Private equity firms are eyeing opportunities to break into the tricky Lloyd's market, but analysts see little prospect of merger and acquisition activity this year

Apollo Global Management’s apparent determination to buy a Lloyd’s insurer calls into question whether other private equity firms – or industry suitors – are of the same mind.

Apollo has made two bids for Brit Insurance Holdings, which rejected both. Some observers have suggested that if Apollo loses patience with Brit, it may go for another Lloyd’s operations, such as Chaucer or Novae.

Lloyd’s is one of the key places for those interested in exposing their capital to insurance and reinsurance risk. International groups including Tokio Marine, Validus and Flagstone Re have bought into the world’s oldest insurance market over the past two years.

Lloyd’s, with its strict entry policy, is not the easiest or quickest place to set up an operation from scratch. But shares of listed Lloyd’s insurers are generally trading at discounts to their net asset values, making them more attractive to buyers. Brit’s shares, for example, are trading at around the £9 mark, while the company put its 2009 net tangible assets at £10.52 a share.

Apollo is not the only private equity firm to have shown interest in Lloyd’s vehicles. Last year, Pamplona Capital Management built up a 9.99% stake in Chaucer, and was rumoured to be interested in increasing it further.

“You can see why a private equity company might take a look at a Lloyd’s business at the moment, because they might see hidden value there,” rating agency AM Best’s general manager, analytics, Miles Trotter says. “The share prices are depressed below net asset value. There is potential for a high-dividend yield, and you might see yourself as being well positioned for when the market turns around and rates improve.”

Furthermore, insurance and reinsurance companies, having replenished their balance sheets in 2009, have a surfeit of capital and little prospect of organic growth given the soft market in most business lines. Those without existing Lloyd’s operations might decide to rectify both situations with a purchase.

Funding issues

For many, however, Apollo’s quest for Brit is an anomaly. Many of the firm’s private equity peers are finding it tough to raise capital, which is limiting their acquisition capabilities. “The Apollo situation has caught everyone slightly off-guard because private equity firms are struggling to get the leverage they were historically able to access,” KBC Peel Hunt analyst Christian Stobbs says.

And while Lloyd’s insurers’ share prices are below book value, Brit’s persistent spurning of Apollo’s advances shows they are prepared to hold out for a good price. “For the time being, Lloyd’s businesses remember having more buoyant share prices in recent history and don’t feel they are in a position where they have to accept a low offer,” Trotter says. “For the balance of 2010, I don’t see mergers and acquisitions as being too active in the Lloyd’s market.”

“There are still a fair number of barriers to doing deals, not least general management’s desire to protect their position and boards’ view that the multiples on the screen are far too low,” Collins Stewart analyst Ben Cohen agrees. “There is a tension between what these businesses think they are worth, what they are fundamentally worth, and the multiples acquirers are willing to pay given the money they have.”

Buying Lloyd’s insurers also comes with risks generally not found outside the market. One is that the success of many Lloyd’s businesses centres on an individual or a small group of people. “If you acquire a Lloyd’s entity, the danger is that there will be dissatisfaction among leading underwriters in the acquired entity. It is too easy for them to go to another Lloyd’s company and take business with them,” Trotter says.

Urge to merge

The situation could alter, however, if there is a benign hurricane season in 2010. This would dampen hopes of hardening rates, pushing down valuations still further. If that happened, buying a Lloyd’s vehicle would be a “no-brainer”, according to Stobbs. “These companies largely make a 12%-15% return on equity. If you buy them at a discount to book value, the maths is very compelling,” he says.

Others feel it could be some time before a lack of catastrophes translates into mergers and acquisitions. “If there is a prolonged period of depressed rates, pressures will grow. But I don’t see that being the situation for the balance of the year,” Trotter says.

A further catalyst for mergers and acquisitions at Lloyd’s could be the European Commission’s Solvency II directive, which comes into force in January 2013. Many expect the additional capital and administrative burdens of the directive to hit smaller companies particularly hard. But firms operating at Lloyd’s could be insulated from its effects to an extent, as Lloyd’s itself is working to lighten the load for syndicates.

While acknowledging that Solvency II will cause an urge to merge among small and mid-sized insurers outside the market, Lloyd’s finance director Luke Savage expects little change to firms within the market. “We can help them with so much of the implementation burden, either by taking that on centrally or helping them manage it within their businesses.”

To the extent that Solvency II does have an impact on Lloyd’s mergers, it is unlikely to be felt for some time. “There may be regulatory pressures on less diversified companies in Europe generally, and that could drive some specialist companies in Lloyd’s and elsewhere into the arms of larger parents,” Trotter says. “But I don’t see that happening in the immediate future – not in 2010 or even into next year.” IT