Description

Overview
Westaim (TSXV:WED) is an investment company traded on the Toronto exchange with a focus on financials. The company has gone full cycle on one investment, Jevco, which more than doubled in TEV from its acquisition in Mar-10 for $261.4M and sale for $530.0M in Sep-12, after which management returned the vast majority of the proceeds to its shareholders. Today, Westaim owns effective control positions in two companies: HIIG, a specialty insurer, and Arena Group, a fundamental credit investment manager. One note: share quotations are for the American Depository Receipts (WEDXF) and all financial figures are in USD, as the subsidiary operations are materially all in the United States.

The thesis on Westaim is a story as old as time for value investors: an undervalued sum-of-the parts. This is a well-run holding company with aligned management that trades at a discount to a book value. Book value, in turn, understates the economic value of each of its two subsidiaries.

At the highest level, the thesis is:

• Market Cap: $281 million; $1.97 / share
• Book Value: $338 million; $2.36 / share (0.83x price-to-book value)
• Economic Value: $470 million; $3.28 / share (0.60x price-to-economic value)
• Probabilistically, economic values are more likely skewed to the upside vs. the downside when compared to a base case shown above
• High quality management team aligned with shareholders (own 9.7% of common shares)
• Any further value-creating acquisitions are purely to the upside

The risks are relatively straightforward for these types of businesses:

• HIIG: quality of underwriting, integration level of acquisitions, and profit sustainability of specialty lines
• Arena: ability to scale the asset base at good fee rates and, relatedly, go-forward investment performance
• One circumstantial negative compliance mark in the background of each portfolio CEO

The above bridge from market value to economic value is shown in more detail below, after which is a brief summary of the understated value of HIIG and Arena. A history of the Company and a more comprehensive explanation of each subsidiary follows.

HIIG is carried on Westaim’s books at 1.1x book value; both trading comps and recent precedent transaction comps would indicate a more appropriate value at ~1.6x. Westaim management received numerous inbounds for HIIG and announced a strategic review in Q2-18, which has not resulted in a sale, at least to-date. While a transaction not clearing is rightfully cause for some trepidation, this author speculates that management is unwilling to part with a good operation that has both organic and acquisition runway unless they can fetch an outsized exit price. Westaim has continued to build value at HIIG since announcing the strategic review, completing two acquisitions in the timeframe.

The Arena Group is a series of entities that combine to create a fundamentally-driven credit investment manager generating equity-like mid-teens returns with a CEO boasting a track record of doing so. There are three groups of Arena entities: Investors, Origination, and Finance. Origination and Finance are held at 1.0x book value and I have no good reasons to dispute those marks.

Arena Investors, however, is carried on the books at -$8.2M of book value. This negative value deeply understates the inherent economic and option value in the business, to say the least, but is a function of start-up costs when building an asset management platform (hiring and building infrastructure ahead of fee income). Westaim’s share of Arena Investors’ EBITDA should be ~$5M on a run-rate basis, but that could quickly break to the upside given the returns, pace of inflows, and senior team’s track record. A 10x multiple would make this a $50M business, which still leaves upside equity potential if the platform continues to scale or even begins to approach the $5B at the top-end of the agreed-to structure between Westaim and Arena management.

As spike945 noted in a great September 2017 write-up, management is composed of seasoned investors with skin in the game (~10% of CSO) and is therefore shareholder-friendly and focused on long-term value creation, not reporting.

History
First, the history of Westaim’s one realized acquisition with current management is well displayed by the company’s own case study on its first acquisition, Jevco. This slide is instructive and a link follows for the full presentation for those so inclined.

https://westaim.com/wp-content/uploads/2014/04/Jevco-Case-Study.pdf

Onto its current iteration; Westaim owns significant stakes in two subsidiary companies and it seems as though they’re running the same type of playbook.

Houston International Insurance Group (HIIG)

HIIG is a multi-line specialty insurer built through acquisitions and owned 44% (on a look-through basis) by Westaim, along with partners Everest RE and Catlin Group, who joined via a private placement. The company writes five lines of business across the following divisions:

1. Accident & Health: Medical Stop Loss to Self-Funded Health Plans through Brokers & TPAs
2. Construction: General & Excess Liability, Commercial Auto & Physical, Property & Inland Marine, and Workers Comp
3. Energy: General & Excess Liability, Commercial Auto & Physical, Property & Inland Marine, and Workers Comp to Offshore, Onshore, O&G, Mining
4. Specialty: General & Excess Liability, Commercial Auto & Physical, Property & Inland Marine, and Workers Comp to Hospitality, Pest Control, Monoline Workers Comp and other niche areas
5. Professional: Insurance Agents Errors & Omissions, Title Agents Errors & Omissions, Miscellaneous Errors & Omissions, Mortgage Protection Insurance, Community Banks, and Allied Health

HIIG is carried on Westaim’s books at a conservative 1.1x adjusted book value, which marks HIIG in the bottom quartile of the valuation range on both book and earnings multiples (implied).

Source: Westaim Q3-18 Report to Shareholders (page 7)

For a business with a better-than-average YTD combined ratio of 96.9% in specialty lines, management seems to have chosen more of a downside mark to value the business. The spirit of under-promise and over-deliver works well here. Fair value for HIIG is likely 1.5-1.7x PB; for the purposes of calculating a base case, 1.6x tangible book for HIIG seems appropriate.

Toward realizing that value, Westaim began to explore strategic alternatives for HIIG in Apr-18 due to “several unsolicited enquiries” for the business. While no sale has been initiated, Westaim has shown to be a willing seller of HIIG should the right price be offered. Additionally, the presence of Everest and AXA (via its acquisition of XL which acquired Catlin) in the cap structure appears to be a good starting point for potential acquirers.

https://mxsbf1l6dew35rko53rw3am1-wpengine.netdna-ssl.com/images/news/Westaim-Press-Release-April-16-2018.pdf

HIIG hasn’t stopped building value, though; they have acquired two companies (Boston Indemnity Company and Creative Risk Underwriters) since announcing the strategic review. If the company can continue to scale its more profitable lines and effectively allocate capital to value-creating acquisitions, the shareholders of the company stand to benefit incrementally to the ~50% valuation bump shown here.

As for risks and a bit of history, the Westaim consortium took over the company for 0.8x book value in Jan-15 due to HIIG being a somewhat troubled private equity backed asset. Bringing in industry veteran Stephen Way along with a new management team, the company has been repositioned through winding down unprofitable lines (much of the acquired business) and making bets on more fruitful areas through acquisition. If and as the insurance market tightens, HIIG’s net premiums written should move toward their gross premiums written, providing increased growth rates in book value. However, continued insurance market softness, a negative reversion in underwriting success, or poor acquisitions or integration could materially harm HIIG’s operations. Although there have been no material signs of operating hiccups, keeping a close eye on the core business and acquisition performance will be important to anyone owning the stock.

As a note to both the thesis and risks, the CEO of HIIG, Stephen Way built HCC from scratch into a $3B specialty insurer from 1974-2006. However, Way ultimately resigned over an option backdating scandal, settling the case with the SEC in 2008 by paying a reasonable fine, essentially returning his proceeds; he was also materially absolved of wrongdoing. While the negative compliance mark is to be taken seriously, both his relative lack of involvement and the governance and oversight of a majority owner should mitigate the issue.

The Arena Group
The Arena Group is a credit investment platform composed of three entities: Arena Investors, Arena Origination, and Arena Finance.

• Arena Investors: an investment manager that derives management fees and incentive fees from the assets under management in its funds
• Arena Origination: the origination vehicle for credit investments for its own account and/or sale to Arena Finance, clients of Arena Investors, or other third parties; largely a fee-advantaged way to invest in Arena Investors’ fund
• Arena Finance: a specialty finance company that purchases credit investments for its own account; effectively a fee-advantaged way to invest directly in Arena Investors’ funds

The Arena Group, as a whole, is owned by Westaim with management having the ability to earn into the profits by scaling up the entity and driving margins. Dan Zwirn, who heads the Arena Group, is personally invested at the Westaim entity level.

The simplified entity chart from their most recent filing shows a structure as follows.

Source: Westaim Q3-18 Report to Shareholders (page 5)

The incentive structure of Arena Group was given at the time of acquisition, as follows.

Source: Westaim November 2015 Corporate Update (page 14)

For Arena Finance and Arena Origination, leaving each at 100% of book, as valued by Westaim, seems appropriate and I could be convinced as to why they should be held at higher or lower valuations. Either way, this difference is not a major value driver.

The interesting piece, though, is Arena Investors. The economic scenarios follow, but the alignment with management is clear: Arena management’s share of EBITDA grows as the platform profitably scales, but in a way that is continuously accretive to Westaim. Arena is likely already managing >$1B in AUM (as of last filing it was $950M). I assume a blended 1.5% management fee and 15% incentive fees for all calculations, which seem neither heroic nor punitive; I’ve included higher and lower assumptions so the reader can choose their own adventure. This implies a $5.0M+ EBITDA attribution today in a rapidly growing business, which should be worth $50M+, as 10x for a company with this rate of earnings growth feels appropriate, especially given the potential upside / optionality. It is currently being carried on the books at a $8.2M LOSS, which is only growing. If performance lags any projection case, it would seem to remain more valuable than less than nothing for which it is on the books under most scenarios. And you get to pay a discount even to that!

Source: Westaim Q3-18 Report to Shareholders (page 58)

What the asset could be worth with reasonable assumptions is a nice kicker: a $3.0B AUM target in two years seems possible with both appreciation and inflows. If they can return 10% (compared to their pacing of mid-teens inception to-date), that would be a ~$20M EBITDA attribution for Westaim. With a relatively benign 8.0x multiple on what would be a rapidly growing asset management platform, that would give Westaim $160M in economic value for Arena around the end of next year. Today’s likely economics are boxed in red; move down two rows for the reasonable end of 2020 case.

The major risk to the value of Arena Investors is scaling assets. Thus far, returns do not seem to be a hurdle to doing so (see below for the latest publicly available returns).

Source: Westaim May-18 Corporate Update (page 13)

Unfortunately, correlated with this is the compliance record of CEO Dan Zwirn’s former eponymous hedge fund, D.B. Zwirn & Co. The first thing to know is that Zwirn was never charged with any wrongdoing, so I presume his innocence and think it immoral to assume otherwise without a lot more information than I have. However, reputation is paramount in running other people’s money, and just the spectre of wrongdoing at the fund that bore his name may be enough to scare clients away, so the perception is the risk. The story is in 2008, it broke that D.B. Zwirn & Co.’s then-CFO Perry Gruss had charged investors with $12.2M in improper expenses and transferred clients’ money among its various funds, leading to a string of redemptions and the ultimate shuttering of the $12B AUM firm despite stellar performance, even through the start of the GFC. The punchline is that this could cause assets to scale more slowly or cap the amount that the fund is able to raise.

Catalyst

Sale of HIIG above its holding value (1.1x)

Scaling of AUM at Arena Investors driving earnings, operating through quarterly reports

Incremental platform acquisitions by the Westaim parent company