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Market Musings - June 4, 2018

We continue our blog series: Market Musings, Volume 2, Edition 16, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Shots Fired At David Einhorn".

Back on April 23, 2018, David Einhorn gave a presentation at the Sohn Investment Conference on Assured Guaranty (AGO) - SEC filings here - wherein he basically stated that the insurer was massively under-reserved. The full presentation can be found here. Based on a cursory review, Einhorn makes some good points on AGO's below-investment-grade (or BIG) portfolio, especially concerning the company's Puerto Rico exposure. However, as can be seen from the chart below, Einhorn's late April presentation has had minimal to zero impact on AGO's stock price to date:

In any event, following Einhorn's AGO presentation another investment fund named Sunesis Capital apparently took umbrage with Einhorn (as they seem to be long AGO) and went on a full-blown attack against Einhorn's reinsurance vehicle Greenlight Re (GLRE) - SEC filings here. The full Sunesis presentation on GLRE can be found here. Sunesis makes several interesting arguments about GLRE, as follows:

a. PFIC Rules - Sunesis claims that GLRE is in jeopardy of violating the PFIC rules, which basically tax disadvantage a publicly-traded entity that qualifies as a passive foreign investment company. As per Wikipedia, "For purposes of income tax in the United States, U.S. persons owning shares of a passive foreign investment company (PFIC) may choose between (i) current taxation on the income of the PFIC or (ii) deferral of such income subject to a deemed tax and interest regime. The provision was enacted as part of the Tax Reform Act of 1986 as a way of placing owners of offshore investment funds on a similar footing to owners of U.S. investment funds (regulated investment companies)."

Below are a few excerpts from Sunesis' presentation on the PFIC issue as it relates to GLRE (note particularly the point Sunesis identifies about Trump's tax bill's effect on GLRE's ability to continue to claim its PFIC exemption):

The interesting thing here is that GLRE has basically admitted that the tax changes have caused them a PFIC problem, since in GLRE's response to the publication of the Sunesis short thesis, the company (while rejecting the overall thrust of the thesis) stated that it will need to "restructure its activities" (whatever that means) in order to retain its PFIC exemption:

"The (Sunesis) Report questions whether the Company 'should be classified as a PFIC'. As Greenlight Re has stated publicly in its annual report on form 10-K for the period ended December 31, 2017, management believes Greenlight Re should not be classified as a PFIC. Under the existing rules prior to the Tax Cuts and Jobs Act, Greenlight Re annually conducted an assessment and determined that in 2017 and in prior years it should not be deemed a PFIC. The Company’s reinsurance activities and risk profile do not support the PFIC designation, but the law change has put more emphasis on balance sheet arithmetic than a qualitative assessment. Greenlight Re intends not to be treated as a PFIC and is in the process of restructuring its activities to ensure that it meets the bright-line applicable insurance liabilities test. Greenlight Re will not need “to increase insurance liabilities in a market that has terrible pricing” or deviate from its underwriting discipline."

b. Incentivized to Lose Money? There is clearly some negative effect from the tax bill on GLRE's PFIC status, although GLRE claims that it will remedy this through "restructuring". So let's assume that is the case (although it is interesting that GLRE provides no specifics on how this "restructuring" will occur) and that the PFIC exemption problem will go away. In our view the more salient point is the subsequent one that Sunesis makes about GLRE, namely that it operates as a reinsurer not for the purpose of making profits, but rather solely to fit under the PFIC exemption safe harbor. In other words, Sunesis claims that GLRE has no real intention of operating a profitable reinsurer with sound underwriting practices; rather, GLRE will underwrite uneconomic reinsurance business simply to retain the tax deferral benefits of the PFIC-exemption for GLRE's investment operations (the fees for which are obviously lucrative for Mr. Einhorn's hedge fund in its role as GLRE's designated investment advisor):

In fairness to Einhorn and GLRE, they claim that Sunesis's "assessment of the Company, its business and strategy is fundamentally flawed". Perhaps so. But it does seem as though GLRE has an incentive to underwrite business regardless of profitability in order to keep the stream of tax-deferred management fees flowing to Mr. Einhorn's hedge fund. Moreover, these fees appear even more attractive than normal hedge fund fees, since they are earned on what looks to be permanent capital, due to Mr. Einhorn's voting and other influence at GLRE (in other words, Greenlight Capital is highly unlikely to fired by GLRE as its investment advisor even if its performance is sub-par, as it has been in recent years). If that is the case (that GLRE is incentivized to underwrite uneconomic business, if necessary, to preserve its PFIC exemption), the long-term outlook for GLRE stock would indeed be quite dire. Using history as a judge, it does appear that GLRE exists for some purpose other than rewarding shareholders, as the stock has massively underperformed the S&P 500 since its IPO eleven years ago:

It should also be noted that the same negative dynamics identified by Sunesis with respect to GLRE (if Sunesis is correct in its analysis) would presumably also be at play for Dan Loeb's offshore reinsurer Third Point Re (TPRE) - SEC filings here. TPRE has done a bit better against the S&P 500 since its public flotation than GLRE, yet has hardly impressed:

Granted, outstanding investment performance by Einhorn and Loeb could prospectively mitigate the negative incentive effects on their respective reinsurers and their underwriting practices. Yet the drag from high investment management fees, as well as apparently perverse incentives related to PFIC and the reinsurance-cum-hedge fun business model, may perpetually doom GLRE and TPRE to underperform the S&P going forward.


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