Paulson’s Math Seen Failing as Hartford Mulls Breakup: Real M&A

John Paulson
Even if John Paulson persuades Hartford Financial Services Group Inc. to break itself up, the hedge fund manager could still come up short in his billion-dollar bet on the 201-year-old insurer. Photographer: Rick Maiman/Bloomberg

Even if John Paulson persuades Hartford Financial Services Group Inc. to break itself up, the hedge fund manager could still come up short in his billion-dollar bet on the 201-year-old insurer.

Hartford’s biggest shareholder said this week he may seek support from investors for a plan to split the property-casualty and life-insurance businesses, pushing the stock to a six-month high yesterday. Hartford, which sells for less relative to net assets than comparable U.S. insurers, according to data compiled by Bloomberg, could be worth $32 a share by separating the units, he said. That’s 50 percent more than its current price.

Paulson, who had his worst year on record in 2011 after making billions of dollars from anticipating the collapse of the U.S. subprime market, needs Hartford to reach about $24.71 a share to recoup his investment, filings to the U.S. Securities and Exchange Commission and data compiled by Bloomberg show. While Dowling & Partners said regulatory hurdles and Hartford’s debt will ultimately prevent a split, even a successful breakup may only boost the insurer’s price to $25 a share, according to FBR & Co. and Stifel Nicolaus & Co.

“I just don’t see how that happens,” Dan Theriault, a New York-based analyst at Portales Partners LLC, said in a telephone interview, referring to Paulson’s estimate for Hartford’s breakup value. “These things, while they look good on paper, really from a reality standpoint don’t create the value that you’d think,” he said.

Shareholder Returns

Armel Leslie, a spokesman for Paulson, who runs the $23 billion hedge fund Paulson & Co. in New York, declined to comment on whether the Hartford investment would be profitable.

Shannon Lapierre, a spokeswoman for Hartford, based in the Connecticut city of the same name, declined to comment on whether breaking up the insurer would boost returns for shareholders and referred to its Feb. 14 statement.

In it, Hartford said “there are potential benefits to a separation,” while it also recognized there are “challenges to successfully executing a separation.”

Founded in 1810, Hartford sells savings products and life insurance policies that compete with those from firms such as MetLife Inc. and Prudential Financial Inc. Hartford’s rivals in the property-casualty market include Travelers Cos. and Berkshire Hathaway Inc.’s car-insurance unit Geico Corp.

Once worth more than $33 billion in 2007, Hartford plunged 96 percent to its low in March 2009 as the worst financial crisis since the Great Depression produced losses on equity-linked variable annuities the insurer sold in the U.S. and Japan, often with guaranteed minimum returns for customers.

‘Force Their Hand’

After Hartford drew down its capital to cover the investment losses, it was forced to take a $3.4 billion bailout from the U.S. government at the end of June 2009.

Paulson started buying shares of Hartford the next quarter, a filing with the SEC showed. His stake in Hartford’s common equity increased to a high of 44 million shares in the second quarter of 2010 and currently stands at about 37.5 million shares, which includes warrants that give Paulson the option to purchase 70,000 shares at a predetermined price, its filing on Feb. 14 with the SEC showed.

Paulson’s firm spent about $927.8 million for its 8.4 percent stake in Hartford, its SEC filing showed, meaning each share cost about $24.71, data compiled by Bloomberg show. That’s 17 percent higher than Hartford’s price of $21.19 yesterday.

Paulson’s campaign is “going to force their hand,” Alan Devlin, a London-based analyst at Atlantic Equities LLP, said in a telephone interview. Assets sales and a breakup are “the best game plan because it gets you to where you want to be in the quickest way,” he said.

Breakup Value

Devlin estimates that Hartford could be worth more than $33 a share in a breakup.

Paulson’s Advantage Plus Fund, which seeks to profit from corporate events such as takeovers and bankruptcies and borrows money to amplify returns, lost 51 percent in 2011. Shares of financial companies were the “primary drag” on the fund’s performance, Paulson said in a third-quarter letter to investors in October, a copy of which was obtained by Bloomberg News.

The firm notified regulators Feb. 14 that it may talk with shareholders to bolster its push to break up Hartford.

Paulson, 56, and Hartford’s Chief Executive Officer Liam McGee had clashed on a Feb. 8 conference call when McGee resisted Paulson’s assertion that Hartford would be worth more to shareholders if it were split into separate businesses.

Hartford trades at 0.42 times its assets minus liabilities, less than any other U.S. insurance company with more than $5 billion in market value, data compiled by Bloomberg show.

‘Exhaustive Research’

MetLife, the biggest U.S. life insurer, trades at about 0.7 times its book value. New York-based Travelers trades at about the value of its net assets.

“We have done exhaustive research on the challenges and opportunities of the Hartford and believe that a spinoff would produce an increase in value for Hartford shareholders,” Paulson said in a letter to McGee published in a statement Feb. 14. “Hartford trades at lower valuation multiples than any of its U.S. insurance peers. Addressing these issues should be Hartford’s highest priority.”

Paulson’s estimate of $32 a share assumes that the property-casualty business can command a valuation of about 1.1 times its shareholder equity and that the life unit would trade at 0.6 times its book value after a breakup, the filing showed.

Hartford said it has $6.8 billion of debt at the holding company that, in the event of a split, would have to be passed to the operating units. The life insurance subsidiaries have “limited capacity to generate statutory earnings” and can assume no more than a third of that debt, it said.

$2 Billion Bet

Paulson, who spent $2 billion buying credit-default swaps on subprime mortgages in 2007 before the housing market collapsed in a trade that helped him become a billionaire, recommended 11 steps to help Hartford pay its debt.

He said Hartford could suspend share buybacks and that profit in coming quarters would ease the burden. The company could also stop selling new products at the U.S. variable annuities division to conserve capital and find buyers for its mutual-fund and group-benefits businesses, Paulson said.

“These assets are likely to fetch more value in an appropriate trade sale than is implied” by the stock price, Mark Finkelstein, an analyst at Evercore Partners Inc., said in a report dated Feb. 15. Divesting and shutting down the life businesses could increase the company’s value to $26 a share to $30 a share, he said. The company is worth about $21.26 a share if it continues with both of the main operations, he said.

Debt Payments

McGee told Paulson on Feb. 8 that a separation probably wouldn’t “create shareholder value,” and the company cited credit ratings and the need for regulatory approvals among the challenges in a slide presentation the same day.

“Management didn’t just brush this off, and they’re not opposed to it -- it’s just they can’t do it,” Robert Glasspiegel, an analyst at Langen McAlenney, a division of Janney Capital Markets in Hartford, said in a telephone interview. “I understand the logic. But I just don’t see how you could execute it. It’s not feasible.”

Gary Ransom, an analyst at Dowling & Partners in Farmington, Connecticut, said in a report to clients that Hartford’s life business isn’t profitable enough to service more than a third of the company’s debt, which has increased almost 50 percent since 2007.

That means its property-casualty unit, if it was spun off, wouldn’t be able to shoulder the remaining liabilities and maintain its credit rating without raising more money, he said.

‘No Silver Bullet’

“There is no silver bullet,” Ransom wrote in a report dated Feb. 9, a day after Paulson said on Hartford’s earnings call it needed “to do something drastic” to boost returns. “A spin-off is essentially impossible without a dilutive equity capital raise,” he said.

Brian Schneider, a Chicago-based insurance analyst at Fitch Ratings, said yesterday a potential split “raised questions” about how Hartford’s life business would pay its debt as it has struggled with lower margins and increased costs.

Regulators could also block a breakup to protect customers from the risk that the life unit wouldn’t be able to repay its obligations, according to Stifel Nicolaus’ Meyer Shields.

Third-quarter net income at the division fell 84 percent to $63 million from a year earlier, according to data compiled by Bloomberg. That’s less than any quarter since it lost money in the same three-month period in 2009.

“If you’ve got a unit whose earnings are weak, and you’ve got significant policyholder liabilities that will emerge over time, I think regulators would hinder that sort of breakup,” Shields said in a telephone interview from Baltimore. “The value of the standalone life company is lower than the more optimistic assumptions that John Paulson described.”

Sum of Parts

Shields said a “very rough” estimate of $25 a share would be a better gauge of Hartford’s value in a breakup. He based the projection on each unit’s earnings.

Randy Binner, an analyst at FBR in Arlington, Virginia, also said $25 a share would be a more realistic projection. That would imply a return of just 1 percent for Paulson, based on the firm’s per-share cost.

Binner’s sum-of-the-parts analysis used 9 times estimated 2012 earnings for the property-casualty business and 7.3 times projected profit for the life unit.

While a split or a spin-off is ultimately unlikely, Dowling & Partners’ Ransom said a more feasible option would be selling the property-casualty business. At a sale price of 1.25 times book value for the property-casualty business, the proceeds would still only give Hartford a value of $21 a share.

Long-Term Interest

The sale wouldn’t significantly boost returns for shareholders because more than half the proceeds would be used to pay down debt and taxes, while ratings companies would require the remaining company to bolster its capital, he said.

Paulson’s interest in Hartford “doesn’t really change anything,” Joshua Schachter, who helps manage about $3 billion at Snow Capital Management LP in Sewickley, Pennsylvania, and owns Hartford shares, said in a telephone interview. “At this point in Hartford’s position, I don’t think splitting the company up is the best thing long term for the shareholders.”

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