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.

             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).

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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