value and opportunity

FBD, the troubled Irish insurer issued an interesting press release last week. In one of my last posts on FBD, I mentioned that their plan for capital raising was still unclear.

This clearly shows that FBD is extremely strained from a capital perspective. The biggest unknown in my opinion is how the proceeds of the sold JV will be reinvested into FBD. They don’t comment on that 45 mn EUR at current prices (5,8 EUR per share) would be more than 20% of the company. I don’t know about Irish company laws, but this normally needs to be done on a subscription rights basis. Or the Farmers provide the subordinated capital ?

A few weeks ago, they were out in the market to raise a subordinated bond. Last week however, FBD came out with a quite surprising announcement:

“Canadian Buffett” Prem Watsa will give them 70 mn EUR in form of a 7% convertible bond.

This is the press release issued on Wed, Sep 16th, 4 pm (ex bla bla comments):

FBD Holdings plc

16 September 2015

€70 million Capital Investment

FBD Holdings plc (“FBD” or the “Company” or with its subsidiaries the “Group”) is pleased to announce that it has entered into an agreement pursuant to which Fairfax Financial Holdings Limited (“Fairfax”) will invest €70 million in FBD through a private placement of a convertible bond instrument (the “Convertible Bond”). The transaction will be subject to FBD shareholder approval.

The Convertible Bond will be a 10 year Solvency II compliant instrument and it will carry a coupon of 7.0% per annum which will be payable semi-annually. The conversion price has been set at €8.50, a 37% premium over the closing share price on 15 September 2015. Unless previously redeemed, the Convertible Bond will be exercisable from year 3 to year 10 and, in the event that the 30 day volume weighted average share price exceeds the conversion price for a period of 180 days, the Convertible Bond will automatically convert into ordinary shares in FBD at the conversion price.

The issue of the Convertible Bond to Fairfax is subject to the execution of a final, definitive agreement between the parties and shareholder approval. As an interim stage in this transaction, agreement has also been reached with Fairfax, that FBD Insurance plc will today issue at 12% per annum, €70 million, 10 year, tier 2 instrument to Fairfax (the “Tier 2 Debt Instrument”). The Tier 2 Debt Instrument will be exchanged for the Convertible Bond within 7 days of Group shareholders approving the issue of Convertible Bond.

Investors clearly seemed to like this deal in the beginning, the stock price jumped from around 6,10 EUR to 7,50 within a few hours, then however the stock pulled back and settled at around 6,70 EUR.

EDIT: the stock is already back down at 6,40 EUR.

So firstly, they will issue a 12% subordinated bond to Watsa and then exchange it into a 7% Convertible. I guess the reason for the first step is that the Irish regulator wanted to see capital FAST and they went for a “standard” structure.

The convertible structure itself is slightly more unusual. On the one hand it needs to by a “hybrid convertible” in order to satisfy the solvency requirements. On the other hand, the thing that is really strange about the convertible is the “mandatory exercise”. Normally, a convertible can be converted “at the option” of the holder and one is not forced to convert. Normal convertibles are often capped at 30-40% upside and this one has no cap, so maybe Prem traded the cap for the mandatory exercise ? I am not yet sure about this specific feature to be honest.

If we try to value the option in an option calculator, at “grant”, the option would have been worth around 46% of the share price or ~ 2,80 EUR per underlying share. This corresponds relatively well with the “sacrifice” of the 7% coupon for the convertible compared to the 12% for the “straight” Hybrid. Prem sacrificed 5% p.a. over the 10 year term which is roughly the amount he received in Option value.

So at first sight, the deal looks pretty fair from FBD point of view if we assume that the initial 12% coupon on the Hybrid is a fair one. That one is however a more difficult call. I would assume that FBD currently is not investment grade so we would talk about a “non-investment grade” Insurance hybrid.

There is not that much non-investment grade hybrid insurance paper outstanding. During a quick search I found one from Italian UnipolSai, rated BB : XS1078235733. This bond has a 9 year maturity to call and trades at around 6-6,5% yield. Further research shows that the highest ever issued coupon of a non-investment grade insurer in the Eurozone was around 6,5%. (Groupama FR0011896513).

So looking at this, Prem got a really good deal: The underlying coupon is at least 5% higher than any comparable deal seen in the Eurozone. With 70 mn EUR volume, this is 3,5 mn p.a. that FBD has to pay extra for the privilege of having Prem Watsa as an investor. To me it looks like that FBD’s management somehow panicked and Prem was the only guy who was quick enough. Good for Prem, bad for the shareholders.

Overall, for me FBD is now “off” my watch list, I don’t think that their main goal is to create shareholder value and the upside over the next few years looks quite limited. For Prem this could work out as he is getting ~5% extra per annum and is protected to the downside to a large extent. If you really like Prem Watsa, it is maybe a better idea to investe alongside his main vehicle compared to an inferior position as shareholder at FBD.