If you were in Manhattan in the 2000’s, you might remember seeing a few gents walking around with the initials DBZ inscribed on their briefcase. At the time, those initials were revered. Today, the initials have almost completely been forgotten, as has the firm they represented. D.B Zwirn & Co. shut its doors in early 2008. For anyone in the Hedge fund space, this might sound familiar.
D.B. Zwirn & Co. was founded by Dan Zwirn in 2001 and by the time the Great Financial Crisis came round (late 2007), the firm had amassed $6 billion in shareholder capital and a portfolio of $12 billion in assets. DBZ chased illiquidity and mostly played around in credit (debt and lending). The theory being that the more esoteric and/or illiquid something was, the higher the payoff was likely to be. Illiquidity doesn’t exactly mean higher risk, though if your capital gets called, it can kill you (like it did DBZ). For a quick example, if I lend $200k to my neighbor who’s building some townhomes, that money would be considered illiquid. Once my neighbor has started construction, I can’t recall my $200k. The money is off being productive – deployed toward labor, land, and materials. If my neighbor is an honest guy, has presold a number of the homes, is building the homes are in a good area, and I lent him the money via a first lien at a 60% LTV, it’s probably not incredibly risky. In fact, it sounds good…that is unless the money I lent him isn’t actually mine. That’s the problem with a hedge fund chasing illiquidity. Hedge funds have other people’s money and then deploy that money to investments. If those other people suddenly need or want their money…watch out.
Dan Zwirn is (or was) a very talented (or lucky) fund manager. Zwirn generated 49 consecutive months of positive returns. 2003 – 2007 returns were 22%, 22%, 19%, 24%, and 16%. Good returns in good times. We don’t know how Zwirn might do in times of stress – or equally important, how his investors might behave when everything around them isn’t lollipops and rainbows (as all financial assets were during DBZ’s existence). We don’t know this because in February of 2008 the fund closed up shop. The reason apparently lies in the fact that, sometime in 2007, the Federales came knocking with some questions about a Gulfstream IV the firm purchased in 2005. Honestly, what 30 something-year-old self-respecting man with massive hedge fund wouldn’t buy a jet? Fast forward through investigations and waterboardings and it turned out that it was the company’s CFO who borrowed some money from the hedge fund to buy the Jet. You can imagine what happened next. The SEC swat team came down on the fund, there was a run on the bank, and investors withdrew money as fast as possible. Then, of course, the fund closed its doors. Dan Zwirn was eventually cleared of all wrongdoing by the SEC in 2011, but it was far too late. The DBZ briefcases around Manhattan were no more.
The SEC did focus their eventual attention on the CFO where it turned out he had, among other things, borrowed money from the hedge fund for a short period of time without disclosing his short-term financing method to his partners. You can read more about the mess here. Zwirn found out about the problem, self-reported it, but the Federales didn’t care.
Long story short is Zwirn is back. And this time, he’s created a fund structure that’s safe from redemptions. But how in the world would Wall Street again trust such a screwup? Well, they haven’t…yet. Someone else has.
Westaim has a storied history, though most of it doesn’t matter to today’s investor. In short, it was a spin-off of a spin-off that eventually liquidated all its vintage holdings. The part of Westaim we care about began in the depths of the financial crisis when a Canadian investment firm, Goodwood, took control of the business. Goodwood’s CEO, Cam MacDonald, became Westaim’s CEO. At this point (2009), Westaim had about $40m in cash and nothing else. Goodwood was simply using it as a platform to make future investments and “create value”.
In early 2010, Westaim raised $275m in equity at $25/share and acquired a specialty insurer called JEVCO for just shy of its book value. In May of 2012, Westaim sold JEVCO for $530 million, or just about 140% of book value. To its shareholders, Westaim then paid out a giant dividend of $37.50/share and retained about $2.50/share – again rendering Westaim a cash shell. I nice, quick win for all involved.
A quick tangent on book value. First, why should something be worth book value? We often hear that as a justification for value. Just because we take all a company’s assets then subtract all its liabilities, doesn’t mean that’s what the business is worth. What if a lot of those assets are intangibles like goodwill? Even worse, what if those assets are held at an inflated value needing a write-down? Or what if those assets are unproductive? This is where return on equity (ROE) comes in. Equity is the same thing as book value. All assets less all liabilities = book value a.k.a. shareholders equity.
If a business has total assets of $1 million dollars and total liabilities of $500k, it’s book value or shareholders equity is $500k. That doesn’t tell us much. When we refer to something’s selling price in reference to its book value, we care about the return on that book value, i.e. its ROE. This is where it gets slightly subjective and artistic. If our hypothetical business – to which we are a silent and non-controlling partner – with a $500k book value makes a profit of $5,000 per year, we likely won’t be paying book value. $5,000/$500,000 = a 1% ROE. That’s a 1% return to me as a shareholder if I buy it at book value. The company would need some hidden magic, an activist investor, or a good story for me to get interested. Going further in our example, let’s say that this business earns $40,000 in profit. That’s a ROE of 8%. If we buy the business at book value, that’s our return as well. Is an 8% return a decent one? Should an 8% earnings yield equate to something being worth its book value? Are we okay with that vs all other options? There are all sorts of issues to weigh at this point. How risky is the business? How embedded is it’s product? Is it growing? How fast? Is it static? What is the company doing operationally underneath those numbers?
To go one step further, what if we could buy our hypothetical business for 75% of book value? Meaning, we’d be paying $375k for $500k in book value. Our ROE would be 10.6%. Or what if the business in question cost 130% of book value due to its rapid growth, consistency of earnings, or whatever else? In that case, we would pay $650k for the $500k in book value and get a ROE of 6.1%. In short, price matters.
In early 2014, Westaim bought another specialty insurer in the Houston International Insurance Group (HIIG). HIIG is based in Houston and got its start in 2007. It’s founder also has an interesting story and rhymes with Zwirn’s.
HIIG was founded by Stephen L. Way, known most widely as the founder of HCC Insurance Holdings. Some quick background here is in order: In 1974, Way founded HCC and took it public 18 years later. He left the company in 2006. From the IPO in 1992 to his “ouster” in 2006, gross written premiums grew from under $100 million to over $2 billion, and assets from under $200 million to $7 billion. This massive growth was helped by Way completing 30 acquisitions during his tenure. HCC also had a pretty impressive underwriting track record under Way’s stewardship. From 1997-2006, the average combined ratio was 90.5% and loss ratio came in at 64.7%. Returns on equity averaged 15.9%. As you can imagine, shareholders faired okay under Way’s tenure – compounding at 20% or a 13x total return. HCC sold to Tokio Marine in 2015 for 1.9x book value.
As I teased earlier, Way was “ousted” in 2005/2006 after the company reviewed its practices around the dating of stock options. There was something fishy going on in the name of trying to make compensation expenses look less than they truly were. Stephen L. Way fell from grace because of this baloney. He settled with the SEC, though nonetheless, his decision was too close to the foul line and a stupid one. Way risked money and reputation he had for money he didn’t have and didn’t need. I’ve come across a number of anecdotes about Way and his lavish lifestyles that have given me pause and have been my largest deterrent in this story. Stephen Way did stay on at HCC as executive chairman until he left to start HIIG.
Today, Westaim owns 43.9% of HIIG, though has control through a partnership structure. Non-controlling partners include Everest Re and the XL Group (via its purchase of Catlin Re). Business results for the last 12 months yielded gross written premiums of about $560 million, though due to the extensive use of reinsurance, net written premiums yielded $262 million with Specialty and Commercial lines making up 45% and 18% respectively. Investments and cash amount to about $620 million. HIIG carries an A.M. Best rating of A- (Excellent).
Like HCC, HIIG is a specialty insurer. In this business, underwriting is much less standardized and risks often more unusual. Because of this, historical competition has been less than standard commoditized insurance, and returns on equity have been high. For HIIG, this hasn’t been the case for the past couple years. Westaim and HIIG think this is simply cyclical and evidence of a soft market, but perhaps this is no country for old men like Stephen Way and the specialty market has changed – time will tell. Part of this recent depressed performance is also blamed on low prevailing interest rates for the investment portfolio, and the recent worldwide CAT events (Hurricanes Irma, Maria, Harvey, Mexico earthquakes, CA wildfires).
Publicly traded specialty insurers (HCC, WRB, MKL, HSX, LRE, RLI viewed over a cycle) trade at about 1.5x book value and average a 14% ROE (in other words, earnings yield to the holders have been 9.3%). I think that’s fair. HIIG is well capitalized and has a book value of $334 million USD. So for HIIG to be valued similar to its peers, it would have to earn $31 million (31/334=9.3%) and show some growth and consistency to boot. How could it do that? Well, it could turn an underwriting profit. Or it could break even on its underwriting and earn a 5% return on its cash and investment balance. We also might assume some combination of the two, like an underwriting combined ratio of 95% on $262 million in net written premiums (yielding a $13 million profit) and a 2.9% return on it’s $600 million cash and investment portfolio. Those numbers are simplistic but illustrative of very reasonable benchmarks. For our purposes today, let’s assume that HIIG can’t find its HCC roots, does only okay over the coming business cycle (returns on equity in the high single digits) and is only worth 1.2x book. Here’s what that looks like:
|Book Value/Share ($USD)||1.02|
|Book Value/Share ($CAD)||1.32|
|1.2x Book ($CAD)||1.58|
Again, if the business can’t get to a reasonable ROE, it’s likely worth less than book value.
This is DBZ part II – the resurgence of Dan Zwirn. Westaim and Cam McDonald stepped in to back Zwirn where Wall Street was unwilling to. DB Zwirn & Co. is resurrected in the form of the Arena Group with Zwirn receiving a $180 million capital injection from Westaim and Westaim getting Arena in return. The ownership structure is a clever one, with Westaim initially owning 100%, though as assets grow (measured in billions of $), and margins grow, Westaim gives Zwirn the option to own more of the business at escalating prices. In fact, Zwirn can eventually own up to 75% of the entity assuming assets under management are over $5 billion and EBITDA margins are over 60%.
AUM is nearing $600 million and I would wager that total committed capital might be nearing the $1 billion mark by their next public report. Returns on deployed capital have been reasonable (about 9.5% through 9 months), though let’s make a few assumptions. We’ll wager that there’s $750m in AUM today, 2&20 management fees, and gross returns at 12%. With an EBITDA margin of 30%, that’s $10m to Westaim. We’d probably need $18 million in fees to flow to Westaim to justify book value (equalling a 10% ROE). So assuming those same fees and returns with EBITDA margins of 35%, we might need AUM to be around $1.2 billion to justify book value without liquidating Arena. Economics might look something like this:
At 9x multiple
Per Share Value (USD)
Arena has spent much of its existence up to this point building out its infrastructure and broker/dealer relationships. Investing in illiquid private credit, structured finance, and private real estate – as Arena does – incurs a much longer lead time and higher start-up costs. Where an equity hedge fund might be a one-man show buying 10 positions with a few billion dollars in AUM, Arena’s game can’t be played like that. Individual opportunities are often small and volume is high – not dissimilar to a small business banker.
Below is the book value in Arena, which is the capital Westaim infused the business with
|Book Value/Share ($USD)||1.25|
|Book Value/Share ($CAD)||1.62|
Perhaps as a kicker, Arean runs a separately managed account for HIIG. If Zwirn performs well with that account, it’s a virtuous circle for the valuation of all businesses.
Westaim does have some liabilities in accounts payable, and other very minor provisions, as well as a negligible cash balance. The other main items on the balance sheet are accounting items for their newly issued preferred securities to Fairfax.
The Fairfax Deal
In June of 2017, Fairfax (the Canadian insurance giant led by Prem Watsa) invested in Westaim. The initial investment is $50 million of 5% coupon preferred stock – to be used by Westaim for potential acquisitions or for “general corporate purposes”. Westaim can or could have called an additional $50 million from Fairfax by Jan. 1 2018. Westaim can prepay these anytime after 2022 or at any time after 2020 if Westaim’s share price is over $5.60/share.
As part of the deal, Westaim issued Fairfax 28.5 million warrants exercisable at C$3.50 (current shares outstanding are 143.2 million). The warrants vest proportionately based on the aggregate percentage of Preferred Securities purchased by Fairfax with an aggregate of 14,285,715 Warrants having vested in June of 2017 based on the closing of the initial $50 million tranche of preferreds. Each vested warrant is exercisable on or prior to June 2, 2022, but the expiry date will be extended to June 2, 2024 if the volume-weighted average trading price of the common shares for the 10 day period ending on June 2, 2022 is less than C$5.60 per common share. After June 2, 2020, Westaim can also elect to require early exercise of the warrants if the volume-weighted average trading price of the common shares for any 10 day period prior to the election is at least C$5.60 per common share.
Fairfax has also agreed to invest up to US$500 million in investments sourced by Arena. Fairfax’s commitment to invest an initial US$125 million with Arena Investors was triggered by its purchase of the Initial Tranche of Preferred Securities in June of 2017. Subject to the satisfaction of certain conditions (including Westaim’s compliance with the indenture governing the Preferred Securities), Fairfax has agreed to invest an additional US$125 million with Arena Investors upon the next C$25 million drawdown of Preferred Securities by Westaim, and an additional US$250 million upon the final C$25 million drawdown of Preferred Securities by Westaim.
I think the endgame here is a buyout of Westaim by Fairfax, it seems right out of Prem’s playbook.
Downside first. The book value of the company is $2.27 USD or C$2.95. Today, one can buy the business for its book value. So assuming HIIG is an underperforming, low-class insurance company worth only book value and Arena’s asset gathering suddenly freezes or sees asset outflows or they decide to liquidate it, we shouldn’t lose much money based on today’s price (at least in theory). If neither business gets to scale or they fail to earn a sufficient ROE and Westaim were to refuse to liquidate them, then they’re worth less than book for sure. How much less? Good question. We’ll watch closely.
Adding together the bolded values from the tables listed above (Arena at book and HIIG at 1.2x book), we get about C$3.20 in value.
Viewing recent business results and momentum gives a more optimistic and I think realistic picture. Asset gathering at Arena has sped up. The company is no longer a capital burner and is significantly de-risked from its year-ago self with total commitments nearing $1 billion – all while trading today at the same price as it was as a true start-up. Dan Zwirn at Arena, Stephen L. Way at HIIG, and Cam MacDonald at Westaim all have a lot of experience in their respective fields, have very impressive track records, and are well aligned.
If the businesses are disappointments and are liquidated or have a hard time earning any return on equity, downside ought to be relatively limited. If they find mild success and are cumulatively worth 1.2x book value, the upside is 20% from today. If the businesses do well and are cumulatively worth 1.4x book value, the Westaim business is worth C$4.13 vs today’s price of C$2.95 – an upside of 40%. The thing is, these are static values and this is not a static business. Arena is in growth mode, and I expect HIIG to again get there when/if pricing rationalizes. Prem Watsa sees value here, as did Catlin and Everest Re. Prem, despite his bad calls on inflation and technology stocks, has generally been a good judge of insurance and finance businesses. Like Warren, his hit rate in those areas is very high.
I think this is probably a tails I get my money back, heads I win investment. Dan Zwirn has done this before and done it successfully. Stephen L. Way has done this before and done it successfully. Neither person needs their current business to be anywhere near as successful as their previous one for this to work. Cam MacDonald comes from a true value shop and he’s done this before. I believe they can do this again. Obvious risks include bad acting from Zwirn or Way. If ROE’s can’t get to 8-10% in the next couple years (equaling owners earnings to Westaim of C$30 million+), I expect this to trade at discount to book value. If owners earnings can’t produce ROE’s of 8-10%+, management could throw good money after bad, though Goodwood’s and MacDonald’s track record hopefully offer some protection in that regard.
Real risks are unknown and unknowable.
Finally, this is a slow-moving business that over time will be valued on the risk-adjusted future profits of the business. Boring, and old-fashioned valuation stuff. They will get no style points from the market as they don’t attract eyeballs, don’t have a sexy product, likely won’t cause social disruption or have a social desirability, and don’t have a rockstar charismatic CEO.
The plus side, I can understand it, I think the businesses are somewhat difficult to kill (cockroach-like), I think the business will be larger and have more value in 3-5 years, the price is reasonable, and it’s run by efficient and historically successful people who are well aligned.
I have had these thoughts about this business for over a year now with little change in share-price or sentiment. The stock is illiquid and the business trades on the TSX (Canadian) venture exchange.
***As is forever and always the disclaimer, this is not investment advice. Do your own work and verify your own numbers. I might buy, sell, or ignore anything at any time and have no obligation to update anything on this site.**