Monday, June 23, 2008

Post Mortem: Berkshire Acquires Gen Re, 1998. Part 3

What the hell happened to Gen Re after the deal???

1. Reinsurance was underpriced in 1998.
2. Underpricing was associated with under reserving, so the balance sheet was too optimistic.
3. Terrorist Attacks, 2001.
4. A lot of hurricanes in 2004-2005 capped off by Katrina.

Once again, here is some data:

The 10 year cost of float has been $6.7 billion over the last 10 years. On the chart, I have this split out into losses from prior years (under reserving, under pricing), Terrorist attacks, and Hurricanes. I am assuming that one mega property catastrophe is likely, but the under pricing, under reserving, and terrorist attacks are unlikely to happen again.

This would put the normalized 'cost of float' at about 1%.

Over the course of the decade, I would be very surprised if the total return on float wasn't significantly higher then 4%. The excess returns are profit.

As far as what didn't happen (but could have happened) are significant recapitalization or dilution.

Post Mortem: Berkshire Acquires Gen Re, 1998. Part 2

What Berkshire gave up when it traded its shares for Gen Re's:

Let's just look at some numbers. Here is the historical balance sheet at the time of the merger, with all entries shown in dollars per Class A share rather then dollars.*

A couple of numbers stand out: The equity portfolio of $33,402 per share and the $9,957 deferred tax liability. One of the main motivations for Buffett's buy and hold strategy is the almost $10k per share in deferred taxes from unrealized gains on the equity portfolio. However, the downside is that the large cap stocks in the portfolio are very richly valued in June of 1998. Here are the major holdings as of 12/1998:

And here is the portfolio at 12/2008:

In order to avoid doing a lot of heavy lifting, I would just point out that Coca-Cola, American Express (3 for 1 split), and The Washington Post account for a hefty chunk of the portfolio and haven't done anything for the last decade (except pay modest dividends).

However you want to value BRK at June 1998, it is hard to argue (especially in retrospect) that paying any premium over book value for a large cap investment portfolio doesn't make much sense. Therefore, the price to book ratio of 2.7 ($80,400 price, $29,621 book) didn't make a lot of sense. If you assume that the stock portfolio made up 50% of Berkshire's value and assign it a value of 1xmarket price, then the price book ratio on the remaining half would be 5.4!

The bottom line is that there is no way that BRK couldn't be considered richly valued at the $80,400 price used to calculate the conversion ratio in the Gen Re merger. The two points here are that Buffett sold high, and in coming to this conclusion, it's easy to get a feel for the value added by the shifts in the investment portfolio facilitated by this deal, from richly priced stocks to bonds and cash.

*This balance sheet differs from the actual pro forma balance sheet in omitting the 'adjustments' column which primarily adds $12 billion in goodwill. Omitting goodwill from the deal more accurately reflects the economics of the combined company.

Sunday, June 22, 2008

RE: How Much is General Re Worth, Anyway?

Before I get totally buried in the fog of accounting arcana, lets briefly run through Jeff's post and address the major points, one by one.

He starts out quoting Buffett on the Dexter Shoe acquisition for stock:

What I had assessed as a durable competitive advantage vanished with a few years. But that’s just the beginning: By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion – to buy a worthless business.

In the case of Dexter, he bought the business, it made no money, and became worthless. There are three things to note: Buffett bought a bad business, he used stock instead of cash, and the stock (with no help from Dexter) went from roughly $10k per share in 1993 to over $100k today. Not that different from selling Apple stock in 2000 and buying Enron stock. Two bad decisions, selling a winner and buying a loser.

In the case of Gen Re, he bought a profitable business which contributed to BRK's current share price. He issued stock priced at $80,400 10 years ago, and is now selling for $125,000. The 267,750 shares of stock issued to buy Gen Re at today's price makes the cost $33.5 billion rather then the $40 billion quoted by Jeff. If you stick to the metrics used when Gen Re was purchased, the float over the 10 years has increased from $15 billion to $23 billion, right in line with the 50% increase in the stock price. From this simplistic perspective, everything is a wash.

After making points about the deal being awful in regard to regulatory issues, which I agree with, he then finishes with the assertion that, "It is hard to imagine that for $40 billion, Warren Buffett could not have re-created General Re, with money to spare." I don't know how to answer that except to say that it is hard to imagine creating a global direct reinsurer like General Re period. Gen Re (along with Munich Re and Swiss Re) are franchises of a sort that can't just be created out of thin air.

The real story is classic Buffett. A deal with compelling economics meets with awful luck and becomes just a reasonable deal. The bad luck include awful timing, since reinsurance pricing in 1998 was worse then anyone realized at the time. As a result, Gen Re was under reserved by $2 billion and business on the books was underpriced by another $2 billion. This was followed in 2001 by the September 11th terrorist attacks which cost another $2 billion. And then, two of the worst hurricane years on record, 2004 and 2005 capped off by Hurricane Katrina.

At the time of the acquisition, Gen Re had about $15 billion in float or investable assets from policy holder supplied funds. They also had a tangible book value of $7.5 billion. This is $22 billion in new investment funds amounted to $84,000 in investments per share for each of the newly issued shares. This increased the investments per share of the combined entity, as noted in the 1998 Chairman's Letter, " During 1998, our investments increased by $9,604 per share, or 25.2% [to $47,647]."

And of course, Buffett went from the tailwind of the 1990's equity markets to the headwinds of this decade. Putting $20 billion in investable funds in Buffett's hands seemed compelling in 1998. In 1998 over a third of Berkshire's stock portfolio consisted of 200,000,000 shares of KO (Coke), then valued at over $13 billion ($13.4 billion out of $37.3 billion at 12/98). A decade later, that holding is valued at $11 billion. So the new money had to do some heavy lifting to get Berkshire to its current level of investments per share of $90,000.

As far as the 'bad luck' that Gen Re suffered over the last decade, they are unlikely to suffer from under pricing or under reserving. A reasonable expectation for catastrophes is more like one $2 billion event (for Gen Re) rather then the two they suffered. However, the real benefit of a company like General Re in Berkshire's portfolio is that it will not need additional capital, but will continue to generate investable cash. What's not to like about that?

Saturday, June 21, 2008

Post Mortem: Berkshire Acquires Gen Re, 1998. Part 1

Jeff Matthews questions the wisdom of Berkshire Hathaway acquiring General Re in 1998 for stock.  This is a difficult question, but as with most Berkshire deals, is worth pondering. First things first -- any acquisition involves what one might call operational risk for lack of a better term. And naturally, it is the unknown unknowns that are always the worst. In this case, the significant regulatory issues that have plagued Gen Re's management in the decade following the sale, and in the process, became a significant distraction for Berkshire as well as a reputational issue.    I will duck this one, at least for now and focus on the financial aspects of the deal.

There are three parts to this analysis:  What they got in 1998, what they gave in 1998, and how the pieces have performed in the subsequent decade.  Part 1 is what Berkshire got.  All the information needed is in a 1998 SEC Form S-4.

"On June 19, 1998, the last full trading day on the New York Stock Exchange prior to the public announcement of the Transactions General Re common stock closed at $220 1/4 per share, and Berkshire Class A Common Stock closed at $80,900 At the exchange ratio of 0.0035 shares of Berkshire Class A Common Stock per share of General Re Common Stock, the equivalent price of a share of General Re Common Stock on June 19, 1998 was $283.15."

The exchange ratio means that Berkshire issued 267,750 Class A share equivalents to get General Re.  Let's take a look at a summarized pro forma balance sheet as of 6/30/1998:

This is a little daunting, so I have created a horribly simplified balance sheet for Gen Re:

The reason that I am showing the balance sheet is that the concept of float seems so simple in the Berkshire Hathaway Chairman's letters, but so slippery when it is discussed.  Liabilities for policy holder funds that will be paid in the future are booked today.  When you book the liability, you also book an offsetting asset.  That asset starts out as cash.  The reason float is good is that you have an asset in cash today and a liability payable in the future.  There is no segregated asset referred to as "float" in the left hand column.  The only way to determine the quantity of float is to look at the liabilities.  Float is buried in the asset column but can only be quantified using the corresponding segregated liabilities.  

First, you can ignore about $10 billion in assets and liabilities associated with Gen Re's financial business (included in the 'other' category).  Secondly, the float is equal to the loss and loss adjustment expenses (which will be paid in the future) and the unearned premium, less the portion of those that haven't been collected.  According to Warren Buffett, the Gen Re float is $15 billion.  In addition, the shareholder's equity (less the goodwill) is also investable.  That's another $7.5 billion.  

For each Berkshire A share, the Gen Re investible float is equal to the $15 billion divided by the 267,750 shares or $56,022 per A share.  Including the tangible equity, you get $84,120 per A share.  

Buffett sold Gen Re's equity portfolio*, so the entire investable amounts were bonds and cash.  So for every new A share issued in 1998, Buffett got $85,000 to invest.  Now insurers are regulated and the investments are subject to some constraints.  In addition, the liabilities proved to be inaccurately valued, effectively increasing the cost of the deal by $2 to $3 billion.  Nevertheless, Buffett got his hands on a lot of cash for each new A share issued.

As far as the theoretical option of simply doing a secondary offering and selling 267,750 shares at $80,000 per share, forget about it.  Berkshire was selling for 2.7 times a book value of less then $30,000, and a lot of that book value was simply publicly traded large cap stocks.  The historical stock prices for Berkshire prior to the merger were:

So you can see that the stock had not sold for over $50k per A share until 1998 and the $84,000 would prove to be a rich valuation.  Regardless of his brilliance, giving Buffett $80k/share to invest $40k/share would be a tough sell.

This is the end of part 1.  Part 2 will examine what BRK gave up when it traded its shares for Gen Re's.  


* From the 1998 Chairman's Letter to Shareholders, "Once we knew that the General Re merger would definitely take place, we asked the company to dispose of the equities that it held. (As mentioned earlier, we do not manage the Cologne Re portfolio, which includes many equities.) General Re subsequently eliminated its positions in about 250 common stocks"