 as per the Merger Agreement, the Annualized Return is in Excess of 100%.
Tower Group (TWGP) represents an interesting arbitrage opportunity for brave investors. The company is set to be taken over by ACP Re, an affiliate of AmTrust Financial (AFSI), at $3 per share in cash. However, TWGP trades at only $2.23 per share as of the close of business on May 6, 2014. The spread is thus a whopping $0.77, or nearly 35% of the current market price. Assuming that TWGP would be worthless if the merger fails, the market is assuming only a 74% chance that the merger will be completed at $3. This appears to be too low, as further discussed below.
The amended preliminary proxy statement for the merger was filed a month ago and can be found here. On page 2 of the proxy, we learn that TWGP expects the merger to be completed during Q3 of 2014 (or between July 1, 2014 and September 30, 2014). In addition, the proxy notes that TWGP has $150.0 million principal amount of 5.0% convertible senior notes that mature on September 15, 2014. Thus, we can safely assume that the merger must be completed ahead of that date. This indicates a maximum holding period, if the merger is completed as scheduled, of approximately 4 months.
Market Seems Excessively Skeptical of the Merger's Completion
Based on TWGP's current stock price, the market appears quite skeptical that ACP will actually go through with the merger at the agreed-upon $3 per share. This seems too pessimistic, however, for the following reasons:
AFSI's management recently stated on their Q1 2014 earnings call that they were pleased with the performance of the Tower reinsurance lines and expect to close the Tower transaction during the summer of 2014: "[The] Tower transaction is progressing and is already contributing to our first quarter results. The cut-through reinsurance agreement we entered into at the beginning of this year with Tower International generated significant gross written premiums in the small commercial business segment. The agreement also contributed to operating earnings in the quarter. We look forward to closing this transaction in the summer of '14."
As explained here, the Tower deal is expected to be highly accretive to ACP, AFSI and their affiliates going forward; hence, they do not appear to have a financial incentive to back out of the deal
TWGP's stock price has recently been negatively affected by a downgrade by Keefe Bruyette, dropping over 8% on May 6, the date of the downgrade; however, one analyst's opinion has no bearing on whether the merger will go through or not
The trading volume since the issuance of TWGP's 10-K has not been materially higher than normal (1.25MM/day versus 3-month run rate of ~1MM), indicating that large holders are not liquidating their stock; as of May 6, only about 4% of the outstanding shares have turned over since the 10-K filing
The various deficiencies in statutory capital as of December 31, 2013 referenced in TWGP's 10-K filing with respect to its insurance subsidiaries either have already been remedied through the January 2014 reinsurance agreements executed with AFSI and its affiliates in connection with the merger agreement or are expected to be remedied upon TWGP's merger with and into ACP. Therefore, TWGP's insurance regulators do not have an incentive to put these subsidiaries into receivership, since the existing capital deficiencies are expected to be addressed within a relatively short time period (i.e., by September 15, 2014)
TWGP's recent price action may, at least partially, be the result of speculators attempting to drive the stock price down in order to profit from bearish option contracts. For example, there is a large open interest in $2 put contracts, which expire on May 17, 2014. This negative pressure on TWGP's stock price would likely be relieved by the May options expiration date, which is next Friday.
TWGP's Reserves Continue to be a Black Cloud over the Merger
On the flip side, TWGP has clearly experienced massive negative reserving issues over the past 4 quarters. For example, p. 17 of the 2013 10-K reveals that TWGP had to increase its reserves for insured events of prior years by over $538MM during 2013. Yet TWGP's reserving issues were well documented at the time ACP entered into the merger agreement with the company (indeed, TWGP was forced into the deal precisely because of the reserving problems; had it not found a buyer, it would have likely gone bankrupt).
The market apparently believes that ACP may either terminate the merger or renegotiate the merger price because of TWGP's reserving issues. In order for ACP to terminate the merger agreement, it would need to show that there had occurred a "Material Adverse Event" (MAE) with respect to TWGP (see Section 6.02(d) of the merger agreement). The definition of an MAE in the merger agreement is as follows:
"Material Adverse Effect" means any effect, change, event or occurrence that, individually or in the aggregate with all other effects, changes, events or occurrences, has a material adverse effect on the business, results of operations or financial condition of the Company and its Subsidiaries taken as a whole; provided, that none of the following, and no effect, change, event or occurrence arising out of, or resulting from, the following, shall constitute or be taken into account, individually or in the aggregate, in determining whether a Material Adverse Effect has occurred or may occur except, with respect to items i, ii, v and viii, to the extent such item has a disproportionate effect on the Company or any of its Subsidiaries as compared to the companies listed in the most recent proxy statement filed by the Company with the SEC prior to the date hereof as the Company's "peer group": *i* any effect, change, event or occurrence that results from or arises in connection with changes or conditions generally affecting the property catastrophe insurance industry in the geographic regions in which the Company and its Subsidiaries operate or underwrite insurance, including natural disasters and catastrophe events, *ii* general economic or regulatory, legislative or political conditions or securities, credit, financial or other capital markets conditions in any jurisdiction, *iii* any change or announcement of a potential change, in and of itself, in the Company's or any of its Subsidiaries' credit, financial strength or claims paying ratings or such ratings of any of the Company's or its Subsidiaries' businesses, *iv* any failure, in and of itself, by the Company to meet any internal or published projections, forecasts, estimates or predictions in respect of revenues, earnings or other financial or operating metrics for any period, *v* geopolitical conditions, the outbreak or escalation of hostilities, any acts of war (whether or not declared), sabotage, terrorism or man-made disaster, or any escalation or worsening of any such hostilities, acts of war (whether or not declared), sabotage, terrorism or man-made disaster, *vi* the execution and delivery of this Agreement or the public announcement or pendency of the Transactions and the Related Transactions, including the impact thereof on the relationships of the Company or any of its Subsidiaries with employees, labor unions, customers, brokers, agents, financing sources, business partners, regulators or reinsurance providers, and including any lawsuit, action or other proceeding with respect to the Transactions, *vii* any change, in and of itself, in the market price or trading volume of the Company's or any of its Subsidiaries' securities, *viii* any change in applicable Law, regulation, GAAP (or authoritative interpretation thereof) or in Applicable SAP, including accounting and financial reporting pronouncements by the SEC and the Financial Accounting Standards Board, *ix* any action required to be taken by the Company, or that the Company is required to cause one of its Subsidiaries to take, pursuant to, or any failure of the Company or any of its Subsidiaries to take an action prohibited by, the terms of this Agreement or the Quota Share Reinsurance Agreements, *x* the cancellation or termination of any policies or contracts of insurance written by any of the Company Insurance Subsidiaries, the termination or commutation of any reinsurance assumed by any Company Insurance Subsidiary or the failure of any Company Insurance Subsidiary, or all of them, to write or renew any insurance or reinsurance business or *xi* any failure by the Company to file or furnish any report, schedule, form, statement or other document or information required to be filed by the Company with, or furnished by the Company to, the SEC; provided, however, that with respect to clauses iii, iv, vii and ix, the underlying reasons for *w* the change or announcement of potential change in the Company's or any of its Subsidiaries' credit, financial strength or claim paying ratings or such ratings of any of the Company's or its Subsidiaries' businesses, *x* the failure to meet such projections, forecasts, estimates or predictions in respect of revenues, earnings or other financial or operating metrics, *y* the change in the market price or trading volume of Company's or any of its Subsidiaries' securities or *z* the failure by the Company to file or furnish any report, schedule, form, statement or other document or information required to be filed by the Company with, or furnished by the Company to, the SEC, may be considered.
Has an MAE occurred with respect to TWGP since the signing of the merger agreement in January 2014? First, neither ACP re nor AmTrust apparently had any issues with the reserves or financials set forth in TWGP's Q3 2013 10-Q filing (filed on February 12, 2014), since ACP issued this press release at the time and AFSI only one week ago reiterated that the merger is expected to close in the summer of 2014. Second, on AFSI's Q1 2014 earnings conference call, the following exchange occurred, indicating that ACP and AFSI likely were aware of TWGP's 2013 year-end reserve levels prior to the filing of TWGP's 10-K several days later:
Ken Billingsley - Compass Point
And then since you'll be administrating the run off, in the past you said you were aware of Tower Group's third quarter '13 reserve increase. I would imagine you're still working on behalf of ACP Re right now looking at Tower Group's current reserve rate.
Barry Zyskind - President & CEO
Yes.
TWGP's Q3 10-Q stated that "ncurred losses and [loss adjustment expense] attributable to insured events of prior years were $483.6 million for the nine months ended September 30, 2013." As noted above, this figure was revised higher to $538.1MM in the 2013 10-K, representing an increase of $54.5MM quarter over quarter. Even if ACP and AFSI were unaware as of May 2nd that this additional reserve strengthening was forthcoming from TWGP (which seems unlikely, in light of Barry Zyskind's statement above), it hardly seems to constitute an MAE worth blowing up the deal over.
Possibility of Deal Repricing
It should also be noted that TWGP's 10-K included language, which did not appear in TWGP's Q3 10-Q, that there can be no assurance that the merger with ACP "will close under the same terms and conditions contained in the ACP Re Merger Agreement." One could interpret this as hinting that a reduction in the merger consideration may be in the cards. However, if ACP and TWGP were to agree on a $0.50 reduction in the merger consideration (from $3 to $2.50), for example, ACP would save less than $30MM, based on the 57MM shares outstanding per TWGP's 10-K. Any reduction in the consideration would also likely give rise to lawsuits by disgruntled TWGP shareholders, additional votes against the deal by such shareholders and/or a higher number of TWGP shareholders dissenting from the deal (one of the conditions to closing is that less than 15% of TWGP's shareholders are dissenting). In light of the fact that the current market cap of AFSI is in excess of $3.2B, it would seem unlikely that ACP and AFSI would risk forfeiting a profitable deal over such a comparatively small amount (less than 1% of AFSI's market cap).
Expected Value for TWGP
Even if one is highly pessimistic and assumes a 40% chance that the ACP / TWGP deal gets repriced at $2.50, a 20% chance that the deal collapses altogether (wiping out TWGP shareholders) and only a 40% chance that the deal goes through at the contracted price of $3, the expected value for TWGP stock is still $2.20 (.40 X $2.50 plus .40 X $3). This would seem to be the floor for TWGP.
If one takes a slightly less pessimistic view and assumes a 20% chance that the deal gets repriced at $2.50, a 10% chance that the deal collapses altogether and a 70% chance that the deal goes through at $3, the expected value for TWGP stock is $2.60 (.40 X $2.50 plus .40 X $3).
For the reasons described above, my view remains that the transaction will be completed at $3 during the summer of 2014. If that is the case, TWGP shareholders will earn annualized returns in excess of 100% from the stock price of $2.23 as of May 6th. Obviously, nothing is guaranteed in the stock market; deals can and do fall apart or reprice lower from time to time. At its current depressed price, however, TWGP appears to present a compelling risk/reward scenario for the brave investor.
