In the annals of CEOs running their own personal fiefdoms without regard for the interests of shareholders, I’m sure there are worse stories than Third Point. However, there can’t be too many.
Third Point just screwed its shareholders again with last week’s acquisition of Sirius. But before we address that, let’s do the history lesson.
Hedge Fund Re’s Origin Conflict
Since inception, the hedge fund re (HFR) model first created by Greenlight has been fraught with peril. It was created to benefit the founder’s personal interest (assets that pay a fee to the management and can’t be redeemed aka “permanent capital”) and take as little insurance risk as permissible.
This isn’t inherently wrong if all parties have eyes wide open. In full disclosure, I worked on an effort to create a hedge fund re. However, it was between consenting adults who all understood the pros and cons of their respective positions.
The biggest “mistake” (in quotes, because it likely was intentional, not inadvertent) was to take these things public and fund them with capital from retail investors who didn’t understand what game they were playing.
The pitch to these investors was they couldn’t get access to these Master of the Universe hedge funds in any other form, so they should pay a premium to book to get in the door.
In reality, there was obviously no assurance the strong performance generated during the financial crisis would continue and, for the privilege of betting on it, one had to take insurance risk they didn’t understand.
It was a one-sided relationship from day one. Perhaps emboldened by the initial advantage, the hedge fund proprietors got even more aggressive. They began to pitch this to private wealth clients so that investment banks could make fees too. Even Jeffrey Epstein got involved!
The Tide Begins to Turn
However, like Icarus flying too close to the sun, the hedge fund reinsurers got too confident. Investment performance turned south defeating the original thesis that it was worth paying a premium for access to these managers.
At the same time, underwriting losses began to emerge as it became clear that when you do a “low risk” transaction with a low quality cedant, the risk is often greater than it appears.
This resulted in the early entrants trading below book value. In other words, there was now a tax to buying a hedge fund re. You would lose in valuation compression what you gained in investment return.
Worse, the second generation entrants put time bombs in their offering documents, requiring them to go public by a certain date or liquidate. When the timer hit zero, given the choice between liquidating and giving people their capital back (and thus losing their “permanent capital”), companies chose to go public way below book and destroy value for their investors.
We have now graduated from the “they asked for it” phase to the “they deserved it”. Of course, as in many stories of abusive behavior, there is usually an authority figure who could have said or done something to stop the problem, but decided to turn a blind eye.
In this case, you might have guessed, that was AM Best. They let these companies sit at weak A- ratings with empty threats rather than use their power to put an end to the charade.
The “Who’s Going to Stop Us” Phase
Emboldened, the hedge fund bosses ignored their tanking stock prices and did whatever they could to preserve their permanent capital. Valuations continued to tank to below 50% of book value.
At those prices, clearly it made sense to put the businesses in runoff to maximize value for the shareholders or sell them to someone willing to pay closer to book value. It has been well reported that some of the HFRs explored this path. They all decided against it. The shareholders be damned.
That brings us to last week’s news. Rather than admit defeat and sell the company, Third Point went on the offensive and doubled down! They bought another troubled reinsurer, Sirius, who had its own ownership conflicts. They even paid a premium for the privilege!
Inexcusably, they issued significant stock to do so even with the stock trading around half of book value. But don’t worry the deal was “accretive on EPS”!!! Many have pointed out how any deal can be accretive on EPS in today’s rate environment but still destroy value. Issuing stock at half of book is the ultimate destruction of book value!
Saying One Thing While Doing Another
Worse, this wasn’t done by some financially naive CEO who grew up on the underwriting side and doesn’t understand capital. No, this deal was orchestrated by a company whose founder actively engages in shareholder activism. In other words, if another company did this, Third Point would likely target it for an activist campaign!
Why would they do so something so clearly shareholder unfriendly? Well, while we don’t know all the details of the post transaction plan yet, a good guess is that Third Point will continue to manage a significant amount of the investments and thus preserve its permanent capital.
The independent board members have a clear obligation here to defend the interests of shareholders over the interests of the insiders. They have grossly failed and should be embarrassed.
Transactions like these are the reason so many Americans no longer trust capitalism. Next time Third Point targets a company, my advice to the target is to respond by suggesting Third Point clean up its own yard first before complaining about someone else’s.