GREENLEA LANE

Private Investment Partnership
Presentation for Best Ideas 2013 Josh Tarasoff – General Partner

THIS DOCUMENT SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF ANY OFFER TO BUY. NO PART OF THIS DOCUMENT IS A RECOMMENDATION OR A SOLICITATION. THE INFORMATION AND BELIEFS CONTAINED HEREIN ARE BELIEVED TO BE CORRECT, BUT THERE IS NO GUARANTEE.

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Markel Corporation (MKL)
• MKL is a financial holding company, the primary business of which is specialty property and casualty insurance • Has compounded book value per share at ~20% annualized since its IPO in 1986 • Founded in 1930; run by three generations of the Markel family; in 2010, passed day-to-day operations to the next generation of senior management • Key statistics: – $440 stock price (as of 01/04/13) – $4.3 billion market cap – $3.8 billion book value – Recently announced agreement to acquire Alterra (ALTE) for $3.1 billion in cash and stock – MKL trading for a slight premium pro-forma book value per share
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Insurance: Generally Mediocre
• Insurers make (or lose) money in two ways
– Underwriting – Investing

• Most underwriting operations lose money
– Highly commoditized product, so competition is based primarily on price – Cyclical business, most of the time “soft market” (excess capacity, low prices) prevails – We have been in a soft market since 2005

• The insurance industry makes up for underwriting losses through investments
– Insurers run large investment portfolios – “Float”—policyholder funds that are held before claims must be paid—is normally the single largest source of funds

• Not surprisingly, the industry earns single-digit ROEs on average

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Insurance: Can Be Wonderful
The intrinsic value of our insurance business will always be far more difficult to calculate than the value of, say, our candy or newspaper companies. By any measure, however, the business is worth far more than its carrying value. Furthermore, despite the problems this operation has periodically handed to us, it is the one—among all the fine businesses we own—that has the greatest potential.
~Warren Buffett, 1990 Letter to Shareholders (emphasis added)

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MKL’s Value-Creation Track Record
• 20% annualized BVPS compounding since the IPO in 1986 • BVPS declined in only 4 years since the IPO
– In each case a new high was reached within 12 months

• Minimum trailing 5-yr BVPS growth = 9% annualized
– This occurred over the 5 years through 2011, during which there was a “perfect storm” of a soft insurance market, low interest rates, and low equity returns

• MKL’s incredible record begs the question: What are the competitive advantages that have allowed it to defy the dismal economics of its industry?

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#1. Niche Insurance Markets
• • MKL underwrites only “specialty” insurance: niches where specialized knowledge and experience are necessary to properly assess risk For decades, MKL has built up institutional expertise and knowledge in its chosen niches

If you can think of some insurance product that you need, and you could get a policy for it quickly and easily, well Markel doesn’t do that. On the other hand, if you were to answer “no” two or three times to an insurance questionnaire, now that’s getting closer to what we like to do. What we do is insure things that are rather complicated and unusual, like children’s summer camps, bass boats with overpowered engines, weddings and event cancellations, vacant properties, new medical devices, new technology, or the red slippers Judy Garland wore in the Wizard of Oz. ~Steven Markel, 2008 Value Investing Conference at Darden Business School
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#2. Underwriting Discipline
• MKL is one of a relatively small class of insurers that maintains a disciplined underwriting culture, which means turning away unprofitable business • This is harder than it may sound:
– There is pressure from brokers and Wall Street to book business – Employees may put their own jobs at risk by shrinking their operations – The adverse consequences of poor underwriting decisions often do not appear for years, as claims develop – The culture of short-term mindedness is entrenched in the industry

• MKL was built from the ground up to achieve underwriting profits and has carefully cultivated its disciplined culture for decades • Underwriters’ bonuses are based on the actual profitability of their own business; therefore, paid out over multi-year periods • MKL has the deserved trust of its employees that when premium volume is shrinking, the expense structure will be managed with a long-term view
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#2. Underwriting Discipline (continued)
MKL 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 78% 85% 84% 78% 81% 106% 97% 97% 97% 99% 100% 99% 98% 101% 114% 124% 103% 99% 96% 101% 87% 88% 99% 95% 97% 102% P&C Industry 108% 105% 105% 109% 110% 109% 116% 107% 108% 107% 106% 102% 106% 108% 110% 116% 108% 100% 98% 101% 92% 96% 105% 101% 101% 108% 26-year average combined ratio % of years profitable MKL 96% 69% P&C Industry 106% 12%

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#3. Equity Investing
• MKL makes a substantial allocation to equities in its portfolio
– The vast majority of insurance investment portfolios are in fixed income – MKL allocates an amount equal to 50-80% of its shareholders’ equity to equities – The rationale is that it is appropriate to match infinite-duration funding (equity) with infinite duration securities (equities), and that equities will yield long-term returns that are superior to those of fixed income instruments

• Conventional thinking does not reward this policy
– Owning equities increases volatility and is sometimes perceived as risky – Unrealized gains that build up in the investment portfolio bypass the income statement, thereby also bypassing the analysis of many analysts

• Tom Gayner is responsible for MKL’s investments
– Pursues a disciplined, long-term value investing strategy – 22-year record (1990-2011) at MKL of compounding 10.9% annualized, 2.6% better than the S&P 500 including dividends – Extremely low portfolio turnover (tax efficient)

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#4. Private Equity Investing
• In 2005 , MKL began to acquire businesses through Markel Ventures
– – – – Currently comprised of 13 businesses Aggregate run-rate revenue of $500 million Still a small part of MKL, but in hyper-growth Same investment criteria as for stocks: good businesses (high return on capital), honest and able management, double-digit implied returns

• Advantages of owning businesses outright:
– MKL can dictate capital allocation – No tax leakage – Source of unregulated cash flow

• MKL’s competitive advantages in private equity
– Ideal home for business owners who wish their businesses to survive and flourish after the transaction – Private equity and strategic buyers are unattractive to such owners; MKL will not cut staff, leverage the company, or “flip” it
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#5. Culture
The Markel Style
Markel has a Commitment to Success. We believe in hard work and a zealous pursuit of excellence while keeping a sense of humor. Our creed is honesty and fairness in all our dealings.
The Markel way is to seek to be a market leader in each of our pursuits. We seek to know our customers’ needs and to provide our customers with quality products and service. Our pledge to our shareholders is that we will build the financial value of our Company. We respect our relationship with our suppliers and have a commitment to our communities. We are encouraged to look for a better way to do things…to challenge management. We have the ability to make decisions or alter a course quickly. The Markel approach is one of spontaneity and flexibility. This requires a respect for authority but a disdain of bureaucracy. At Markel, we hold the individual’s right to self-determination in the highest light, providing an atmosphere in which people can reach their personal potential. Being results-oriented, we are willing to put aside individual concerns in the spirit of teamwork to achieve success. Above all, we enjoy what we are doing. There is excitement at Markel, one that comes from innovating, creating, striving for a better way, sharing success with others…winning.

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#5. Culture (continued)
• Culture is often considered a “soft”—as opposed to a “structural”—competitive advantage
– Culture is, nonetheless, critically important in certain businesses – If properly managed, can also be one of the most durable competitive advantages

• Insurance and investing are two businesses in which culture is indisputably critical to long-term success
– Successful organizations must attract talented employees, permit them to operate free from short-term constraints, and incent them to manifest a long-term mindset

For us the underwriting of our specialty insurance risk is really the same process as the fundamental analysis necessary to make sound investment decisions.

~Steven Markel, 2008 Value Investing Conference at Darden Business School
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#5. Culture (continued)
• Talented, success-driven people, who enjoy their work
– Impossible to convey in this presentation, but obvious upon examination

• Performance-based compensation
– Senior executive bonuses based on trailing 5-year compounding of book value per share – Underwriter bonuses based on actual profitability of their own business (multi-year)

• Employee stock ownership
– Major commitments of personal net worth by senior executives – Pervasive employee ownership (including over 260,000 shares in 401K and stock loan programs)

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Digression: Self-Reinforcing Business Models
• Well-performing businesses are often priced for mean-reversion
– This is a natural analytical tendency—and a rational one, because mean-reversion is the rule, rather than the exception

• In such cases, great results can be obtained by owning a non-meanreverting business over the long term • I think the business models that are most likely to defy meanreversion are self-reinforcing business models
– The likelihood of future success increases as time goes on

• Self-reinforcing dynamics are often qualitative—as opposed to quantitative—in nature
– They do not directly present themselves in the financials

• MKL has self-reinforcing dynamics—virtuous circles—which I believe will propel continued above-average performance over the long term
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Virtuous Circle #1: Insurance
Talent
Skilled Honest Success-driven

Employee Ownership
Aligns long-term interests

Longevity
Accumulated expertise Reputation Customer relationships

Book value per share growth

Culture
Disciplined Long-term minded Performance-based

Underwriting
UW profit Free float Risk management

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Virtuous Circle #2: Investing
Talent
Skilled Honest Success-driven

Employee Ownership
Aligns long-term interests

Longevity
Accumulated knowledge Idea network Reputation / deal flow

Book value per share growth

Culture
Disciplined Long-term minded Performance-based

Investing
Capital appreciation Investment income Operating income

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Virtuous Circle #3: Structure
Insurance
Underwriting profits Free float

Optionality
Multiple opportunity sets Opportunistic capital allocation Capitalize on turbulence

Markel Ventures
Internal investment Free cash flow

Public Securities
Fixed income Equities

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Virtuous Circles = Momentum
• The concept of a virtuous circle is simple, but deceivingly powerful • It means that momentum builds, every day And so having started out as Grahamites, which, by the way, worked fine— we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with unusual managerial skill plainly present in some individual or other, or some system or other. ~Charlie Munger

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Alterra Acquisition
• This past December 19th, MKL announced its acquisition of Alterra Capital Holdings Limited
– Alterra is a publicly traded specialty insurer (ALTE) that had been trading at 80% of book value – Deal value is $3.1 billion in 1/3rd cash and 2/3rd stock; 1.1x Alterra’s book value – Major acquisition for MKL: Alterra’s gross premiums and book value are equal to 80% and 77%, respectively, of its own – Modestly accretive to MKL’s book value per share ($395  $415)

• Rationale on the insurance side:
– Alterra is a high-quality company with a disciplined culture
• History of favorable reserve developments and sub-100% combined ratios

– Complementary insurance operations will produce a diversification of insurance risks, economies of scale, and business opportunities
• Trailing-12-month gross premiums written will increase by 80% to $4.4 billion

• I believe the main attraction for MKL is the investing side:
– MKL’s unique capability will be applied to Alterra’s portfolio – The deal is nearly 30% accretive to investments per share, net of debt
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Alterra (continued)
• Following the announcement of the acquisition, MKL stock traded down by ~10% ($486 to current $440) • I believe this is the result of two factors:
– Arbitrage-related selling – Concern that Alterra is under-reserved (the liability on its balance sheet representing the estimate of future claims is understated)

• Investors have unpleasant memories of MKL’s last major acquisition, that of Terra Nova in 2000
– Terra Nova entailed several years of adverse reserve developments and underwriting losses, before reaching profitability

• Simply stated: the situations are different
– Terra Nova was known to be a troubled company that would require a challenging period of integration – Alterra is a well-performing operation with a disciplined culture and a profitable underwriting record

• Admittedly, the operational outlook for the next few years is far from clear
– (But this is always the case!)
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Valuation
MKL’s historical price / book value ratio (1986 – 2012)

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Valuation (continued)
• Current MKL stock price of $440 represents ~105% of pro-forma book value per share—one of its lowest valuations ever
– MKL is priced not merely for mean-reversion, but for an immediate end to its ability to generate high returns on capital

• Historical average P/B = 2x • Pro-forma net investments per share = 2.45x PF BVPS • MKL has enormous momentum to propel further compounding of intrinsic value

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Another Way To Look At It
• MKL is not and insurance company but an investment vehicle • What are the desirable attributes of an investment vehicle?
– – – – – – Patient, disciplined value investing approach Skilled, experienced investors at the helm Ownership mentality, aligned interests Permanent capital, with inflows Structural advantages in allocating capital Cheap, stable leverage (float)

• All of these factors working in combination should produce extraordinary results (and they have for over 2 decades)

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Thank You

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