A month ago it might have seemed ludicrous to speculate about when the Class of 2005 would go public. But with Flagstone's IPO bid and others rumoured to be seeding the pipeline, this group of start-ups is bucking the trend, discovers Helen Yates.
Could the Class of 2005 really defy convention and produce a rash of initial public offerings (IPOs) in 2007? "Do I think there will be IPOs next year?" asks Mark Hvidsten, CEO of Willis Analytics and Solutions. "I'm absolutely sure that IPOs will be considered by a number of the Class of 2005 start-ups." Flagstone Re's filing with the Securities and Exchange Commission on 25 October for a $175m IPO certainly adds weight to that prediction.
It is shaping up to be a fruitful year for the Bermuda-based start-ups, which came into being a year ago following the most dramatic North Atlantic storm season to date, with Hurricanes Katrina, Rita and Wilma costing the industry in excess of $56.5bn (according to ISO's Property Claim Services). While existing reinsurers' balance sheets took a hammering a new wave of start-up reinsurers, raising $7bn in new capital, joined the fray hoping to profit from significant rate hikes on wind-exposed lines.
One year on, with a benign hurricane season now coming to an end, the start-ups are likely to be reaping the rewards in their first year of trading. While this is certainly satisfying beginnings, one year of successful trading does not constitute the three to five years typically taken for a reinsurance company to reach the IPO stage in its lifecycle. Yet many industry observers are anticipating public listings as early as 2007. "It wouldn't surprise me if more IPO announcements are made next year," confirms Andrew Green, a partner at Mazars.
Breaking the mould
Looking back to previous waves of start-ups in Bermuda - those that set-up following Hurricane Andrew in 1993 and the Class of 2001 - the time taken between inception and public listing does seem to be getting shorter. "The Class of 2001 certainly went public quicker than the Class of 1993," recalls Fitch Ratings senior director Mark Rouck. "And with the Class of 2001 there tended to be fewer acquisitions of those companies than the Class of 1993. I think that was partially a result of market conditions." While there are numerous dynamics at play that will influence when the Class of 2005 goes public, one notable difference between this class and previous generations of start-ups is its investor base.
Backing the Class of 2005 to varying degrees are hedge funds and private equity investors. Hedge funds, often described as opportunistic and highly liquid investment vehicles, are a relatively new source of reinsurance capital and are the most obvious distinction between the 2005 start-ups and those that went before. Hedge fund investments in the insurance and reinsurance industry have grown rapidly as the asset class has sought uncorrelated investments in this arena.
Consultant Andrew Barile worked on the first public offering of a Bermudian reinsurer in 1978 and has since been involved in numerous others. He sees an altogether different beast in hedge fund-backed reinsurance companies. "Five years is what it typically takes to IPO - that was the traditional approach and what I learned when I went to business school," he explains. "These people (the hedge funds) are not traditionalists."
Barile believes hedge fund investors have a shorter-term horizon than traditional private equity investors and that many will have prearranged their exit strategies. Whether this means they could exert pressure on the start-ups to go public at a set time is questionable. But with one hurricane season under their belts, some comfortable profits and a ripe IPO market, Hvidsten thinks market conditions could cause some coercion. "There must be at least a temptation to try and monetise this," he says. "If you're an investor with a relatively short time horizon I could understand why there might be a more vociferous pressure for (going public) than the previous rounds of start-ups."
Despite their shorter-term nature, the hedge funds that choose to put their money in start-ups aren't expecting to walk away after six months, argues Rouck. He believes they are behaving more like private equity investors and understand it takes time for a start-up to establish a track record. Andrew Green agrees and points out there are plenty of other options for hedge funds that don't want the time commitment. "If they wanted a shorter investment they probably would have invested in existing reinsurance entities, special purpose vehicles or cat bonds," he says. "It's a longer-term commitment going into a start-up than a sidecar, for example." He believes it's more a case of assuming the investors are rational and aren't going to sell out prematurely.
Of course there is a question mark over the long-term performance of hedge funds themselves as an asset class. And there have been some well-documented problems - the collapse of Amaranth for example, a hedge fund which lost a massive $6bn in September after betting on oil futures and is now liquidating its assets. In the event that any of the Class of 2005 investors took such a hit their outlook could change very suddenly. "Suppose you were unlucky enough to take hedge fund money and every one you picked was in trouble," suggests Barile. "Then you've got to be pretty active as a CEO."
Green believes market conditions will be a much greater influence on when the Class of 2005 choose to IPO than any pressure they might be receiving from their backers. In order for any company to undergo a successful listing it is essential to get the timing right. "At the moment the capital markets are quite buoyant and there's a lot of activity, so the opportunities are there - but they can also go quite quickly," he warns.
With the equity markets at an all-time high and the success of the Allied World Assurance Company (AWAC) public offering still fresh in the market's mind, it is undeniably a good time to list on the major exchanges (most Bermuda reinsurers list on the New York Stock Exchange). AWAC, the last of its Class of 2001 contemporaries to go public, enjoyed a good reception when it listed 8.8 million shares on the NYSE in July this year. This was followed by the company exercising its full over-allotment option to purchase an additional 1.32 million shares, bringing gross proceeds from the launch to $344m.
But it is not just the state of the equity markets that will drive a reinsurer's tactical decision to IPO. The reinsurance cycle is another a key factor. While the upside of a benign hurricane season is a welcome opportunity to post some solid profits in year one of trading, the flip side is the increased likelihood of downward pressure on rates moving into 2007. With price increases of over 100% this year on some lines - notably retrocession and Gulf of Mexico energy - this year's calm storm season is predicted to have a stabilising effect on premium rates. And if they are expected to come down, reinsurers might seek to go public sooner rather than later.
Next year's storm season will be pivotal says Rouck. "If hurricane activity is benign this year and next year, and premium rates start to drop off in 2007 and 2008 as we think they will, current investors in these entities might accelerate their attempts to IPO." Of course, there are no certainties in reinsurance and next year it could all look very different.
The consensus is that we are in a heightened period of hurricane activity and should expect to see more hurricanes like Katrina and her sisters making landfall in years to come. With the experts predicting a period of more frequent and intense storms, forecasts that are reflected in this year's recalibrated catastrophe models, last year's record-breaking storm season could become the norm. In addition, the rating agencies have introduced more stringent capital requirements to reflect these greater exposures, all of which increases the pricing of these risks.
Against this backdrop it does seem strange that the new start-ups might not be required to weather at least a couple more hurricane seasons before going public. "What is surprising is that with a business that has significant volatility attached to it investors aren't keener to see more of a track record before piling in," comments Hvidsten. He notes that not only are investors seemingly more willing to waive the traditional track record requirement, there is also a general trend of capital recycling itself quicker. "Capital is a lot more fungible nowadays - it flows more easily and takes different forms more easily," says Hvidsten. "That suggests that, all other things being equal, it should speed up the start-up to IPO part of a company's lifecycle."
Watch this space
While it is anyone's guess which start-ups could follow Flagstone's lead, the rumours are that at least one of its classmates is also considering a public offering. But not all reinsurers are created equal. The post-Katrina start-ups vary significantly in size and some of the larger entities have a wide range of initial investors (see table 1). Of course, four of the Class of 2005 are already listed - Amlin Bermuda, Hiscox Insurance and Omega Specialty, by nature of their parent's listings, and Lancashire, which launched its IPO on the AIM market in December 2005.
Arguably, those more likely to consider the IPO route at this point will be those backed by the more experienced management teams. Start-ups such as Ariel Re and Validus backed by industry veterans Don Kramer and Jeff Greenberg respectively. It is perhaps unsurprising that Flagstone, with hedge fund firm West End Capital Management as its lead investor, is ready to test the IPO waters. Barile sees others dipping their toes in next year as a matter of course. "I wouldn't want to be in a position where the hedge fund owner calls me up and says 'you told me you were going to get me out after one year and you haven't done anything yet'," he explains. "If I were the strategists, the consultants and the owner of that company my philosophy would be: 'let's start exploring it anyway, it doesn't cost us anything but our time to start looking at the IPO market'."
It's worth bearing in mind that going public isn't the only strategy available. As was the case with previous start-ups, the M&A route could be another popular direction to take and if the price of shell companies is anything to go by this could already be on the radar. Noting recent price rises in this area Barile suggests that "some Bermudian companies might already be in the market trying to buy US shell companies in order to diversify in the same way Ken LeStrange did with Endurance." But he emphasises that each company will have its own strategy. "Some will go straight to the investment banking firm and do the IPO, get all the hedge funds' money out. Another approach - like ACE and XL - will be to go and buy a big publicly-held insurance group in the US and expand that way. Others may go overseas. Another - believe it or not - could sell to Munich Re." Just remember - you heard it here first.
- Helen Yates is editor of Global Reinsurance.
WHAT IS AN INITIAL PUBLIC OFFERING?
An initial public offering (IPO) is the process through which a privately held company issues shares of stock to the public for the first time. Going public transforms a business from a privately owned and operated entity into one that is owned by public stockholders. The decision to go public is sometimes influenced by initial investors who wish to cash in on their early investment.
Advantages to going public:
- Financial - access to capital that does not have to be repaid, a potentially higher valuation, increased net worth of the company, future access to capital through equity or debt financing, great ability to enter into mergers and acquisitions because stock can be offered rather than cash, enhanced liquidity; and
- Public image - increases credibility and exposure, increased ability to attract and retain employees through equity incentives.
Disadvantages to going public:
- Financial - compliance with reporting requirements will increase costs;
- Control - loss of flexibility and control for management;
- Disclosure - financial statement disclosure and audit requirements will apply, stock exchanges will require public disclosure of significant events, and filings will reveal information about the company that would not otherwise be available. Overall the company will be subject to much greater scrutiny; and
- Market pressure - there may be a temptation to focus too much on short-term results to maintain stock prices.