Description

HRG Group

HRG Group (“HRG”) offers the opportunity to achieve above average arbitrage-like returns (~22.5% gross) without assuming “deal break” risk. HRG is a holding company, with public stakes in Spectrum Brands (“SPB”) and Fidelity & Guaranty Life (“FGL”) representing the vast majority of the NAV. HRG trades for $13.96 / share compared to NAV of $17.10 / share. I believe that HRG will eventually transition into a single-asset holding company (SPB shares) and subsequently merge with SPB. I recommend purchasing HRG and hedging the look-through exposure to SPB and FGL, with the opportunity for ~22.5% gross returns with little downside other than time risk.

What is HRG?

HRG was formerly the public investment vehicle of Phil Falcone / Harbinger. As of today, the company consists of controlling stakes in SPB and FGL, a reinsurance operation called FrontStreet Re, and an asset management business (HGI Asset Management Holdings) in wind-down. The following table outlines the NAV.

Who owns HRG?

Leucadia owns 23.7% of the company. Fortress owns 16.8% of the company. A handful of other hedge funds push the “effective” ownership over 50%. Leucadia and Fortress currently control 3 / 7 of the board, with Joe Steinberg serving as Chairman.  Leucadia’s standstill with HRG expired March 2016.

Why will the spread close?

1. Rational Outcome for HRG:  HRG owns ~$4 billion of appreciated SPB stock. By virtue of HRG’s C-Corp status, HRG would owe a large amount in taxes should it ever sell its SPB stock. If HRG desires to monetize its SPB investment, the easiest and most tax-efficient solution for all parties would be a stock-based merger of HRG and SPB. This outcome likely requires streamlining HRG, so as not to burden SPB with extraneous lines of business.

2. Rational Outcome for Largest HRG Shareholders: Both Leucadia and Fortress are in the investment business. It would not be rational for them to advocate for new investments to be made out of the HRG entity due to dilution (they would rather invest directly) and an additional layer of taxation. Moreover, maximizing value of their indirect stake in SPB requires eventually minimizing the HRG / SPB discount.  

3. Evidence of Streamlining: Given that the company has not announced any plans to work towards a single-asset holding company structure, investors must determine if recent actions support a streamlining hypothesis. I offer the following evidence:

1. FGL: HRG put FGL up for sale and is currently contracted to sell the business to Anbang Insurance for $26.80 / share in cash. More on this later.

2. HGI Energy: Compass Production Partners (an E&P) was the last remaining asset of subsidiary HGI Energy. HRG announced on July 5, 2016 that they entered into an agreement to sell Compass.

3. HGI Asset Management: HRG has not made any new investments recently from the asset management subsidiaries and has been winding down their loan portfolios, with exposures declining from $800mm to less than $200mm.  

4. Personnel Moves: Serial director Gene Davis resigned from the board on May 5, 2016. Managing Director and VP of Investments David Maura was effectively migrated to employment at Spectrum Brands on January 6, 2016, now serving as its non-executive Chairman.  Chief Accounting Officer Michael Sena resigned on May 20, 2015.

5. Leucadia Disclosure: The 2014 Leucadia Annual Report noted that “Despite the strength and growth of these two underlying assets, throughout 2014, HRG’s stock traded at a significant discount to the sum of the value of its shares in these publicly traded stocks combined with HRG’s other net assets. We believe significant upside potential remains to be realized by narrowing this valuation gap and supporting the continued growth of Spectrum and Fidelity. The 2015 Annual Report noted that the opportunity at HRG was to “Drive Value Through Simplification” and that they believe the “sale of Fidelity, combined with the additional sale of other assets, may help to close the ongoing gap between HRG’s share price and the sum of the value of its various parts.”

4. Rational Outcome for SPB: HRG fully controls SPB despite owning 58% of the shares. SPB shareholders may enjoy eliminating the “controlled company” status of the business.

Why does this opportunity exist?

The current discount to NAV would not be excessively wide if one did not believe there was a path to closing the gap over a reasonable amount of time. Since the “transaction” is unannounced, many investors may not be aware of the opportunity.

Risks

1. FGL Deal Break: Anbang withdrew its insurance regulatory change of control application with the New York Department of Financial Services on May 27, 2016. Based on the decline in the price of FGL shares, the market / merger arbitrage community likely believes the probability of closure has diminished significantly. Press reports have speculated that the inability to receive approval in New York on the first go stemmed from unwillingness on behalf of Anbang to disclose its ultimate beneficiaries. Though I do not have an opinion on the likelihood of deal closure, I do acknowledge that a “deal break” would likely elongate the timeline of the investment and reduce the IRR. There were numerous other bidders for FGL as a part of the sale process (though bid levels will probably decline in the event of a re-auction).

2. Leucadia / Fortress Incentive: The large shareholders may not be in a hurry to “collapse the spread” given that they have an unhedged position. Moreover, there may be a desire to extract a control premium for their stake in HRG by eventually selling the HRG entity outright (which while favorable from a valuation perspective, may take more time). These concerns are somewhat offset by the frictional costs of maintaining HRG as a publicly listed entity. Moreover, I believe investors will likely profit simply from the intermediate step of creating a single-asset holding company (a 20% discount would likely be too wide for a liquid single-asset holding company without meaningful reinvestment risk).     

3. Absence of Leucadia Open Market Purchases: Leucadia has not increased their position in HRG since the expiration of the standstill. If a collapse was imminent, one would think that Leucadia would exploit the “free money” opportunity and acquire more shares.  

Catalyst

Discussed above.