friedman fleischer & lowe llc the insurance industry's ability to attract capital given...
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FRIEDMAN FLEISCHER & LOWE LLC
The Insurance Industry's Ability to Attract Capital Given Historically Low ROE
– A Perspective by Friedman Fleischer & Lowe LLC
Rajat Duggal
May 17, 2005
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FRIEDMAN FLEISCHER & LOWE LLC
Overview of Friedman Fleischer & Lowe LLC
• FFL Strategy
- Focus on U.S. middle-market companies with enterprise values of $50-$500 million
- Target outstanding companies, focusing on high ROIC
- Proactive industry focus with a generalist mindset
- Enhance business performance through effective company involvement
• FFL Capital Under Management
- $335MM committed to FFL I (1999 vintage)
- $815MM committed to FFL II (2004 vintage)
• Insurance Investments
- Montpelier Re (Startup capital – Dec. 2001)
- Wilton Re (Startup capital – Dec. 2004)
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Overview of Friedman Fleischer & Lowe, LLC
• Financial Services
• Insurance
• Business Services
• Education and Training
• Healthcare
• Consumer Products
• Marketing and Media
FFL I CommitmentsTargeted Industries
Healthcare9%
Consumer Products
36%
Business Services36%
Insurance11%
Financial Services
8%
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Reasons FFL Invests in the Insurance Industry
1. Cyclicality provides opportunities for above-average returns
2. Limited correlation to market allows for efficient portfolio diversification
3. Niche insurance opportunities can generate above-average returns
4. Certain insurance sectors enable low volatility investments
5. Opportunities for value-creation by improving operations
6. Less competitive buyout environment
7. Industry currently experiencing significant change
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-5%
0%
5%
10%
15%
20%
25%
1980 1985 1990 1995 2000
Property & Casualty Return on Equity
Source: A.M. Best, RAA Swiss Re Economic Research & Consulting, FPK
-5%
0%
5%
10%
15%
20%
25%
1980 1985 1990 1995 2000
Property & Casualty Return on Equity
Source: A.M. Best, RAA Swiss Re Economic Research & Consulting, FPK
1. Cyclicality
FFL Invests in Montpelier Re – Dec. 2001
FFL Exits Montpelier Re – 2003-2004
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1. Cyclicality
(0%)
20%
38%
23%
-5%
5%
15%
25%
35%
2001 2002 2003 2004
Montpelier Re Return on Equity
2003 P&C Industry ROE
IRR = 42.1%
Money Multiple = 2.1x
• Timing cycle well leads to high ROE and investment returns
-5%
5%
15%
25%
35%
2001 2002 2003 2004
Montpelier Re Return on Equity
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%Correlation to Market Performance By Industry
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%Correlation to Market Performance By Industry
2. Non-correlation to market
• Relative to other industries, returns in insurance are less correlated to overall market movement
• Enables diversification in portfolios with other industry holdings
P&C Insurance = 40%
Life Insurance = 50%
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3. Niche opportunities – Above Average Returns
• Certain insurances niches have outperformed rest of industry
• FFL seeks to make investments in these higher performing niches
- Evaluated investments in specialty property, MGAs and non-standard auto
8% 9%12%
-5%
5%
15%
25%
35%
2002 2003 2004P&C IndustryMercuryProgressive
Return on Equity
Picking the right insurance sub-segments can
generate above average returns
8% 9%12%
10.3%
15.0%
19.9%
-5%
5%
15%
25%
35%
2002 2003 2004P&C Industry MercuryProgressive
Return on Equity
8% 9%12%
10.3%
15.0%
19.9%21.3%
28.3%31.5%
-5%
5%
15%
25%
35%
2002 2003 2004
P&C Industry Mercury Progressive
Return on Equity
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4. Selective Insurance Sectors – Low Volatility
• Some insurance sectors (e.g. Life) have inherently lower volatility of returns
($15,000)
($10,000)
($5,000)
$0
$5,000
$10,000
$15,000
$20,000
1992 1994 1996 1998 2000 2002
P&C Life
U.S. Pre-Tax Operating Earnings ($MMs)
Source: A.M. Best, P&C and Life & Health 2004 Aggregates & Averages
($15,000)
($10,000)
($5,000)
$0
$5,000
$10,000
$15,000
$20,000
1992 1994 1996 1998 2000 2002
P&CLife
U.S. Pre-Tax Operating Earnings ($MMs)
Source: A.M. Best, P&C and Life & Health 2004 Aggregates & Averages
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4. Selective Insurance Sectors – Low Volatility
Investing in low volatility businesses increases risk-adjusted returns and enables portfolio balancing and diversification
21%
28% 28%32% 34%
37%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Coke LifeAverage
GE Merck GM EBAY
Volatility - Last 4 Years
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72%68% 66% 65% 63% 65% 67% 69%
0%
10%
20%
30%
40%
50%
60%
70%
80%
1998 1999 2000 2001 2002 2003 2004 Q12005
LBO Debt/Total Cap
4. Selective Insurance Sectors – Low Volatility
Lower leverage mitigates risks relative to typical LBO deal
Specialty
P&C
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5. Value-creation by improving operations
• Insurance industry has been relatively slow to adopt recent technologies
- Outsourcing business functions to more efficient providers
- Adoption of certain advanced business practices and technologies
• Provides opportunities to invest and improve operations
• Aligns well with FFL’s competencies and investment strategy
- FFL combines strong operational and investment expertise
David Lowe – Former CEO of ADAC and winner of Malcolm Baldridge National Quality Award for Business Excellence
FFL has worked extensively with portfolio companies to improve operations
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6. Less competitive buyout environment
• Significant capital overhang exists among U.S. private equity firms
$0
$50
$100
$150U.S Uninvested Buyout Capital ($BN)
Source: “Private Equity Performance 2004; The Coming Shakeout” Thomson
.
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6. Less competitive buyout environment
• Private equity investors are less willing to invest in insurance- Statutory accounting and actuarial analysis complex and different
- Balance sheet v. income statement orientation more typical for buyout funds
• Total current funds over $1BN under management is over 150
• But only a few funds are currently focused on insurance- Blackstone- CSFB- Cypress Group- Friedman Fleischer & Lowe- Hellman & Friedman- J.P. Morgan- MMC- Warburg Pincus
Insurance presents opportunities to invest in less competitive environments
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7. Rapidly Changing Industry Dynamics
• Changing business models
• Higher regulatory scrutiny
• Potential divestitures by entities under investigation
• Capital flight from industry leaves under-priced assets
• Elliot Spitzer . . . . Need I say more??
Change Creates Opportunity
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Summary
• Insurance industry will continue to be an attractive sector for investment
- Cyclicality will always exist
- Niche lines will produce above-average returns
- Portfolios will continue to need diversification and balancing
- Operational improvements will continue to create value creation opportunities
- Industry change creates opportunity
FFL will continue to opportunistically pursue investments in the insurance industry