This post is a sort of footnote to my previous post on GLRE. Think of it as sort of a meditation on the value of incentive fees. I'm just going to think out loud here so I may have some things that may or may not make sense. I don't claim that anything here is more accurate or new or anything like that.
Anyway, here goes.
What is GLRE Worth to Einhorn?
We know that the hedge fund industry has been looking for ways to raise permanent capital for a long time. Max Re was started by Moore Capital, for example. And then we have Greenlight Capital Re. I have always said that Einhorn is really incented to make this thing work.
If GLRE works out well, this can be really, really good for Einhorn and that's why I think he is going to run this thing really carefully and he is really incented to make it work without blowing up. Of course, no matter how hard people try, you can't eliminate the risk of something bad happening.
So let's look at what GLRE is worth to Einhorn.
Einhorn owns (according to the 2012 proxy) around 6.3 million shares of GLRE (including shares owned by the family trust). That comes to $155 million. This should be enough to keep people focused on not screwing up.
But we know that GLRE was set up to raise permanent capital. So let's see what that is worth. In the case of GLRE, it's pretty easy to evaluate.
At the end of 2012, GLRE had $1.2 billion of investments. All of this is managed by Einhorn (via DME). The fee structure is straight forward: 1.5% management fee (payable monthly) and a 20% incentive fee paid annually with no preferred rate of return or hurdle rate. There is a loss carryforward provision, but let's ignore that for now assuming Eihorn can do well over time.
The management fee part is easy to value. On $1.2 billion in investments, management fees come to $18 million/year. At the usual 10x multiple, that is worth to $180 million. The value of this management fee stream alone is worth more than Einhorn's stake in GLRE ($180 million versus $155 million). If we assume that investments can grow 5%/year through investment returns and/or float growth, this management fee stream can be worth $360 million ($18 million / (10% discount rate - 5% growth rate). If they can grow investments at GLRE by 8%/year, then this stream an be worth $900 million.
But then this gets into the argument about the silliness of these cash flow models that go out into perpetuity; who is going to expect GLRE to grow 5% or 8% forever? (I'm not going to bother with multi-stage models).
You can see, though, why the hedge fund business can be such a lucrative business. Just moving those assumptions around can lead to some huge numbers. Anyway, moving on.
Incentive Fee Value
Einhorn gets 20% of the profits without a hurdle or preferred rate. So this valuation should be easy. One way to look at this is to think of the manager just owning 20% of the AUM outright. They get the profits that accrue to that 20% but then don't have to share the losses, so it's sort of better than owning 20% of the AUM outright. Of course, that doesn't mean there is liquidation value for the manager, though. But that would be true no matter how you value the incentive fee stream. You will get a positive value, but in liquidation the manager gets nothing.
But anyway, assuming you own 20% of the AUM is a rough valuation that I use so you don't have to make any assumptions about returns. This would be a problem with managers that have a hurdle or preferred rate, though, as they don't get paid unless they make their hurdles. So there may have to be a discount for the years they don't make the hurdles (even though they may make it back over time).
Anyway, the easiest, possibly most accurate way to look at the value of an incentive fee stream is to value it as an option. You get the upside and don't have to incur losses on the downside. You don't have to put up any capital up front. So having an incentive fee contract is simply owning a call option on the AUM (or 20% of the AUM).
And as much as people hate option models, it does work in many cases.
So let's look at what a 20% incentive fee on $1.2 billion in AUM is worth. The two key inputs in this case is going to be interest rates and volatility of the investments. Just looking at the annual returns, it looks like GLRE's investments have a volatility of around 14%-18% (was 18% in last five years).
I will just use 15% for now. The interest rate is an interesting question. We can just use the risk free rate, but nobody is going to finance a hedge fund position at the risk free rate (after LTCM, I don't know who would finance a stake in a hedge fund at a low rate unless the borrower had other liquid assets against the loan). So I'll use 3% as the interest rate. The strike price of the option will be 101.5% (because the 20% incentive fee is paid out only after netting out the management fee, which in this case is 1.5%).
So anyway, here is a matrix of option values, assuming 101.5% strike price, one year term and various interest rate and volatility levels (interest rates of 1%, 3% and 5%; volatility of 10% and 15%):
Interest rates
Volatility 1% 3% 5%
10% 3.8% 4.8% 5.9%
15% 5.8% 6.7% 7.8%
18% 7.0% 7.8% 8.9%
Assuming 15% volatility and 3% interest rate, you get 6.7% in call option value. One might argue the 15% volatility is too high for a long/short fund as that may be due to the financial crisis. Equity long/short funds might have more normal volatility of 10%.
At 10% volatility and 3% interest rate, the call option is worth 4.8%.
So by having this deal with GLRE, the incentive fee value to Einhorn (or DME Advisors) for one year is 4.8% x 20% (you only get 20% of the upside) = 1% of AUM.
This call option is granted every year, though. So using a discount rate of 10%, this 1% of AUM call option value comes to 10% of AUM (1%/10%).
With AUM at $1.2 billion, this incentive fee agreement is worth $120 million. Again, this could easily be worth $240 million if we assume AUM growth of 5%/year. But let's just keep AUM flat.
So summing up all the pieces, this whole GLRE package is worth to Einhorn (and whoever else he shares it with):
Ownership of GLRE stock: $155 million
Management fee: $180 million
Incentive fee: $120 million
$455 million
The value of GLRE to Einhorn with the above assumptions is basically $455 million. The value of GLRE stock that he actually owns accounts for only 1/3 of this total value.
Furthermore, the $155 million of GLRE stock he owns is arguably worth more than a similar amount of his own money he has invested in his funds due to the leverage from float that GLRE enjoys, and the tax free status of GLRE so that book value can compound tax free over time (leveraged and tax free can be pretty powerful).
If you assume that investments at GLRE will grow 5%/year, the above table can be rewritten:
Ownership of GLRE stock: $155 million
Management fee: $360 million
Incentive fee: $240 million
$755 million
In this case, the GLRE ownership stake would only be worth 20% of the whole package.
Having said all of that, I do think that this option model valuation is very conservative and is a reasonable lower bound valuation of the incentive fees, particularly the valuation using 10% volatility. Why? Because it is a totally blind estimate as if Einhorn's returns will be random going forward.
But we know that Einhorn and other good hedge funds manage risk actively, so this is sort of a silly assumption. If we thought Einhorn's returns going forward would be random, we wouldn't invest in GLRE!
I think that the S&P 500 index one year call option value would also be a lower bound valuation. Why? Because we expect Einhorn to outperform the S&P 500 index over time. If someone asked me if I would like to have (for free) a call option on the performance of Einhorn's fund or on the S&P 500 index, it would be an easy decision for me to say I would like the call option on Einhorn's fund. Right? If you agree, then an S&P 500 index at-the-money (or 101.5% strike) call option value would be a lower bound valuation for the call option on an Einhorn fund.
Option valuations give credit to volatility regardless of bias; an option holder won't have to take losses to the downside, so the more volatile the underlying, the more valuable the option.
An active hedge fund (a good one, at least) takes care of the downside and tries to keep volatility of the fund itself low so a normal option valuation would typically undervalue it (in a sense, the better a fund does, the lower the call option value that a model might spit out).
Conclusion
It seems to me that there is a lot riding here for Einhorn in terms of value. If this works out, it can be really good for Einhorn. This is why I think he will take a lot of time to make sure it works out. Of course, there is no guarantee that it works out; history is littered with supersmart people trying very hard and blowing up anyway.
But still, what people think of GLRE will really hinge on what they think of Einhorn. Those that don't like hedge funds won't like GLRE. Those that like hedge funds but don't like Einhorn won't like GLRE. It's almost that simple at this point.
And as for valuation, slightly above book is very cheap if you like Einhorn and think he can do well going forward. The fact that he hasn't done too well in the recent past may actually be a good thing as there is no froth here, and hopefully Einhorn is getting more focused as a result of his not-so-great performance. (I remember watching Tepper say his greatest years were preceded by his worst years; so any year he is down is a great time to invest as they perform very well the following year). It's a no-brainer for Einhorn fans (but again, there is risk here).
Anyway, these are just some thoughts that were floating around in my head over the weekend. I may notice some logical flaws here and there after posting this, but that's OK. I think the gist of it is correct even though it may not be of value to many readers (I can already imagine many hedge fund disbelievers laughing at the notion that hedge fund managers can manage downside and lower volatility. Yes, I remember the big, high profile hedge fund blowups of years past).
Showing posts with label GLRE. Show all posts
Showing posts with label GLRE. Show all posts
Monday, February 25, 2013
Wednesday, February 20, 2013
Greenlight 2012 Results
So, Greenlight Capital Re (GLRE) announced a not so good quarter/year. Investment performance came in at +7.1% which is not very good given a +16% stock market last year. In 2011, the return was 2.1%, same as the S&P index, and 2010 was +11% versus the S&P's +15%. So that's three years in a row that Einhorn failed to beat the S&P 500 index. That's not good.
The BPS (fully diluted adjusted BPS) growth hasn't been too hot either over the past three years. BPS grew 13%, 1% and 2% in 2010, 2011 and 2012 versus +15%, 2% and 16% for the S&P 500 index. BPS also lagged the S&P 500 for the last three years.
But!
But hold on. We always advocate the long term. It may be a mistake to jump to conclusions on recent history. We know that a lot of investment errors occur due to the overweighting of the most recent data points.
GLRE has done better over time. Here is the table of net investment performance (of GLRE's investments) and BPS growth compared to the S&P 500 index:
The GLRE investment return for 2004 is only for two quarters, so I just looked at returns/changes since the end of 2004 (the S&P 500 index return for 2004 is for the full year so is not comparable).
On this longer term basis, GLRE looks much better. GLRE's investments returned an average 9% (versus 4% for the S&P 500) over eight years and 5.7%/year (versus 1.7%/year for the S&P 500) over the past five years. That's an average outperformance of 3.8%/year over eight years and 2.4%/year over five years.
BPS change, which is basically a function of investment return and combined ratio, also outperformed the S&P 500 index by a nice margin (see above table).
Insurance Business
Other than investments, the other piece of GLRE's return is the insurance business. For that, let's take a look at the combined ratio. For 2012, it looks pretty bad. The combined ratio came in at 112.9%, far higher than it's ever gotten, and far worse than the competition.
I just updated the combined ratio table that was in GLRE's presentation last year and this is what it looks like:
TRH was merged into Alleghany (Y) and hasn't reported yet. But if you look at the others, it doesn't look too good. The average, too, since 2008 doesn't look good for GLRE's business.
Questioned about this during the 4Q12 conference call, they said it's due to one or two things (commercial autos) and they are working on it. But you know, does it matter if, for example, all of your stocks you bought went down or if one stock pick really tanked? I don't know. Just because the bad combined ratio is because of one (or two) bad idea, that isn't too comforting if it has such an impact on the total ratio. It just illustrates how concentrated/focused the business is and how important it's going to be to be right.
Hedges did say, though, that some of this is due to timing; GLRE didn't start writing insurance until recently whereas the competitors have been writing for a long time with policies written during the hard market years. Some of the low combined ratios recently have come from reserve releases from that period which GLRE doesn't have. There is definitely some truth to that as we know insurers have been releasing reserves for the past few years.
In any case, it looks like over the longer term, Einhorn is fulfilling his end of the bargain (outperforming the S&P 500 index) while the insurance side has seemed to lag (whether it's because of the reserve release issue, one time mistakes or just bad insurance underwriting).
Anyway, I updated a table that GLRE showed in their presentation last year. It shows how ROE changes according to various scenarios of investment returns and combined ratios.
I used the current balance sheet of net earned premiums of 60% of capital and investment assets of 150% of capital.
Below is how ROE would change according to the two inputs:
If the insurance business can just break even and the investments return 10-15%/year, BPS can grow 15-23%/year.
The big question, of course, is if they can achieve that.
I did raise some concerns about Einhorn due to his getting into what seems like macro investing. I may be wrong but my impression has been that he has gotten into this after the financial crisis. I have said before that so many value investors and equity managers spent so much time on the macro in the past few years that I felt that there is sort of a macro-forecasting/investing bubble going on.
The yen trade has certainly paid off in the past couple of months but it has been on the books for a while now so who knows if the returns is worth it given how long it's been there.
Whatever happens to these trades, I wonder if these things distract Einhorn from what I think he is supposed to be really good at (stock picking).
Anyway, I do understand that managers want to put on low cost, tail hedges to benefit from large movements that may negatively impact the equity portfolio. But I have my reservations about that. Also, managers may want to get into new areas to deploy larger amounts of capital. It's one thing when you are a $500 million - $1 billion equity manager, but when your assets get up to $5-10 billion, macro starts to get very attractive because of the large, liquid markets that you can deploy capital in.
I won't mention the New York Mets thing (some believe that when hedge fund managers start dabbling in trying to own a sports team, that may signify the end of their good run as their focus seems to be elsewhere. But David Tepper seemed to do well last year so...).
Increasing AUM, of course, is another factor. I don't have detailed data on Einhorn, but I'm sure the best years were the early years when he had way less capital. Can he get back to 10-20%/year performance at this AUM level? This is a question for all hedge fund managers at some point. We will have to wait and see.
Anyway, here is a look at GLRE's stock price versus the BPS over time:
It seems to have averaged 1.2x book over time and is now trading at $24.57/share, 1.1x book value.
GLRE hasn't done as well as I would have thought in the past couple of years, but they have done well over time. I don't own a lot of GLRE, but I still do like it. The potential is there for this to be a really good performer over time and it is reasonably priced.
Of course, things can go the other way too. James Tisch, on one of the Loews conference calls recently said (not about GLRE specifically) that these reinsurance companies started by hedge funds may not realize that the insurance business can lose more than the premiums earned (combined ratios can get over 200%). He seems to feel that some of these entities may not understand the risk that they are taking.
(Note after the fact: It may not have been a conference call, but a TV interview that he said this. And I think he meant that CR can get above 200% or some such thing. I may revise this if I find exactly what he said, but it's not that relevant to this post, actually; just that insurance can be risky!).
It's a very interesting and scary point. This is an interesting situation, but it is risky (this is no Berkshire Hathaway). It is a no-brainer in a sense; get levered return on Einhorn (levered due to insurance float) at close to book value, but not without risk.
The BPS (fully diluted adjusted BPS) growth hasn't been too hot either over the past three years. BPS grew 13%, 1% and 2% in 2010, 2011 and 2012 versus +15%, 2% and 16% for the S&P 500 index. BPS also lagged the S&P 500 for the last three years.
But!
But hold on. We always advocate the long term. It may be a mistake to jump to conclusions on recent history. We know that a lot of investment errors occur due to the overweighting of the most recent data points.
GLRE has done better over time. Here is the table of net investment performance (of GLRE's investments) and BPS growth compared to the S&P 500 index:
GLRE Investment Performance and BPS Growth
The GLRE investment return for 2004 is only for two quarters, so I just looked at returns/changes since the end of 2004 (the S&P 500 index return for 2004 is for the full year so is not comparable).
On this longer term basis, GLRE looks much better. GLRE's investments returned an average 9% (versus 4% for the S&P 500) over eight years and 5.7%/year (versus 1.7%/year for the S&P 500) over the past five years. That's an average outperformance of 3.8%/year over eight years and 2.4%/year over five years.
BPS change, which is basically a function of investment return and combined ratio, also outperformed the S&P 500 index by a nice margin (see above table).
Insurance Business
Other than investments, the other piece of GLRE's return is the insurance business. For that, let's take a look at the combined ratio. For 2012, it looks pretty bad. The combined ratio came in at 112.9%, far higher than it's ever gotten, and far worse than the competition.
I just updated the combined ratio table that was in GLRE's presentation last year and this is what it looks like:
GLRE Combined Ratios Versus Comps
Questioned about this during the 4Q12 conference call, they said it's due to one or two things (commercial autos) and they are working on it. But you know, does it matter if, for example, all of your stocks you bought went down or if one stock pick really tanked? I don't know. Just because the bad combined ratio is because of one (or two) bad idea, that isn't too comforting if it has such an impact on the total ratio. It just illustrates how concentrated/focused the business is and how important it's going to be to be right.
Hedges did say, though, that some of this is due to timing; GLRE didn't start writing insurance until recently whereas the competitors have been writing for a long time with policies written during the hard market years. Some of the low combined ratios recently have come from reserve releases from that period which GLRE doesn't have. There is definitely some truth to that as we know insurers have been releasing reserves for the past few years.
In any case, it looks like over the longer term, Einhorn is fulfilling his end of the bargain (outperforming the S&P 500 index) while the insurance side has seemed to lag (whether it's because of the reserve release issue, one time mistakes or just bad insurance underwriting).
Anyway, I updated a table that GLRE showed in their presentation last year. It shows how ROE changes according to various scenarios of investment returns and combined ratios.
I used the current balance sheet of net earned premiums of 60% of capital and investment assets of 150% of capital.
Below is how ROE would change according to the two inputs:
Return-on-Equity with Various Investment Returns and Combined Ratios
If the insurance business can just break even and the investments return 10-15%/year, BPS can grow 15-23%/year.
The big question, of course, is if they can achieve that.
I did raise some concerns about Einhorn due to his getting into what seems like macro investing. I may be wrong but my impression has been that he has gotten into this after the financial crisis. I have said before that so many value investors and equity managers spent so much time on the macro in the past few years that I felt that there is sort of a macro-forecasting/investing bubble going on.
The yen trade has certainly paid off in the past couple of months but it has been on the books for a while now so who knows if the returns is worth it given how long it's been there.
Whatever happens to these trades, I wonder if these things distract Einhorn from what I think he is supposed to be really good at (stock picking).
Anyway, I do understand that managers want to put on low cost, tail hedges to benefit from large movements that may negatively impact the equity portfolio. But I have my reservations about that. Also, managers may want to get into new areas to deploy larger amounts of capital. It's one thing when you are a $500 million - $1 billion equity manager, but when your assets get up to $5-10 billion, macro starts to get very attractive because of the large, liquid markets that you can deploy capital in.
I won't mention the New York Mets thing (some believe that when hedge fund managers start dabbling in trying to own a sports team, that may signify the end of their good run as their focus seems to be elsewhere. But David Tepper seemed to do well last year so...).
Increasing AUM, of course, is another factor. I don't have detailed data on Einhorn, but I'm sure the best years were the early years when he had way less capital. Can he get back to 10-20%/year performance at this AUM level? This is a question for all hedge fund managers at some point. We will have to wait and see.
Anyway, here is a look at GLRE's stock price versus the BPS over time:
Greenlight Re Fully Diluted Adjusted Book Value per Share vs. Stock Price
It seems to have averaged 1.2x book over time and is now trading at $24.57/share, 1.1x book value.
GLRE hasn't done as well as I would have thought in the past couple of years, but they have done well over time. I don't own a lot of GLRE, but I still do like it. The potential is there for this to be a really good performer over time and it is reasonably priced.
Of course, things can go the other way too. James Tisch, on one of the Loews conference calls recently said (not about GLRE specifically) that these reinsurance companies started by hedge funds may not realize that the insurance business can lose more than the premiums earned (combined ratios can get over 200%). He seems to feel that some of these entities may not understand the risk that they are taking.
(Note after the fact: It may not have been a conference call, but a TV interview that he said this. And I think he meant that CR can get above 200% or some such thing. I may revise this if I find exactly what he said, but it's not that relevant to this post, actually; just that insurance can be risky!).
It's a very interesting and scary point. This is an interesting situation, but it is risky (this is no Berkshire Hathaway). It is a no-brainer in a sense; get levered return on Einhorn (levered due to insurance float) at close to book value, but not without risk.
Tuesday, May 22, 2012
Einhorn's Macro Trades
We know that Einhorn has taken a view on some sovereign credit, Japanese yen and gold etc. So I thought I'd take a quick look at his macro positions.
First of all, for reference, at the end of the first quarter total investments were $1.18 billion and shareholders' equity was $869 million.
Positions
This is not all of the macro positions, but just some of the larger ones:
Long Position:
Commodities: $104 million
Einhorn has said that he wants to keep 10% of funds invested in gold as a tail hedge, so I guess this $104 million is all gold. He also owns gold stocks which would be in the equity portfolio and may own some GLD which may be booked in the equity portfolio.
Short Position:
Non-U.S. sovereign: $150 million
Interest rate options: $3 billion notional amount
Credit default swaps:
Sovereign debt: $281 million notional
Corporate debt: $287 million notional
Put Options: $260 million notional amount (Japanese yen?)
Futures: $335 million (doesn't say if it's long or short or what the underlying is; probably interest rate instrument given interest rate exposure table below)
For the above positions, I would guess that the sovereign shorts and interest rate options relate to the Japan trade and may include others.
Foreign Currency Risk
GLRE has exposure to foreign exchange, but the big exposure is the Japanese yen (JPY). In the table in the 10Q that shows FX risk, it shows that a 10% increase in the U.S. dollar against the JPY would lead to a $40 million gain, and a 10% decrease would lead to a $15 million loss. The asymmetry is due to the position being held as a put option.
So this is a pretty large position. There is a smaller position in the Euro, but it seems the JPY is the big FX trade.
Interest Rate Risk
The interest rate risk table shows what the exposure is on a 100 basis point move in interest rates due to holdings in corporate bonds, sovereign bonds, interest rate options and futures, credit default swaps etc.
Below is the gain on a 100 basis point increase in interest rates (this isn't the whole table; I just picked large items, and it's pretty symmetrical so I didn't put in what happens on a 100 basis point decrease in rates).
Debt: $11 million
Interest rate options: $1.5 million
Futures: $15 million
Net: $27 million
So that's a snapshot of exposures that GLRE has on the non-equity portfolio; a sizable position in gold, Japanese yen puts, short sovereigns and interest rate futures and long some credit default swaps on corporates and sovereigns.
How Have These Trades Done in the Past?
GLRE breaks out gains and losses recognized in their derivatives portfolio so I looked at the past five years (they didn't disclose details further back) to see if they have been making money on these trades or not.
Here are some figures I pulled out of past 10K's:
gain (loss) on derivs: Total gains recognized in income
Equity: Shareholders' equity of GLRE
Total Inv: Total investments of GLRE
Gain/loss on equity swaps: Derivs gain/loss on equity total return swaps
% equity: derivatives gain/loss as a percent of shareholders' equity
% invest: derivatives gain/loss as a percent of total investments
derivs gain excl equity swaps: Total derivs gain/loss without equity swaps
% equity: the above as a percentage of shareholders' equity
% invest: the avove as a percentage of total investments
Investment return: Return on investment portfolio at GLRE
So it looks like these derivatives positions have cost GLRE some money over the years. Equity total return swaps are included in here, but these may be part of the equity portfolio so it may not be a good idea to include. They may be structured to offset positions in the equity book etc. It doesn't reflect, I don't think, Einhorn's macro views. That's why I created a column where I net out the equity swap gains and losses to get a more 'pure' derivatives gain or loss.
According to that, GLRE has usually spent around 1.6% per year of the investment portfolio on these macro trades. Of course, the temptation is to think that if Einhorn didn't do these trades, then GLRE would have done 1.6%/year better in their investment portfolio.
But I would not look at it like that. If these macro, tail hedges were not on, then Einhorn very well may have had less long equities or otherwise reduce risk (and return) elsewhere in the portfolio. So you can't really look at it that way. (You would be slightly better off without homeowner's insurance too, but would you really live in a house you own if it wasn't insured?)
Also, this derivatives gain/loss doesn't include their large gold position which is held as a commodity long position, not a derivatives position (Also, gold stocks and gold ETF's would be in the equity portfolio).
So just looking at the derivatives gain and loss like this doesn't tell the whole picture.
Judging from the above table, I am sort of surprised that there wasn't some sort of gain during the financial crisis in 2008-2009. But overall, it seems like a manageable expense to keep these trades on as they may eventually work out. Even if not, the overall investment performance with these derivatives losses has been pretty good in an awful environment.
Anyway, it looks like they have some sizeable positions that can really benefit from some chaos in the market. A $3 billion notional amount interest rate position is large; almost 3x the total investment portfolio. But since this is in the form of interest rate options, the downside risk is limited so this won't lead to any unpleasant surprises.
The JPY position, too, is a put option so can't cause big damage. The worst that can happen is the option expires worthless.
Additive to Returns
What's important to remember is that these positions are additive to total returns and don't require a whole lot of capital. A lot of these positions can simply be supported by the assets held in the investment portfolio.
Despite these large 'bets', GLRE maitains a fully invested long/short equity portfolio at the same time. As the above shows, even when the trades don't work out, they don't lead to large losses, but small losses sort of like the cost of insurance. Einhorn is managing this part of the portfolio, presumably, like an insurance plan (small constant losses are OK to protect the portfolio and for a chance at outsized gains when he is right).
The other thing to remember is that these macro trades cost very little for GLRE and he gives up nothing on the long - short equity side.
Time and again, I hear of and talk to people who try to trade in and out of leveraged interest rate and FX ETF's to try to make money (and nobody does, of course). But these folks usually have to sell their Apple stock to buy their 3x leverage interest rate ETF. Or maybe they sell their MCD stock or whatever.
Institutional Advantage Over Retail Investors
So for most individual investors, these macro plays turn into either-or situations; either they maintain a stock portfolio and stay away from the macro stuff, or they sell some of their stocks to put on some macro plays via various ETFs.
What they don't realize is that guys like Einhorn don't have to do that at all. They can still stay fully invested in their best stock ideas, and oh, if they see a good macro trade, they can put on sizable interest rate and foreign exchange positions.
This, by the way, is why people like Soros was able to make so much money over the years. In all those years he made huge amounts of money on macro bets, he typically had an equity portfolio supporting all of that, and in bull markets it funded many of the macro bets (or subsidized them in dry periods).
Individual investors typically don't have that advantage, so if they don't like the market, sell their stock and buy inverse bond ETFs, they are screwed when they are wrong. They might get a double whammy; they lose money on the ETF trade, and most likely the stock they sold went up! (this scenario is most likely because it's often at bear market bottoms where individuals decide to sell their stocks and buy an inverse S&P fund; they sell their stock and go short at precisely the wrong moment!)
Not Einhorn. If he is wrong, he still has his equity porfolio and he can manage his macro exposure without touching it.
That's a big difference and is really the key to why some of these hedge funds can make such great returns over long periods while individual investors that try to become a George Soros often fail; it's almost impossible to pull off without this advantage.
First of all, for reference, at the end of the first quarter total investments were $1.18 billion and shareholders' equity was $869 million.
Positions
This is not all of the macro positions, but just some of the larger ones:
Long Position:
Commodities: $104 million
Einhorn has said that he wants to keep 10% of funds invested in gold as a tail hedge, so I guess this $104 million is all gold. He also owns gold stocks which would be in the equity portfolio and may own some GLD which may be booked in the equity portfolio.
Short Position:
Non-U.S. sovereign: $150 million
Interest rate options: $3 billion notional amount
Credit default swaps:
Sovereign debt: $281 million notional
Corporate debt: $287 million notional
Put Options: $260 million notional amount (Japanese yen?)
Futures: $335 million (doesn't say if it's long or short or what the underlying is; probably interest rate instrument given interest rate exposure table below)
For the above positions, I would guess that the sovereign shorts and interest rate options relate to the Japan trade and may include others.
Foreign Currency Risk
GLRE has exposure to foreign exchange, but the big exposure is the Japanese yen (JPY). In the table in the 10Q that shows FX risk, it shows that a 10% increase in the U.S. dollar against the JPY would lead to a $40 million gain, and a 10% decrease would lead to a $15 million loss. The asymmetry is due to the position being held as a put option.
So this is a pretty large position. There is a smaller position in the Euro, but it seems the JPY is the big FX trade.
Interest Rate Risk
The interest rate risk table shows what the exposure is on a 100 basis point move in interest rates due to holdings in corporate bonds, sovereign bonds, interest rate options and futures, credit default swaps etc.
Below is the gain on a 100 basis point increase in interest rates (this isn't the whole table; I just picked large items, and it's pretty symmetrical so I didn't put in what happens on a 100 basis point decrease in rates).
Debt: $11 million
Interest rate options: $1.5 million
Futures: $15 million
Net: $27 million
So that's a snapshot of exposures that GLRE has on the non-equity portfolio; a sizable position in gold, Japanese yen puts, short sovereigns and interest rate futures and long some credit default swaps on corporates and sovereigns.
How Have These Trades Done in the Past?
GLRE breaks out gains and losses recognized in their derivatives portfolio so I looked at the past five years (they didn't disclose details further back) to see if they have been making money on these trades or not.
Here are some figures I pulled out of past 10K's:
gain (loss) on derivs: Total gains recognized in income
Equity: Shareholders' equity of GLRE
Total Inv: Total investments of GLRE
Gain/loss on equity swaps: Derivs gain/loss on equity total return swaps
% equity: derivatives gain/loss as a percent of shareholders' equity
% invest: derivatives gain/loss as a percent of total investments
derivs gain excl equity swaps: Total derivs gain/loss without equity swaps
% equity: the above as a percentage of shareholders' equity
% invest: the avove as a percentage of total investments
Investment return: Return on investment portfolio at GLRE
So it looks like these derivatives positions have cost GLRE some money over the years. Equity total return swaps are included in here, but these may be part of the equity portfolio so it may not be a good idea to include. They may be structured to offset positions in the equity book etc. It doesn't reflect, I don't think, Einhorn's macro views. That's why I created a column where I net out the equity swap gains and losses to get a more 'pure' derivatives gain or loss.
According to that, GLRE has usually spent around 1.6% per year of the investment portfolio on these macro trades. Of course, the temptation is to think that if Einhorn didn't do these trades, then GLRE would have done 1.6%/year better in their investment portfolio.
But I would not look at it like that. If these macro, tail hedges were not on, then Einhorn very well may have had less long equities or otherwise reduce risk (and return) elsewhere in the portfolio. So you can't really look at it that way. (You would be slightly better off without homeowner's insurance too, but would you really live in a house you own if it wasn't insured?)
Also, this derivatives gain/loss doesn't include their large gold position which is held as a commodity long position, not a derivatives position (Also, gold stocks and gold ETF's would be in the equity portfolio).
So just looking at the derivatives gain and loss like this doesn't tell the whole picture.
Judging from the above table, I am sort of surprised that there wasn't some sort of gain during the financial crisis in 2008-2009. But overall, it seems like a manageable expense to keep these trades on as they may eventually work out. Even if not, the overall investment performance with these derivatives losses has been pretty good in an awful environment.
Anyway, it looks like they have some sizeable positions that can really benefit from some chaos in the market. A $3 billion notional amount interest rate position is large; almost 3x the total investment portfolio. But since this is in the form of interest rate options, the downside risk is limited so this won't lead to any unpleasant surprises.
The JPY position, too, is a put option so can't cause big damage. The worst that can happen is the option expires worthless.
Additive to Returns
What's important to remember is that these positions are additive to total returns and don't require a whole lot of capital. A lot of these positions can simply be supported by the assets held in the investment portfolio.
Despite these large 'bets', GLRE maitains a fully invested long/short equity portfolio at the same time. As the above shows, even when the trades don't work out, they don't lead to large losses, but small losses sort of like the cost of insurance. Einhorn is managing this part of the portfolio, presumably, like an insurance plan (small constant losses are OK to protect the portfolio and for a chance at outsized gains when he is right).
The other thing to remember is that these macro trades cost very little for GLRE and he gives up nothing on the long - short equity side.
Time and again, I hear of and talk to people who try to trade in and out of leveraged interest rate and FX ETF's to try to make money (and nobody does, of course). But these folks usually have to sell their Apple stock to buy their 3x leverage interest rate ETF. Or maybe they sell their MCD stock or whatever.
Institutional Advantage Over Retail Investors
So for most individual investors, these macro plays turn into either-or situations; either they maintain a stock portfolio and stay away from the macro stuff, or they sell some of their stocks to put on some macro plays via various ETFs.
What they don't realize is that guys like Einhorn don't have to do that at all. They can still stay fully invested in their best stock ideas, and oh, if they see a good macro trade, they can put on sizable interest rate and foreign exchange positions.
This, by the way, is why people like Soros was able to make so much money over the years. In all those years he made huge amounts of money on macro bets, he typically had an equity portfolio supporting all of that, and in bull markets it funded many of the macro bets (or subsidized them in dry periods).
Individual investors typically don't have that advantage, so if they don't like the market, sell their stock and buy inverse bond ETFs, they are screwed when they are wrong. They might get a double whammy; they lose money on the ETF trade, and most likely the stock they sold went up! (this scenario is most likely because it's often at bear market bottoms where individuals decide to sell their stocks and buy an inverse S&P fund; they sell their stock and go short at precisely the wrong moment!)
Not Einhorn. If he is wrong, he still has his equity porfolio and he can manage his macro exposure without touching it.
That's a big difference and is really the key to why some of these hedge funds can make such great returns over long periods while individual investors that try to become a George Soros often fail; it's almost impossible to pull off without this advantage.
Monday, May 21, 2012
Greenlight Re Investor Meeting Notes 2012
I attended this event today and here are some notes. As usual, this is not intended to be a comprehensive summary at all so I won't get into every detail. Also, there may be mistakes. Reading through the many Berkshire Hathaway annual meeting notes, we know that many people can hear the same thing and interpret it differently so keep that in mind.
There was a slide presentation in the beginning (so I'm just jotting down some key points, and sometimes copying down the whole slide):
Who We Are
Some of the bullet points are:
Our Approach
Symmetric Approach
There are similarities in how both the insurance side and investment sides are run. They both focus on capital preservation / downside risk on deal-by-deal basis, concentrate on best investments (or deals), focus on economics, bottom-up approach, portfolio is sum total of good opportunities and they both have small team of "highly skilled generalists".
The above seeks to "deliver superior long-term growth in book value".
Growth in Book Value per Share Over the Long Term
Book value per share has grown 11.7%/year since 2004.
How Do We Compare?
GLRE has both much lower net earned premium / surplus and invested assets / surplus than others, but has managed to compound book value at 11.7%/year.
Combined Ratio Comparison
Hedges (Bart Hedges, the CEO of GLRE) said that the competitors exclude corporate overhead from their combined ratio calculations, but GLRE includes it. If GLRE excluded corporate overhead, the combined ratios of GLRE would be 2% lower.
He said that their low leverage business made them underperform in the good years but spared them in the bad year of 2011 (with the Japan earthquake/tsunami, New Zealand earthquake etc.)
Motor Liability Commercial
Hedges talked about their mistake in Motor Liability Commercial, but that the contracts are rolling off and as the losses works it's way through, there will be less of an impact going forward.
Areas of Focus
Hedges talked about some opportunities in areas they are focusing on:
Takeaways
So summing up,
Market Conditions
Persistent low interest rate environment reduces investment income putting more pressure on underwriting earnings and increases interest for high yielding catastrophe bonds, side cars etc. (which is not good for insurance pricing).
Economic uncertainties reduces demand for insurance and inflationary environment has leveraged impact on excess layers and long duration liabilities
Aging U.S. population and increasing obesity trends leads to higher utilization (health care) and higher costs per visit and slower return to work (workers comp?).
With some comments on opportunities going forward, Hedges passes the podium to David Einhorn:
Investment Approach
Investment returns of 9.6%/year compares to 5.3% for the S&P 500 index, 6.6% for the Russell 200 and 7.5% for the Barclays Aggregate Bond Index.
He showed a table showing attractive Sharpe Ratio and low correlations to the market (0.58 correlation to S&P 500 index and 0.14 to bond index) and some other metrics (used by hedge funds).
Current Investment Environment
Then CFO Tim Courtis talked about the business in general.
Calculation of Float
He noted that many companies calculate float differently, but that GLRE uses a simple measure. He adds up total investments (including cash, restricted cash, due to prime brokers and many items not in the actual "total investments") and subtracts adjusted shareholders' equity and he calls that "float".
Appearance of Debt
He also talked about the fact that data vendors like Yahoo Finance show debt on GLRE's balance sheet and he gets asked about it often. He pointed out that GLRE has never issued debt as part of the capital structure.
The 'debt' that shows up is actually cash collateral put up to support a letter of credit. Since the financial crisis, regulations have made it harder to offer letters of credit; they need cash collateral. So GLRE puts up cash out of a margin account to support the letter of credit. So net-net, it's not actually debt outstanding; margin borrowing is offset by cash that sits in a custody account to support the LOC.
How Reinsurance Companies Make Money
Courtis did a quick tutorial on how reinsurance companies make money. I think most readers understand this, but it was well-presented so here goes:
ROE = Underwriting Return + Investment Return
ROE = (P/E) * (100% - CR) + (IA/E) * (IR)
where: P = Earned premium
E = Equity
CR = Combined Ratio
IA = Invested Assets
IR = Invested Return
Courtis talked about the two types of leverage: Underwriting leverage and investment leverage (float).
Return on Equity Breakdown
This is the breakdown of the change in fully diluted adjusted book value per share:
To illustrate the power of the dual engine model, Courtis showed two tables (which I hastily reproduced here):
The numbers in the top row are the combined ratios and the column to the left show investment returns.
So assuming the same ratios as the year 2011, earned premiums at 47% of capital and invested assets at 134% of capital, the ROE would be the following depending on various combined ratio and investment returns:
Earned premiums = 47% of capital
Invested assets = 134% of capital
So with a combined ratio of 100% and a 15% investment return, GLRE would increase book value by 20%. If they had a 120% combined ratio but earned 15% on their investments, they would still increase book by 11%.
Courtis was careful to say this is not a forecast or estimate, but just illustrative, he put up a table that showed what happens if earned premiums were 50% of capital and invested assets increased to 175% of capital. In that case, the ROE, or change in book values under various investment returns and combined ratios would be:
Earned premiums = 50% of capital
Invested assets = 175% of capital
So with a 100% combined ratio and a 15% return on the investment portfolio, GLRE would grow book 26%. In a great year if combined ratio was 90% and the investments returned 20%, they can grow book 40%.
This is the power of a dual engine strategy.
He (or someone) mentioned that the capital is not fully deployed. When market conditions improve, then GLRE can do pretty well.
This is a chart of the fully diluted adjusted book value per share of GLRE compared to the stock price. GLRE has rarely traded below book (at least on a quarterly basis) and usually trades at a good premium (this is my comment, not GLRE's).
The average based on quarterly prices and data is around 1.23x, so it does seem cheap right now on this basis (again, my comment, not GLRE's). Courtis said that they will leave it up to the market how to value GLRE.
So with that done, the Q&A started:
Q&A
Is the interest rate for margin debt (to support LOC) fixed or float?
Float. No need to fix it. Matches the LOC. As to a follow up question about whether GLRE should be locking in low rates by issuing debt or borrowing, Einhorn pointed out that there is leverage already built into the GLRE model so there is no need to borrow.
Commercial Trucking Losses; was it market-wide or GLRE specific?
They thought with better trucks and systems, lower traffic due to slower economy etc. that frequency should go down but it didn't; it went up. This was market-wide and not GLRE specific and they can't find a reason it happened. The policies are rolling off so shouldn't have impact in the future.
Thailand Floods?
Someone asked that Japanese insurance companies are upping their loss estimates on the Thailand flood; is GLRE seeing any of that? GLRE said they have some exposure there but aren't seeing anything reaching their limits.
Not Being U.S. Corporation Factor in Trucking Losses?
Someone asked whether being a non-U.S. entity was a factor in causing the losses in the Commerical Trucking business. Would it have been different if they were a U.S. corporation and had their own guys on the ground looking at this stuff? Being a Cayman entity, they are restricted in what they can do within the U.S. Hedges pointed out that they do have outside auditors looking at this stuff; they go through audits both on the underwriting side and the claims side, so they do see what's going on. They do a lot of that.
Would Competitors Put Pressure on Prices in GL's Areas of Focus?
Hedges talked about the market in general and said that it is dynamic. The portfolio would move around over time and "could change quite a bit". They will go where the opportunities are so what that is today may not be the same as some time in the future.
Isn't Severity Pricing More Inefficient?
Someone pointed to the "Buffett model" of insurance, that severity pricing is more inefficient; shouldn't GLRE be looking at that? Hedges points out that there is a lack of information and modelling in the severity business that leads to "unknown unknowns". Models were wrong during the hurricanes. The tails are very hard to model.
Also, Hedges pointed out the difficulty in marrying the severity business with the asset side investment strategy. It's difficult to walk that line between the two sides and maintain their credit ratings.
He did mention that they will write severity business if the pricing makes sense, pointing out that they had a lot of it in 2006 when pricing was firmer after the hurricanes wiped out a lot of capital.
Question to Einhorn: Sovereign Crisis, how and when will it unfold?
Einhorn said it's impossible to know when and how these things unfold. Monetary policy is holding things together for now but that is not sustainable. As for how he is preparing for it, GLRE owns gold, FX options (Japanese yen puts) and credit and interest rate derivatives. He can't say when and how; all he can do is prepare.
GLRE and Hedge Fund Conflict?
Someone asked how Einhorn deals with potential conflict between the two entities. Einhorn said that both portfolios are mirrors so they are managed the same, but they can't be exactly the same as securities can't move between the two entities. So they will never be exactly the same but it's a rounding error problem.
Other issues that might cause a difference is something like the withholding tax. Sometimes it may not make sense to own something in the Cayman entity for tax reasons. There may be some difference due to legacy positions; hedge funds may own old positions held since before GLRE was formed.
Also, GLRE has limit on margin. Sometimes in certain situations, the hedge fund might be more leveraged and that may cause a difference in returns. But that won't be often.
But in general and over time, these differences should not be significant.
Question about 1.5-3 years short duration of insurance book
I think someone asked whether it would be better for GLRE to have a longer duration book in insurance. Einhorn said that he doesn't think longer duration is good or better. Long tail business has risk like inflation and being locked into a bad policy for a longer time. Shorter tail businesses can be repriced more often so has less risk.
Hedges pointed out that shorter tail insurance and primary layers have less inflation risk.
Housing?
Someone asked Einhorn about the housing market. He said that housing is improving and it's broad-based. In terms of construction, he said we are "well passed the bottom".
Equity Net Exposure based on Market View?
Someone asked about corporate profit margins (high and unsustainable?) and whether Einhorn takes that into account in determining net long/short exposure.
Einhorn responded that he does make comments about the markets every now and then, but that it's immaterial in terms of structuring the equity portfolio. The portfolio is structured on a bottoms up basis; it's a function of how many long ideas and short ideas they have. After they build up their portfolio, they look at the net position and then sees if it makes sense given what's going on in the world.
What's the biggest challenge in growing premiums?
Someone asked if it was pricing, not being able to look at enough deals or what? Hedges said that it is general market conditions (soft market). The market was good when they started underwriting in 2006 after a lot of capital left (due to hurricanes). Severity was good and GLRE had more back then.
How to think about macro bets in terms of net long/short exposure
Einhorn pointed out that macro bets are not included in the net long/short book; those are only equity positions. Macro bets are additive to the overall portfolio. As for what is in the macro bets, he points out that there is quite a lot of detail disclosed in the 10k and 10q's. You can see sensitivities to certain exposures (how much will be gained/loss on yen movement etc...).
And that's it.
There was a slide presentation in the beginning (so I'm just jotting down some key points, and sometimes copying down the whole slide):
Who We Are
Some of the bullet points are:
- "dual-engine" reinsurance and investment strategy is fundamentally different (make money on both insurance and investment sides of the business)
- Seek to earn economic profit on every reinsurance contract and every investment in all market conditions
- Compensation structure focuses on economics of business (paid based on underwriting profits, not premium growth etc...)
- Measure progress by growth in fully diluted adjusted book value per share over the long term
Our Approach
- Employs "symmetric" and complementary reinsurance and investment strategies
- Client-centric underwriting approach to develop long term relationships
- Portfolio is heavily weighted towards frequency business (95% frequency in 2011)
- Selective in severity transactions when priced right
- Seek to partner with specialists
Symmetric Approach
There are similarities in how both the insurance side and investment sides are run. They both focus on capital preservation / downside risk on deal-by-deal basis, concentrate on best investments (or deals), focus on economics, bottom-up approach, portfolio is sum total of good opportunities and they both have small team of "highly skilled generalists".
The above seeks to "deliver superior long-term growth in book value".
Growth in Book Value per Share Over the Long Term
Book value per share has grown 11.7%/year since 2004.
How Do We Compare?
GLRE has both much lower net earned premium / surplus and invested assets / surplus than others, but has managed to compound book value at 11.7%/year.
Combined Ratio Comparison
Hedges (Bart Hedges, the CEO of GLRE) said that the competitors exclude corporate overhead from their combined ratio calculations, but GLRE includes it. If GLRE excluded corporate overhead, the combined ratios of GLRE would be 2% lower.
He said that their low leverage business made them underperform in the good years but spared them in the bad year of 2011 (with the Japan earthquake/tsunami, New Zealand earthquake etc.)
Motor Liability Commercial
Hedges talked about their mistake in Motor Liability Commercial, but that the contracts are rolling off and as the losses works it's way through, there will be less of an impact going forward.
Areas of Focus
Hedges talked about some opportunities in areas they are focusing on:
- Florida homeowners
- Employer Stop Loss (health)
- Small Account Workers Comp, General Liability and Commercial Auto
- Property Catastrophe Retro
Takeaways
So summing up,
- Measures results based on growth in fully diluted adjusted BPS
- Frequency oriented strategy has preserved capital in volatile times
- Client-centric underwriting model has gained market recognition
- Underwriting portfolio is concentrated in highest conviction ideas
- Well positioned for growth when market conditions improve
Market Conditions
Persistent low interest rate environment reduces investment income putting more pressure on underwriting earnings and increases interest for high yielding catastrophe bonds, side cars etc. (which is not good for insurance pricing).
Economic uncertainties reduces demand for insurance and inflationary environment has leveraged impact on excess layers and long duration liabilities
Aging U.S. population and increasing obesity trends leads to higher utilization (health care) and higher costs per visit and slower return to work (workers comp?).
With some comments on opportunities going forward, Hedges passes the podium to David Einhorn:
Investment Approach
- Value Long/short investments with macro hedges
- Focus on capital preservation
- Average gross long exposure of 90% long and 53% short since formation of GLRE
- Annualized return of 9.6%/year since formation of GLRE
Investment returns of 9.6%/year compares to 5.3% for the S&P 500 index, 6.6% for the Russell 200 and 7.5% for the Barclays Aggregate Bond Index.
He showed a table showing attractive Sharpe Ratio and low correlations to the market (0.58 correlation to S&P 500 index and 0.14 to bond index) and some other metrics (used by hedge funds).
Current Investment Environment
- U.S. economy and corporate earnings continue to grow
- Quantitative easing on hold for now; commodity prices trending lower
- Wide disparity of equity valuations (Einhorn notes that there are a lot of cheap stocks and expensive stocks so that is an opportunity)
- European problems remain unsolved
- Slowdown in China
- Possible Japan sentiment change (Einhorn thinks Japan has passed the point of no return (in terms of too much government debt)
- Currently 96% long and 57% short (now more net long as they added to longs during recent downturn)
- Largest holdings Apple, Arkema, GM (he said is a cheap stock), gold and Seagate. He also mentioned MSFT, Dell, gold stocks and puts on the Japanese yen
- Longs included cash-rich large cap tech stocks
- Shorts include misunderstood cyclicals and overpriced deteriorating businesses
- overlaying macro hedges due to risky fiscal and monetary policies
Then CFO Tim Courtis talked about the business in general.
Calculation of Float
He noted that many companies calculate float differently, but that GLRE uses a simple measure. He adds up total investments (including cash, restricted cash, due to prime brokers and many items not in the actual "total investments") and subtracts adjusted shareholders' equity and he calls that "float".
Appearance of Debt
He also talked about the fact that data vendors like Yahoo Finance show debt on GLRE's balance sheet and he gets asked about it often. He pointed out that GLRE has never issued debt as part of the capital structure.
The 'debt' that shows up is actually cash collateral put up to support a letter of credit. Since the financial crisis, regulations have made it harder to offer letters of credit; they need cash collateral. So GLRE puts up cash out of a margin account to support the letter of credit. So net-net, it's not actually debt outstanding; margin borrowing is offset by cash that sits in a custody account to support the LOC.
How Reinsurance Companies Make Money
Courtis did a quick tutorial on how reinsurance companies make money. I think most readers understand this, but it was well-presented so here goes:
ROE = Underwriting Return + Investment Return
ROE = (P/E) * (100% - CR) + (IA/E) * (IR)
where: P = Earned premium
E = Equity
CR = Combined Ratio
IA = Invested Assets
IR = Invested Return
Courtis talked about the two types of leverage: Underwriting leverage and investment leverage (float).
Return on Equity Breakdown
This is the breakdown of the change in fully diluted adjusted book value per share:
To illustrate the power of the dual engine model, Courtis showed two tables (which I hastily reproduced here):
The numbers in the top row are the combined ratios and the column to the left show investment returns.
So assuming the same ratios as the year 2011, earned premiums at 47% of capital and invested assets at 134% of capital, the ROE would be the following depending on various combined ratio and investment returns:
Earned premiums = 47% of capital
Invested assets = 134% of capital
So with a combined ratio of 100% and a 15% investment return, GLRE would increase book value by 20%. If they had a 120% combined ratio but earned 15% on their investments, they would still increase book by 11%.
Courtis was careful to say this is not a forecast or estimate, but just illustrative, he put up a table that showed what happens if earned premiums were 50% of capital and invested assets increased to 175% of capital. In that case, the ROE, or change in book values under various investment returns and combined ratios would be:
Earned premiums = 50% of capital
Invested assets = 175% of capital
So with a 100% combined ratio and a 15% return on the investment portfolio, GLRE would grow book 26%. In a great year if combined ratio was 90% and the investments returned 20%, they can grow book 40%.
This is the power of a dual engine strategy.
He (or someone) mentioned that the capital is not fully deployed. When market conditions improve, then GLRE can do pretty well.
Fully Diluted Adjusted Book Value Per Share and Stock Price
This is a chart of the fully diluted adjusted book value per share of GLRE compared to the stock price. GLRE has rarely traded below book (at least on a quarterly basis) and usually trades at a good premium (this is my comment, not GLRE's).
The average based on quarterly prices and data is around 1.23x, so it does seem cheap right now on this basis (again, my comment, not GLRE's). Courtis said that they will leave it up to the market how to value GLRE.
So with that done, the Q&A started:
Q&A
Is the interest rate for margin debt (to support LOC) fixed or float?
Float. No need to fix it. Matches the LOC. As to a follow up question about whether GLRE should be locking in low rates by issuing debt or borrowing, Einhorn pointed out that there is leverage already built into the GLRE model so there is no need to borrow.
Commercial Trucking Losses; was it market-wide or GLRE specific?
They thought with better trucks and systems, lower traffic due to slower economy etc. that frequency should go down but it didn't; it went up. This was market-wide and not GLRE specific and they can't find a reason it happened. The policies are rolling off so shouldn't have impact in the future.
Thailand Floods?
Someone asked that Japanese insurance companies are upping their loss estimates on the Thailand flood; is GLRE seeing any of that? GLRE said they have some exposure there but aren't seeing anything reaching their limits.
Not Being U.S. Corporation Factor in Trucking Losses?
Someone asked whether being a non-U.S. entity was a factor in causing the losses in the Commerical Trucking business. Would it have been different if they were a U.S. corporation and had their own guys on the ground looking at this stuff? Being a Cayman entity, they are restricted in what they can do within the U.S. Hedges pointed out that they do have outside auditors looking at this stuff; they go through audits both on the underwriting side and the claims side, so they do see what's going on. They do a lot of that.
Would Competitors Put Pressure on Prices in GL's Areas of Focus?
Hedges talked about the market in general and said that it is dynamic. The portfolio would move around over time and "could change quite a bit". They will go where the opportunities are so what that is today may not be the same as some time in the future.
Isn't Severity Pricing More Inefficient?
Someone pointed to the "Buffett model" of insurance, that severity pricing is more inefficient; shouldn't GLRE be looking at that? Hedges points out that there is a lack of information and modelling in the severity business that leads to "unknown unknowns". Models were wrong during the hurricanes. The tails are very hard to model.
Also, Hedges pointed out the difficulty in marrying the severity business with the asset side investment strategy. It's difficult to walk that line between the two sides and maintain their credit ratings.
He did mention that they will write severity business if the pricing makes sense, pointing out that they had a lot of it in 2006 when pricing was firmer after the hurricanes wiped out a lot of capital.
Question to Einhorn: Sovereign Crisis, how and when will it unfold?
Einhorn said it's impossible to know when and how these things unfold. Monetary policy is holding things together for now but that is not sustainable. As for how he is preparing for it, GLRE owns gold, FX options (Japanese yen puts) and credit and interest rate derivatives. He can't say when and how; all he can do is prepare.
GLRE and Hedge Fund Conflict?
Someone asked how Einhorn deals with potential conflict between the two entities. Einhorn said that both portfolios are mirrors so they are managed the same, but they can't be exactly the same as securities can't move between the two entities. So they will never be exactly the same but it's a rounding error problem.
Other issues that might cause a difference is something like the withholding tax. Sometimes it may not make sense to own something in the Cayman entity for tax reasons. There may be some difference due to legacy positions; hedge funds may own old positions held since before GLRE was formed.
Also, GLRE has limit on margin. Sometimes in certain situations, the hedge fund might be more leveraged and that may cause a difference in returns. But that won't be often.
But in general and over time, these differences should not be significant.
Question about 1.5-3 years short duration of insurance book
I think someone asked whether it would be better for GLRE to have a longer duration book in insurance. Einhorn said that he doesn't think longer duration is good or better. Long tail business has risk like inflation and being locked into a bad policy for a longer time. Shorter tail businesses can be repriced more often so has less risk.
Hedges pointed out that shorter tail insurance and primary layers have less inflation risk.
Housing?
Someone asked Einhorn about the housing market. He said that housing is improving and it's broad-based. In terms of construction, he said we are "well passed the bottom".
Equity Net Exposure based on Market View?
Someone asked about corporate profit margins (high and unsustainable?) and whether Einhorn takes that into account in determining net long/short exposure.
Einhorn responded that he does make comments about the markets every now and then, but that it's immaterial in terms of structuring the equity portfolio. The portfolio is structured on a bottoms up basis; it's a function of how many long ideas and short ideas they have. After they build up their portfolio, they look at the net position and then sees if it makes sense given what's going on in the world.
What's the biggest challenge in growing premiums?
Someone asked if it was pricing, not being able to look at enough deals or what? Hedges said that it is general market conditions (soft market). The market was good when they started underwriting in 2006 after a lot of capital left (due to hurricanes). Severity was good and GLRE had more back then.
How to think about macro bets in terms of net long/short exposure
Einhorn pointed out that macro bets are not included in the net long/short book; those are only equity positions. Macro bets are additive to the overall portfolio. As for what is in the macro bets, he points out that there is quite a lot of detail disclosed in the 10k and 10q's. You can see sensitivities to certain exposures (how much will be gained/loss on yen movement etc...).
And that's it.
Wednesday, May 16, 2012
GLRE: David Einhorn at Book
So David Einhorn is in the news again lately and I do notice that GLRE is trading around book value so I thought I'd post an update on this. I posted before that GLRE is a way to get hedge fund exposure at book value.
I did say then that this is the same as the Berkshire Hathaway model, but I should say it's more based on the same idea but not the same model. In BRK's case, they wholly own the insurance businesses that they use to hold investments. Also, the insurance businesses also own some wholly owned businesses.
In the case of GLRE, the idea is the same; to use insurance float to make investments. The key difference is that GLRE is a pure insurance company and they outsource the investment management to Einhorn's hedge fund (or more specifically, an entity called DME Advisors). So it's a similar idea but different structure.
Also, of course, GLRE then pays hedge fund-like fees to Einhorn.
Investment Performance Update
One nice thing about having GLRE listed is that they do post returns of their investment portfolio on a quarterly basis.
Here is the latest:
From inception (of GLRE) through the end of last year, Einhorn has returned +9.3% per year. Going through to the end of April, 2012, the return is +9.5%/year and this is net of fees and expenses. GLRE pays a 1.5% management and 20% incentive fee to DME Advisors.
(As I keep saying, hedge fund fees are fine if they perform. What matters is net returns after fees. If that is good, then fees is not a problem. I don't see a problem with pay-for-performance. People who don't perform well and charge high fees will cease to exist pretty quickly).
The largest holdings in the portfolio as of April-end were Apple, Arkema, General Motors and Seagate Technologies.
They also own a large stake in Oaktree Capital Management (recent filing) which I posted recently about (read here). Oaktree (OAK) is run by Howard Marks who is certainly one of the all-time greats in the investment world. We can't know what Einhorn is thinking, but I think other than the fact that OAK is a great shop run by great people, I think the counter-cyclical aspect of OAK probably appeals to him greatly. Einhorn, like many others, sees big problems ahead due to so much debt around the world. When things blow up, OAK will be there to raise capital and pick up the pieces at great prices. They will actually *benefit* in bad times.
The portfolio as of the end of the 1Q was 32% net long according to the 1Q earnings call (you can see equity long and short outstanding on the balance sheet), and that was bumped up to 39% net long in April. GLRE also owns a big position in gold; I think they maintain a 10% position in gold. There are also some macro bets like currency trades and credit default swaps (against Japan, for example).
Balance Sheet
At this point, the insurance business is still in a startup phase so the p/l is largely driven by investment results. Total investments were $1.18 billion at the end of March 2012 versus shareholders' equity of $869 million. So that's an investment leverage of 1.4x which is low for an insurance company. Again, that's largely due to the startup nature of GLRE. So the risk profile of GLRE from an insurance and investing standpoint is still much lower than the typical insurance company (Markel, for example, has an investment leverage of 2.5x). Investment leverage often reflects both investment and insurance risk; investment risk because returns/losses are magnified by the leverage and insurance risk because much of the leverage in an insurance company comes from 'float' and when they are underreserved, or a bad insured event occurs, that can lead to big losses if the insurance company is too levered (too much float versus equity).
Insurance
The combined ratio came in at 102.4% in the first quarter of 2012 versus 103.8% for the full year in 2011 and 102.8% for 2010. The insurance business isn't really 'seasoned' here yet so it will take more time to see what kind of track record GLRE can develop in terms of underwriting in the longer term.
Book Value per Share
At the end of the day, an insurance company wants to grow book value per share over time. For GLRE, fully diluted adjusted book value per share is the scorecard that we want to keep an eye on.
Here is the 'scorecard' since 2004 (when GLRE started):
Fully diluted
BPS
2004 $10.21
2005 $11.63
2006 $14.27
2007 $16.57
2008 $13.39
2009 $18.95
2010 $21.39
2011 $21.61
March 2012 $23.29
GLRE grew BPS +11.3%/year through the end of 2011 and +12.1%/year through March 2012, which is a little more than the investment returns; this is due to the investment leverage.
Investment Leverage
Investment leverage is now a modest 1.4x, but if they can just break even on the insurance business and Einhorn earns 10% net of fees, that's a 14% growth in book right there. If some of his bets pan out and he starts generating more typical hedge fund-like returns (OK, I hear laughter... bear with me), then GLRE can really grow book even with just 1.4x investment leverage.
Leveraging a Hedge Fund? Are You Nuts!?
Well, seeing that so many insurance companies are long mostly bonds in what many call the biggest bubble of all time (and a perception that bonds are 'safe') with much higher leverage, leaning on the comfort of AAA and AA credit ratings, Einhorn' portfolio may even be much safer.
Also, I don't know the investment guidelines in Einhorn's hedge funds, but the investments at GLRE do have restrictions (if this is too small to read, just look it up in the 10-K):
Keep in mind that the leverage mentioned above only relates to the investment portfolio and not the leverage at the GLRE balance sheet level. For example, if GLRE gave $100 to Einhorn to invest, then the 'equity' is $100 as far as Einhorn is concerned.
Conclusion
This is certainly not without risk. Many things can go wrong here. Einhorn may not perform going forward. The insurance business can become a total disaster. One of them can be enough for this not to work. Both can happen, which would be a disaster.
But with shares trading at $24.77 and fully diluted adjusted book value per share at $23.29 (1.06x book), it's certainly an interesting opportunity.
I did say then that this is the same as the Berkshire Hathaway model, but I should say it's more based on the same idea but not the same model. In BRK's case, they wholly own the insurance businesses that they use to hold investments. Also, the insurance businesses also own some wholly owned businesses.
In the case of GLRE, the idea is the same; to use insurance float to make investments. The key difference is that GLRE is a pure insurance company and they outsource the investment management to Einhorn's hedge fund (or more specifically, an entity called DME Advisors). So it's a similar idea but different structure.
Also, of course, GLRE then pays hedge fund-like fees to Einhorn.
Investment Performance Update
One nice thing about having GLRE listed is that they do post returns of their investment portfolio on a quarterly basis.
Here is the latest:
From inception (of GLRE) through the end of last year, Einhorn has returned +9.3% per year. Going through to the end of April, 2012, the return is +9.5%/year and this is net of fees and expenses. GLRE pays a 1.5% management and 20% incentive fee to DME Advisors.
(As I keep saying, hedge fund fees are fine if they perform. What matters is net returns after fees. If that is good, then fees is not a problem. I don't see a problem with pay-for-performance. People who don't perform well and charge high fees will cease to exist pretty quickly).
The largest holdings in the portfolio as of April-end were Apple, Arkema, General Motors and Seagate Technologies.
They also own a large stake in Oaktree Capital Management (recent filing) which I posted recently about (read here). Oaktree (OAK) is run by Howard Marks who is certainly one of the all-time greats in the investment world. We can't know what Einhorn is thinking, but I think other than the fact that OAK is a great shop run by great people, I think the counter-cyclical aspect of OAK probably appeals to him greatly. Einhorn, like many others, sees big problems ahead due to so much debt around the world. When things blow up, OAK will be there to raise capital and pick up the pieces at great prices. They will actually *benefit* in bad times.
The portfolio as of the end of the 1Q was 32% net long according to the 1Q earnings call (you can see equity long and short outstanding on the balance sheet), and that was bumped up to 39% net long in April. GLRE also owns a big position in gold; I think they maintain a 10% position in gold. There are also some macro bets like currency trades and credit default swaps (against Japan, for example).
Balance Sheet
At this point, the insurance business is still in a startup phase so the p/l is largely driven by investment results. Total investments were $1.18 billion at the end of March 2012 versus shareholders' equity of $869 million. So that's an investment leverage of 1.4x which is low for an insurance company. Again, that's largely due to the startup nature of GLRE. So the risk profile of GLRE from an insurance and investing standpoint is still much lower than the typical insurance company (Markel, for example, has an investment leverage of 2.5x). Investment leverage often reflects both investment and insurance risk; investment risk because returns/losses are magnified by the leverage and insurance risk because much of the leverage in an insurance company comes from 'float' and when they are underreserved, or a bad insured event occurs, that can lead to big losses if the insurance company is too levered (too much float versus equity).
Insurance
The combined ratio came in at 102.4% in the first quarter of 2012 versus 103.8% for the full year in 2011 and 102.8% for 2010. The insurance business isn't really 'seasoned' here yet so it will take more time to see what kind of track record GLRE can develop in terms of underwriting in the longer term.
Book Value per Share
At the end of the day, an insurance company wants to grow book value per share over time. For GLRE, fully diluted adjusted book value per share is the scorecard that we want to keep an eye on.
Here is the 'scorecard' since 2004 (when GLRE started):
Fully diluted
BPS
2004 $10.21
2005 $11.63
2006 $14.27
2007 $16.57
2008 $13.39
2009 $18.95
2010 $21.39
2011 $21.61
March 2012 $23.29
GLRE grew BPS +11.3%/year through the end of 2011 and +12.1%/year through March 2012, which is a little more than the investment returns; this is due to the investment leverage.
Investment Leverage
Investment leverage is now a modest 1.4x, but if they can just break even on the insurance business and Einhorn earns 10% net of fees, that's a 14% growth in book right there. If some of his bets pan out and he starts generating more typical hedge fund-like returns (OK, I hear laughter... bear with me), then GLRE can really grow book even with just 1.4x investment leverage.
Leveraging a Hedge Fund? Are You Nuts!?
Well, seeing that so many insurance companies are long mostly bonds in what many call the biggest bubble of all time (and a perception that bonds are 'safe') with much higher leverage, leaning on the comfort of AAA and AA credit ratings, Einhorn' portfolio may even be much safer.
Also, I don't know the investment guidelines in Einhorn's hedge funds, but the investments at GLRE do have restrictions (if this is too small to read, just look it up in the 10-K):
Conclusion
This is certainly not without risk. Many things can go wrong here. Einhorn may not perform going forward. The insurance business can become a total disaster. One of them can be enough for this not to work. Both can happen, which would be a disaster.
But with shares trading at $24.77 and fully diluted adjusted book value per share at $23.29 (1.06x book), it's certainly an interesting opportunity.
Wednesday, September 28, 2011
GLRE: Hedge Fund Exposure at Book
Greenlight Capital Re is a reinsurance company that was started up by David Einhorn of Greenlight Capital. Einhorn is one of the new generation hedge fund managers putting up impressive figures (along with Bill Ackman of Pershing Square) as a deep research, focused (concentrated) equity hedge fund. Einhorn does short stocks too so it is basically an equity long/short fund. The level of research they do is very deep, and this can be seen in his book "Fooling Some of the People All of the Time".
Hedge funds have always had trouble with capital; in good times they receive a lot of money to invest, and when things turn bad people want to redeem and get out all at once (most recent run-for-the-exits being in 2008). This is problematic for hedge fund managers because investors tend to want to leave when the news is bad so the markets tend to be falling. The managers are forced to sell into the weak market which hurts performance. Sometimes this feeds on itself; weak markets provoke redemptions which leads to worse performance (from selling their large holdings into a weak market) and even more redemptions.
By creating an insurance company, Einhorn hopes to raise some 'sticky' capital; capital that can't be redeemed when the headlines get scary. Since insurance companies receive 'float' to invest, the capital won't be subject to the whims of investors. The capital raised for the insurance company will also be permanent capital (equity capital). If all goes well, this capital raised for the insurance company and the float it receieves on insurance policies written will become nice, long term, sticky capital for Greenlight Capital to invest.
This is basically the model of Berkshire Hathaway. I think Henry Kravis has mentioned enviously that Berkshire Hathaway has a great business model (private equity firms like KKR raise investment funds that have a fixed term, like five or seven years after which they have to return the capital to investors. For KKR to stay alive, they have to keep raising new funds from investors to replace funds that are returned upon maturity).
The use of an insurance company to raise sticky capital has been tried before. Moore Capital Management, a hedge fund, started Max Re (former ticker symbol, I think, was MXRE) with the same strategy. They wanted to use a fund of funds model to invest the float. In this case, the insurance business did relatively well and the fund of funds performance turned out to be very subpar. The last I heard, the plan was to put the insurance company investments into traditional fixed income like other insurance companies rather than have Moore Capital continue to manage it. Oddly, when I did a quick google on this subject, I couldn't find any mention anywhere of MXRE. I couldn't find any old SEC filings either.
Anyway, back to the topic of Greenlight Capital Re.
Is Einhorn Any Good?
The first and most important question in this idea, of course, is how good is Greenlight Capital, the hedge fund? The hedge fund was founded in 1996 and I do remember he returned +29%/year in the first ten years of it's existence through 2006.
Through the end of 2010, Greenlight Capital has gained +21.5%/year net of fees. That is a pretty good return no matter how you slice it. That's more than +20%/year over 14 years. What's even more amazing is that this happened in not such a wonderful market environment. Remember, the stock market peaked back in 2000 and excluding a brief new high in 2007, the market has gone nowhere since then. In fact we had two horrible bear markets. And yet, Greenlight had what would be a pretty good return even in a bull market.
OK, since we know that the first ten years was really good at +29%/year (which is also astounding as the period 1996-2006 included the internet bubble and collapse/bear market), the more recent returns were obviously not as good.
Greenlight started managing the investments of Greenlight Capital Re in 2004 so the returns are available in the company's SEC filings. Let's look at Greenlight's returns from 2004:
Investment Returns
2004 +5.2% (inlcudes only two quarters, not full year)
2005 +14.2%
2006 +24.4%
2007 +5.9%
2008 -17.6%
2009 +32.1%
2010 +11.0%
That's an average of 10.5%/year. (The insurance company's investments are managed by an Einhorn entity called DME Advisors which is separate from the hedge fund, but it is assumed that the portfolios have similar characteristics).
What About the Insurance Company?
Here is a table summarizing some figures from Greenlight Capital Re.
net
premiums combined Total Loss and Total
earned ratio inv LAE sheq BPS
2006 26.6 109.60% 244 5 312 14.27
2007 98.0 92.20% 591 42 606 16.57
2008 114.9 96.50% 494 81 491 13.39
2009 214.7 96.50% 831 137 729 18.95
2010 287.7 102.80% 1,052 186 839 21.39
All figures in $millions except combined ratio and BPS.
Total inv: Total investments
Total sheq: Total shareholders equity
BPS: Fully diluted adjusted book value per share
The combined ratio is the number that shows if an insurance company is making or losing money on it's insurance business, excluding investment gains/losses. A combined ratio of over 100% means it lost money and under 100% means the business made money.
The average combined ratio for GLRE for the past five years is around 100%, which means it is breaking even on the insurance business. I don't know how good this number is as the insurance business is really just starting up. You will notice that net premiums written has grown from $27 million to $288 million in the last five years. That's because they started with zero in 2004.
The insurance business is hard to predict, but I think we can be pretty sure that Einhorn has directed his insurance executives to act Berkshire-like in their policy writing; in other words, write business for profit, not for volume.
Much of the insurance business is driven by volume. Agents are paid commissions so they are motivated to sell policies at whatever the price. But some insurance companies, notably Berkshire Hathaway, focus on only writing business that is priced decently.
I think Einhorn is really focused on that for the insurance business (even though he doesn't run it. As a 17% owner, founder and chairman, I think he will pick people who have the right approach to insurance).
Of course there is still a risk. However, the risk at this point at GLRE is pretty limited. For example, as of June 2011, the loss and loss adjustment expense reserves at GLRE were about $219 million versus total shareholders' equity of $770 million. It is more typical that this loss and loss adjustment expense to be much larger versus shareholders equity. The larger the loss and LAE is versus shareholders equity, the larger the impact of underwriting errors.
For reference, here are comparisons of loss and loss adjustment expense reservevs (loss and LAE) and total shareholders' equity of GLRE compared to Ace (ACE), White Mountain (WTM) and Transatlantic Holdings (TRH):
Loss and LAE reserves Total Shareholders Equity
GLRE $219 million $770 million
ACE $39 billion $24 billion
TRH $ 9 billion $4.3 billion
WTM $5.6 billion $4.2 billion
So loss and LAE reserves at GLRE is only 28% of total shareholders' equity while other reinsurers seem to have the loss and LAE reserves above shareholders' equity; sometimes far above.
It's important to point out that GLRE's insurance business is still in the upstart stage, so this figure will probably go up over time, as long as pricing allows (I don't think Einhorn will encourage writing underpriced policies).
So at this point, underwriting errors will not have that much of an impact on GLRE.
The biggest driver of GLRE's performance will be the returns on their investments.
GLRE had an IPO in May 2007. Shares were offered to the public at $19.00/share, and the fully diluted adjusted book value per share at as of the end of March 2007 was $13.67 (the offering was at 1.4x BPS).
Investments
As of June 2011, GLRE had total investments of $1.04 billion versus total shareholders' equity of $770 million. This is a long/short portfolio of equities, primarily, and I think he still owns a bit of gold (this is one thing I don't like too much about Einhorn; it bugs me when an equity specialists starts dabbling in commodities).
Since the portfolio is long/short, this $1.04 billion is not competely exposed to the equity market. In the 10Q for the second quarter of 2011, it says that the portfolio has a net long position of around 23%. This means that out of the $1.04 billion portfolio, the net exposure (long positions minus short positions) is around $230 million.
Over time, if the insurance business can at least break even, then the growth in book value of GLRE will reflect the investment performance of Einhorn. If the insurance business continues to grow and the insurance float grows, then total investments will grow versus shareholders' equity and that will provide some leverage on the returns Einhorn can achieve.
For now, total investments is around 1.35x shareholders' equity, so if Einhorn can deliver a 10% return on total investments and the insurance business breaks even, GLRE's book value should grow around 13.5%. (The fully diluted adjusted book value per share of GLRE has grown at around 13%/year over the past five years versus an average of around 10%/year return on their investments)
As of the end of June, the fully diluted adjusted book value per share of GLRE was $19.82, down 7.3% for the year (which makes sense as the performance on the investment portfolio was -5.3% year-to-date, a ratio of 1.38). Since the equity portfolio is a long/short, we really have no idea how GLRE has done since June.
If we assume the portfolio has been relatively flat, then GLRE at $20.50 is trading at a 3% premium to book value per share. That's quite a bargain if you think Einhorn can still continue to be a successful investor.
There is no reason to believe that Einhorn can't continue to do well. He also owns 17% of GLRE so he is really incented to make this work; if this works and the company can grow, I'm sure he would love to have GLRE become a Berkshire-like vehicle for him. The risks are obvious; that Einhorn had a lucky streak in his early years and he is done, or the insurance business will not do well and eventually blow up, or a combination of both.
Hedge funds have always had trouble with capital; in good times they receive a lot of money to invest, and when things turn bad people want to redeem and get out all at once (most recent run-for-the-exits being in 2008). This is problematic for hedge fund managers because investors tend to want to leave when the news is bad so the markets tend to be falling. The managers are forced to sell into the weak market which hurts performance. Sometimes this feeds on itself; weak markets provoke redemptions which leads to worse performance (from selling their large holdings into a weak market) and even more redemptions.
By creating an insurance company, Einhorn hopes to raise some 'sticky' capital; capital that can't be redeemed when the headlines get scary. Since insurance companies receive 'float' to invest, the capital won't be subject to the whims of investors. The capital raised for the insurance company will also be permanent capital (equity capital). If all goes well, this capital raised for the insurance company and the float it receieves on insurance policies written will become nice, long term, sticky capital for Greenlight Capital to invest.
This is basically the model of Berkshire Hathaway. I think Henry Kravis has mentioned enviously that Berkshire Hathaway has a great business model (private equity firms like KKR raise investment funds that have a fixed term, like five or seven years after which they have to return the capital to investors. For KKR to stay alive, they have to keep raising new funds from investors to replace funds that are returned upon maturity).
The use of an insurance company to raise sticky capital has been tried before. Moore Capital Management, a hedge fund, started Max Re (former ticker symbol, I think, was MXRE) with the same strategy. They wanted to use a fund of funds model to invest the float. In this case, the insurance business did relatively well and the fund of funds performance turned out to be very subpar. The last I heard, the plan was to put the insurance company investments into traditional fixed income like other insurance companies rather than have Moore Capital continue to manage it. Oddly, when I did a quick google on this subject, I couldn't find any mention anywhere of MXRE. I couldn't find any old SEC filings either.
Anyway, back to the topic of Greenlight Capital Re.
Is Einhorn Any Good?
The first and most important question in this idea, of course, is how good is Greenlight Capital, the hedge fund? The hedge fund was founded in 1996 and I do remember he returned +29%/year in the first ten years of it's existence through 2006.
Through the end of 2010, Greenlight Capital has gained +21.5%/year net of fees. That is a pretty good return no matter how you slice it. That's more than +20%/year over 14 years. What's even more amazing is that this happened in not such a wonderful market environment. Remember, the stock market peaked back in 2000 and excluding a brief new high in 2007, the market has gone nowhere since then. In fact we had two horrible bear markets. And yet, Greenlight had what would be a pretty good return even in a bull market.
OK, since we know that the first ten years was really good at +29%/year (which is also astounding as the period 1996-2006 included the internet bubble and collapse/bear market), the more recent returns were obviously not as good.
Greenlight started managing the investments of Greenlight Capital Re in 2004 so the returns are available in the company's SEC filings. Let's look at Greenlight's returns from 2004:
Investment Returns
2004 +5.2% (inlcudes only two quarters, not full year)
2005 +14.2%
2006 +24.4%
2007 +5.9%
2008 -17.6%
2009 +32.1%
2010 +11.0%
That's an average of 10.5%/year. (The insurance company's investments are managed by an Einhorn entity called DME Advisors which is separate from the hedge fund, but it is assumed that the portfolios have similar characteristics).
What About the Insurance Company?
Here is a table summarizing some figures from Greenlight Capital Re.
net
premiums combined Total Loss and Total
earned ratio inv LAE sheq BPS
2006 26.6 109.60% 244 5 312 14.27
2007 98.0 92.20% 591 42 606 16.57
2008 114.9 96.50% 494 81 491 13.39
2009 214.7 96.50% 831 137 729 18.95
2010 287.7 102.80% 1,052 186 839 21.39
All figures in $millions except combined ratio and BPS.
Total inv: Total investments
Total sheq: Total shareholders equity
BPS: Fully diluted adjusted book value per share
The combined ratio is the number that shows if an insurance company is making or losing money on it's insurance business, excluding investment gains/losses. A combined ratio of over 100% means it lost money and under 100% means the business made money.
The average combined ratio for GLRE for the past five years is around 100%, which means it is breaking even on the insurance business. I don't know how good this number is as the insurance business is really just starting up. You will notice that net premiums written has grown from $27 million to $288 million in the last five years. That's because they started with zero in 2004.
The insurance business is hard to predict, but I think we can be pretty sure that Einhorn has directed his insurance executives to act Berkshire-like in their policy writing; in other words, write business for profit, not for volume.
Much of the insurance business is driven by volume. Agents are paid commissions so they are motivated to sell policies at whatever the price. But some insurance companies, notably Berkshire Hathaway, focus on only writing business that is priced decently.
I think Einhorn is really focused on that for the insurance business (even though he doesn't run it. As a 17% owner, founder and chairman, I think he will pick people who have the right approach to insurance).
Of course there is still a risk. However, the risk at this point at GLRE is pretty limited. For example, as of June 2011, the loss and loss adjustment expense reserves at GLRE were about $219 million versus total shareholders' equity of $770 million. It is more typical that this loss and loss adjustment expense to be much larger versus shareholders equity. The larger the loss and LAE is versus shareholders equity, the larger the impact of underwriting errors.
For reference, here are comparisons of loss and loss adjustment expense reservevs (loss and LAE) and total shareholders' equity of GLRE compared to Ace (ACE), White Mountain (WTM) and Transatlantic Holdings (TRH):
Loss and LAE reserves Total Shareholders Equity
GLRE $219 million $770 million
ACE $39 billion $24 billion
TRH $ 9 billion $4.3 billion
WTM $5.6 billion $4.2 billion
So loss and LAE reserves at GLRE is only 28% of total shareholders' equity while other reinsurers seem to have the loss and LAE reserves above shareholders' equity; sometimes far above.
It's important to point out that GLRE's insurance business is still in the upstart stage, so this figure will probably go up over time, as long as pricing allows (I don't think Einhorn will encourage writing underpriced policies).
So at this point, underwriting errors will not have that much of an impact on GLRE.
The biggest driver of GLRE's performance will be the returns on their investments.
GLRE had an IPO in May 2007. Shares were offered to the public at $19.00/share, and the fully diluted adjusted book value per share at as of the end of March 2007 was $13.67 (the offering was at 1.4x BPS).
Investments
As of June 2011, GLRE had total investments of $1.04 billion versus total shareholders' equity of $770 million. This is a long/short portfolio of equities, primarily, and I think he still owns a bit of gold (this is one thing I don't like too much about Einhorn; it bugs me when an equity specialists starts dabbling in commodities).
Since the portfolio is long/short, this $1.04 billion is not competely exposed to the equity market. In the 10Q for the second quarter of 2011, it says that the portfolio has a net long position of around 23%. This means that out of the $1.04 billion portfolio, the net exposure (long positions minus short positions) is around $230 million.
Over time, if the insurance business can at least break even, then the growth in book value of GLRE will reflect the investment performance of Einhorn. If the insurance business continues to grow and the insurance float grows, then total investments will grow versus shareholders' equity and that will provide some leverage on the returns Einhorn can achieve.
For now, total investments is around 1.35x shareholders' equity, so if Einhorn can deliver a 10% return on total investments and the insurance business breaks even, GLRE's book value should grow around 13.5%. (The fully diluted adjusted book value per share of GLRE has grown at around 13%/year over the past five years versus an average of around 10%/year return on their investments)
As of the end of June, the fully diluted adjusted book value per share of GLRE was $19.82, down 7.3% for the year (which makes sense as the performance on the investment portfolio was -5.3% year-to-date, a ratio of 1.38). Since the equity portfolio is a long/short, we really have no idea how GLRE has done since June.
If we assume the portfolio has been relatively flat, then GLRE at $20.50 is trading at a 3% premium to book value per share. That's quite a bargain if you think Einhorn can still continue to be a successful investor.
There is no reason to believe that Einhorn can't continue to do well. He also owns 17% of GLRE so he is really incented to make this work; if this works and the company can grow, I'm sure he would love to have GLRE become a Berkshire-like vehicle for him. The risks are obvious; that Einhorn had a lucky streak in his early years and he is done, or the insurance business will not do well and eventually blow up, or a combination of both.
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