Merger Arb – 9.5% Upside
UK insurer Direct Line is being acquired by the industry giant Aviva. Consideration stands at £1.297 in cash + 0.2867 AV shares + £0.05 dividend, currently worth £2.70/share. The spread stands at 9.5%. DLG’s board has indicated it is prepared to recommend the offer to shareholders if made binding. Aviva is now conducting due diligence. Given the history between DLG’s new management team and the buyer, it’s unlikely that Aviva will uncover some kind of a deal breaker during the due diligence. The odds are high that the binding papers will be signed and the spread will narrow.
PUSU date has been set for December 25. Downside to pre-announcement levels is 30%.
The sequence of events here has been rather curious:
- Earlier this year, in February-March, Belgian insurer Ageas made two offers for DLG at £2.33/share and £2.37/share. Both were rejected as too low.
- Shortly afterward, DLG appointed Adam Winslow, who previously led general insurance at the industry giant Aviva, as the new CEO. Winslow then brought in two former Aviva colleagues as DLG’s new CFO and CRO.
- Last month, DLG was approached by none other than Aviva itself. The initial offer £2.50/share (£1.125 in cash + 0.282 AV shares) was also rebuked.
- FT has reported that after the initial offer was rejected, AV ramped up pressure on DLG’s management by engaging directly with shareholders, and even considered a hostile bid. However, investors also pushed for a higher offer.
- Last week, Aviva delivered the increased current bid.
AV is a serious buyer, clearly committed to this acquisition.
DLG’s ownership is relatively concentrated, with the 11 largest holders collectively controlling 53% of the company. Aviva and Direct Line also share several major investors, including Schroders, Fidelity, Redwheel, and M&G. So it’s that shareholders will swiftly approve the merger.
The offer values Direct Line at 1.6x BV and 2.6x TBV, near all-time high multiples despite the company being unprofitable since 2022. DLG has faced significant challenges in recent years, primarily in its main segment – motor insurance. The company underpriced inflation before 2022, resulting in massive losses as soaring inflation drove up auto repair costs. However, segment’s performance has been stabilizing recently, with a profitable first half of 2024 (see the table below). Based on pre-2022 profitability levels, the acquisition values DLG at 10x PE, which aligns with its historical valuation and Aviva’s current valuation (10x PE, 2.1x TBV). Aviva expects to realize substantial cost synergies from this buyout.
While the transaction would merge two major competitors in the UK motor and home insurance markets, at a quick glance it seems that regulatory risk should be low. In motor insurance, DLG and Aviva are the second and third largest players, with combined market share estimates ranging from 14% (here) to 20% (here), depending on the source.
In home insurance, Aviva is the market leader with nearly 9% share (as of 2022), while Direct Line is the third-largest with just over 6%.
CMA (UK’s antitrust watchdog) usually doesn’t scrutinize transactions where combined market share lands below 25%. It doesn’t look like the threshold will be breached here. Mergers with higher combined market share are also often allowed if the market remains competitive and is relatively easy to enter. For example, CMA has recently approved the Vodafone-Three merger, which gave the combined company control of 35% of the mobile network market.
However, it’s worth noting that there’s been some speculation on the media (here and here) that CMA will still want to take a “close look” here. So in case I’m wrong about the regulatory risk, the spread might remain wide even after the definitive agreement is signed.
“While the transaction would merge two major competitors in the UK motor and home insurance markets, at a quick glance it seems that regulatory risk shouldn’t be low”
Is “shouldn’t” correct? The rest of the narrative implies regulatory risk “should be low”, or “shouldn’t be high”.
For the top line, “Merger Arb – 9.5% Upside”, for ease of reference would it be possible to include the entry price required to generate the specific upside? E.g., “Merger Arb – 9.5% Upside (at entry price of 2.47)”
Thanks
I second the suggestion that all top lines include the required entry price to achieve the up/downside. It’s a useful little flourish!
Typo on my side. I mean to say that regulatory risk is low. Now corrected in the write-up above.
Thank you for suggestion regarding entry prices. Will try to incorporate it.
Motor Insurance prices have increased very significantly in recent years. Global used car price story plus impacts of Brexit on importing parts, weaker £, labour in the repair shops. It became very political, MPs asking about price gouging. This is all google-able, see here as one example (https://www.gov.uk/government/news/ministers-bring-together-industry-experts-and-consumer-champions-to-tackle-spiralling-costs-for-drivers). The UK CMA explicitly talks about investigating areas that impact consumer cost of living where inflation has been seen, I.e the vet or groceries investigations (see some rhetoric here https://www.gov.uk/government/publications/cost-of-living-update/cma-cost-of-living-update).
The UK CMA arguably has a political taste to it like the US has shown recently. Worth keeping in mind. May be reflected in the 9.5% spread but flagging here anyway.
Don’t forget your short AV/ div, the spread is actually sub 7% and I see a downside at 37%, not just 30%.
Yes, AV dividend (expected early April 2025, at least 22.3 pence) will reduce the spread by about 2.3%. There also is a stamp duty cost of 0.5% for initiating the long DLG position.
So the current spread is only 6%. And will likely shrink to 4% after the definitive agreement is signed. Doesn’t look very attractive.
The dividend on AV shares is only due in April, so I have excluded it from calculations. I would expect binding agreement to be signed earlier. But of course, this could keep the spread from narrowing significantly, even after the binding agreement is signed.
Snowball, out of curiosity, how do you know this? Also, how should one verify such things in the future?
“There also is a stamp duty cost of 0.5% for initiating the long DLG position.”
One has to pay 0.5% stamp duty when buying (but not when selling) stocks of London-listed companies, unless:
(1) The company is incorporated outside UK (e.g. AVAP). or,
(2) The company is AIM-listed (e.g. EQLS). or,
(3) You are buying its ADRs traded in other markets (e.g. DEO, UL).
Your brokers will charge the stamp duty.
It’s important to take this cost into account when doing UK merger arb, when the spread is already tight.
How long do you expect this to take to close once it goes definitive?
I think we can only speculate at this point, as it likely all hinges on regulatory review, which would remain the main risk if a definitive agreement is signed. However, the key play here is for a definitive agreement to be reached, not necessarily waiting for the full completion of the merger. Even with regulatory risk, I don’t believe the spread should increase from current levels once an agreement is reached. In the worst case, it might just stay the same.
Interesting idea. How likely do you think it is that Ageas returns with a competing bid or that Aviva has to bump its offer let’s say to 300p?
I think both of these are unlikely. Regarding Ageas, over six months have passed, and Ageas has remained silent; I haven’t seen any rumors either. As for Aviva’s bump, management has already expressed a willingness to accept the current offer, and it seems shareholders will also agree. So, there are no incentives for Aviva to improve the bid.
How does Merger law work in the UK, specifically –
1) What’s the base rate here – do most such “Possible Offers” go definitive?
2) For non-definitive deals (with a 12/25 PUSU date), shouldn’t spreads be much higher (unless, of course, base rate for “Possible Offers” is above is 80%+)?
I don’t think there are reliable statistics for this, and each case is different anyways.
Could you explain why you think the December 25 PUSU date should result in higher spreads? Not sure I see the connection.
The drop in Aviva share price has knocked off 10p from the preliminary offer. I can see Aviva increasing the bid (more cash or more shares) to bring the offer back to 275p with the now lower share price.
This rarely happens, especially when both the acquirer and the target are in the same industry.
Redwheel, which holds stakes in both DLG and AV, recently trimmed its position slightly below the reporting threshold, from 5% to 4.86%. It’s a minor change, so it might not signal much.
https://www.londonstockexchange.com/news-article/DLG/holding-s-in-company/16821007
Definite agreement announced this morning on the original terms (275p offer). Currently the spread is 6.2% and due to Aviva share price decline, the offer is only worth 265p. They expect to close the transaction in mid-2025. I think it is attractive to hold (12% annualized spread) with the option of Aviva share price recovering. As outlined above, regulatory risk should be low with a combined market share of below 25% (even though there had been some noise about regulatory scrutiny about the deal.
I was hoping the spread would narrow more upon signing of the definitive agreement, so I am out now at a tiny gain (+3%). While I agree with Marko that regulators will likely give a pass for this deal, if you factor differences in dividend yields (due in April) for DLG and Aviva the spread is under >5%.