The Value of Capital vs. The Value of Management

There is an interesting tug-o-war between the value of capital and the value of management evident in hedge funds, but even more strikingly highlighted perhaps in reinsurance. This is worthy of examination if only for the fact that they sit at opposite ends of the proverbial rope, producing (at present) an unimaginably large gulf between the two.

Anchoring one side, we have have the traditional reinsurance company. Once jokingly the last refuge for those ex-college football players that failed in the sleepy primary insurance market, these companies have come a long way from their disparaging caricature and Lloyds scandals - a time coinciding with capacity shortages from Hurricane Andrew that spawned a new class of dedicated entity with less-conflicted, more professional managements. They now sport reasonably disciplined underwriting and specialty lines that give them some diversification, with some even moving up the food chain to compete in the primary market. In this realm, the market for new-venture creation is reasonably efficient with an able management team able to raise capital from a variety of experienced private equity and dedicated insurance investors and garner between 5 & 10% of equity on long-term incentive plans in exchange for pedigreed stewardship of capital in a start-up. Capital thus maintains 90% to 95% of the upside (less operating costs), symmetrically bearing the same downside. As with most externally-funded enterprises, it is Capital that reaps most (90 - 95%) of the the reward in the growth [if any] of the enterprise. This "split" is seen as reasonably sufficient to align Management's and Capital's interests, without creating undue agent-principal dilemmas, or grandiose empire-building endeavors.

Anchoring the other side, we have a hedge-fund model applied to a dedicated reinsurance risk-taker, such as that which London-based MAN recently purchased a portion. Here, Capital (i.e. the Investor) pays "one-and-something" plus a deeded 20% performance fee on the (net) upside, though bears the full burden of the downside-risk, albeit without performance fees. Perhaps there is also a high-water mark, for which one would need to review the PPM in detail, the presence of which increases the attractiveness over the course of the profit and loss of a full cycle. Capital placed at risk here has ALL the downside of the underwritten "risk", but none of the upside of the business growth. Here management receives a full 20% of immediate economic spoils and 100% of the business-growth options that arise from the successful stewarding of Capital ostensibly through wise portfolio management, prudent risk-management, and avoiding adverse risk, and undoubtedly a barge-full-'o-luck.

The obvious question arises as to precisely "why" the Capital funding a purposeful reinsurance company formation is able to obtain seemingly so much more of the upside (at the expense of management) with seemingly the same downside, than Capital investing in a reinsurance hedge fund. If it were a matter of a small difference, it would be a dull topic of conversation, and you might be watching "House" re-runs instead of reading this. But being that the order of magnitude of difference is so large, it demands an answer.

The first question should be: are we comparing "like with like"? Th answer is essentially is yes. Both are providing risk-capital to effectively underwrite reinsurance risk. Both are more or less dependent upon external events for realization of profit. Both use essentially the same standard industry modeling techniques (eg RMS). And both profit more (less) in hard (soft) markets respectively. There may exist subtle differences in risk selection, leverage, and portfolio management, but these are less important determinants in the scheme of things. Florida windstorm or California quake are essentially homogenuous risks.

So what is different that might possibly be used as an excuse to justify keeping all the business upside or yielding ALL of it in its entirety it to one's agent? Liquidity, for one, differs - at least on the surface. The commitment of insurance VC is not an annual event, whereas Capital in a reinsurance hedge fund can be withdrawn within stipulated guidelines, typically less onerous than VC lock-ups. Of course if you buy a share of a listed reinsurance company in the secondary market, there are no restrictions. In fact, the reinsurance hedge-fund might be "less liquid", by comparison. To be fair, buying risk through the trading of shares entails high market impact for sizable risk, but this too is reasonably manageable if spread across a portfolio.

Leverage and prudence may also differ. Katrina fatally blew-apart more than one catastrophe reinsurer - not because it was SOOO bad, but because management over-leveraged and under-diversified. In bridge and traders parlance it's called "shooting the moon". Most diversified, well run companies took hits and stomached the loss but it IS easier for the corporate entity to "reach" via leverage than the reinsurance investment manager who - without a proper balance sheet - well might face jail for a similar transgression. That is, of course, if he could a find a counterparty dullard enough to accept an under-capitalised promise for which there is no recourse...

Investment returns - premiums, excess capital, etc. provide another temptation for management not available to the reinsurance hedge fund. This could be good or bad, depending upon whether your investment pecadillo happens to be called "SCA" and Amaranth or its called "Paulson Global Opportunity Fund". On this front, many-a-reinsurance company has failed miserably in its pursuit of higher returns(hedge funds), non-core empire building (SCA), or social status hob-nobbing (Hollywood movie investment). Others however have soundly and soberly managed to earn higher returns than those available to just underwriting risk and placing it some collateralized trust structure. It is understandable for investors to desire to disentangle the two. However, IF one, for whatever reason, has investment alpha, the coorporate structure allows this to be better exploited resulting in higher returns overall to investors. However, the jury thus remains out on this front as to whose advantage this favours.

Cost structures are different. That is a major selling point of the hedge fund, vs. the largesse of corporate boards, Sarbox compliance, prima-dona underwriters, staff pensions costs, etc. But many costs are inherent in acquiring business to develop a more diversified risk book, and building an enterprise with depth, longevity, and redundancy that makes counterparty's feel safe, and allows more complex structures and risks to be assumed (presumably with better spreads) rather than merely marginally providing liquidity to a limited number of homogenous markets. Wining and dining, freebies, conferences, etc.fees, commissions, kickbacks all entice business, and senior people with relationships and expertise require meaningful compensation all which hits the bottom line. Moreover, these costs exist even in a disaster year where losses pile up due to the disaster or catastrophe-du-jour. One could argue that the Corporate's expense ratio is not dissimilar to "2&20" which might make one agnostic as to which structure one invests with. In reality, these "costs" are part-capex, and should build greater long-term value.  Yet, even IF the former were true, and one was indifferent, there is still the little chestnut about whether the business "optionality" should accrue to Management or Capital.

Transparency. Paradoxically, the HF structure provides MORE transparency than the corporate entity. Industry insiders say that a "clean reinsurer" is an oxymoron. There are only "less bad ones". Whether its the investment portfolio, or the current risk position, legacy risks, or malfeasance, one is never quite certain what's under hood. That said, there is no shortage of younger (both public and private cos. who are - relatively speaking - "clean", and there is nothing to prevent motivated capital from essentially setting up themselves (as Citadel, DE SHaw, and others have done), and cutting a deal with a capable management team.

While none of these reasons themselves are compelling, is there not something that explains it? For here where are today, with fine (not that I am qualified to pass this judgment) listed reinsurance companies trading at 5x forecast (and historical) earnings and up to 25% discounts to tangible book, solid management teams and well-operating infrastructures, existing relationships and books of business, and YET, MAN decides to buy into the other model, i.e. the hedge fund model, despite the seeming availability of BOTH the underwriting upside AND future enterprise appreciation upside, and do it at a reasonable discount too.

One possible answer might be - as queer and comical as it sounds - is that they simply have different investor bases. The corporates have smart, long-term, money who presumably value long-term growth and are willing to stomach illiquidity, volatility and discounts to book over the intermediate-term. The hedge fund model has investors that values one thing: "one-percent-per-month" in addition to the technicality that they often CAN ONLY INVEST IN HEDGE FUNDS, irrespective of how sub-optimal it may in comparison to investing in the same risk through a listed corporate. Yet another example of a local optimization problem. For the reinsurance HF investors are NOT irrational - just constrained, and a tad self-interested (yet another principal-agent dilemma). One can measureably sympathize with the investor who rolled the dice and bought a portfolio of listed reinsurers in 2007, which navigated the storm season and earthquake risk well, made ~18% returns on their equity except for the odd-ball who had monoline(s) exposure, YET their shareholders stomached negative mark-to-market returns (including dividends) despite the increases in book vals. But that was then, and this is now. When listed co's are trading at large prems to book, I can understand the aversion of opportunistic investors who just want the underwriting risk. But when they are cheap, very cheap, wisdom almost certainly favours the listed corporate, hands-down.

While the original question was "why would Capital not extract full potential rents from its existence, size and investment horizon?" perhaps I should lay that aside, and invert it into the more germane question which is: "IF the gulf is so wide, why would start or join a reinsurer when they could start a reinsurance hedge fund??!?!"