The insurance industry provides some attractive targets for leveraged buyout firms, but there's a problem.

Insurance companies are subject not only to ratings on their debt, but also to ratings on their ability to pay claims. And since rating agencies frown on leverage, it means deals can hamper the companies' ability to do business.

But David Stone, a New York insurance executive with the backing of some major banks, found a way to get around that problem. "There are niches in the insurance industry that provide significant opportunities" for buyout firms, he said.

To participate "they have to significantly change the companies' cost structures," Mr. Stone added. "It's much easier to have a strategic platform with which to do that."

Merely buying the company is not enough, he said. The buyer has to be able to create synergies to improve returns after the purchase.

Three years ago Mr. Stone, chairman and chief executive of Penn Corporation Financial Inc., and Stephen Phickes, the firm's president and chief financial officer, brought together the top lenders to the insurance industry to form Knightsbridge Capital LLC, a $100 million limited partnership devoted to investments in the insurance industry.

The banks included NationsBank Corp., Bank of New York Corp., Bankers Trust New York Corp., Chase Manhattan Corp., Fleet Financial Group Inc., First Union Corp., First Chicago Corp., Dresdner Bank AG, Banc One Corp., and ING Barings.

Mr. Stone and Mr. Phickes are general partners in Knightsbridge.

By marrying Knightsbridge's equity muscle with Penn Corp.'s strategic platform, the firm is able to make investments in the insurance industry with less leverage and more comfort from the rating agencies.

Each bank has made a $5 million to $12 million investment in the fund, and Penn Corp. holds a $15 million stake. The fund has made five investments since its inception, and Penn Corp. is on its way to becoming a $10 billion-asset company, roughly 10 times its size before Knightsbridge was formed.

Mr. Stone, like many other buyout executives, said banks have been invaluable in providing ideas.

"If a bank brings us in on a specific transaction, as long as they provide competitive (rates) it's their opportunity to broaden the services that they're able to perform," Mr. Stone said.

But rewarding a bank for a transaction idea does not override the need to find an appropriate capital structure.

If the banks "want to do something and they're not demonstrating a transaction that's competitive, then we're not going to penalize the economics of the partnership for an artificially controlled relationship," Mr. Stone said.

Two years ago ING Barings brought Penn Corp. the idea of buying the insurance company assets of the bankrupt ICH Corp., a Louisville, Ky.-based insurance company. Penn Corp. and Knightsbridge purchased the equity of the insurance companies through a newly formed holding company, Southwestern Financial Corp.

Six banks participated in financing the deal: ING, First Union, and First Chicago backed Penn Corp.'s $100 million portion of the deal, while Bank of New York, NationsBank, and Banc One financed the $125 million on the KnightsBridge side.

ING also syndicated a $50 million bridge financing portion.

"This greatly benefited us, and it has broadened our relationship with the banks significantly," Mr. Stone said.

A few weeks ago Penn Corp. announced plans to buy Acordia Inc., an Indianapolis-based insurer, from Anthem Inc. NationsBank, which had a relationship with Acordia, brought Penn Corp. the idea for the acquisition and subsequently took a multifaceted role in the financing.

"One of the purposes of doing this was to broaden the relationships with the banks so that we would see opportunities for both Penn Corp. and Knightsbridge and its partners," Mr. Stone said.

Though some buyout firms, like Kohlberg, Kravis, Roberts & Co., have tried to focus on special niches in the insurance industry, most successful acquisitions have been done through joint ventures between strategic buyers and buyout funds.

"The industry had gotten to the point where acquisitions that put financial buyers and strategic buyers together have become commonplace," Mr. Stone said.

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