As the market rises to new all-time highs, investors must
seek margins of safety that are hidden from plain sight and uncorrelated to
other common investments. With valuations where they are, these companies are
often in industries that are troubled, misunderstood, and off the radar for
most investors.
Imperial Holdings (IFT) fits the bill for all of those
traits and investors today can buy Imperial Holdings for less than 0.65X
tangible book value. Upside to book value, an obvious valuation factor for most
financial companies, would result in a 55% return for a patient investor. I
believe that this is far below the fair value for IFT’s book of life
settlements, and upside is in excess of $12 per share, more than 100% above the
closing price as of March 26, 2014.
The opportunity exists because the once thriving
secondary/tertiary life settlement market has been all but abandoned by
institutional investors, scared off by litigious insurers like Phoenix and a
lack of manufactured policies. My research indicates that this undue pessimism
towards life settlement contracts (LSC) has begun to reverse itself, or has at
least stabilized. Investors who are far smarter than me are snapping up
contracts and policies, seeking to capitalize on the uncorrelated, and
excessive, IRRs. These investors seem to agree with our thesis that life
settlements should outperform most other asset classes over a long enough time
period.
The exact length cannot be known, and this has certainly
tainted the asset class for many investors. However, I believe that patience
will be rewarded handsomely, and more importantly, downside will be minimal.
The market is missing the shift that has taken place, and Imperial Holdings is
the proverbial baby being thrown out with the bathwater. Imperial Holdings is set
up to perform well even if capital does not return to the space thanks to
alternative loan programs, capable management, and insiders who are fully
aligned with common shareholders and buying shares on the open market. Although
the only sure things in life are death and taxes, Imperial will profit from the
former and is shielded from the later for some time.
“I can’t tell you the amount of fraud we’re seeing in this area, it’s
absolutely unreal” Joe Rotunda, Director of Enforcement for the Texas State
Securities Board discussing life settlements with the Wall
Street Journal on April 12, 2010
Background
No investment in life settlements would be complete without
a brief background of the asset class and troubles. While the entire history of
these contracts is outside of the scope of this report, I encourage readers to
research the history of fraud and unscrupulous behavior in the industry.
With all that said, life settlements serve a very valuable
purpose. If John Doe takes out a life insurance policy from Big Insurance Co,
John will pay a premium for a long period of time. When he originally signed up
John had two kids and a wife and wanted to know that his family would be taken
care of in the unfortunate event of his early passing.
However, John lives to be older, his kids are out of college
and the policy is no longer needed. John is sick of paying the premiums, which
eat up a chunk of his income every year. John would like to stop paying the
premium because, perhaps, John wants to travel the world. Or perhaps John has
an incurable disease that needs treatment. The details aren’t important; all
that matters is that John needs cash, so John can do the following:
1. Lapse
on his policy. He will no longer pay premiums but will lose all benefits to his
policy.
2. Notify
Big Insurance Co and receive a “cash surrender value.” This value is typically
a small portion of the face value of the policy. While a step up from lapsing,
taking a cash surrender value is rarely an economically attractive option after
factoring in inflation, opportunity costs, fees, etc.
3
3. Go
to a life settlement broker and see if outside institutions are willing to bid
on his policy.
John is no dummy. John chooses #3 and (on average) he
receives four
times more than Big Insurance Co would have given him for surrendering his
policy. The benefit that John’s family would have received upon his death is
transferred to the institution that purchased his life settlement policy. John has more cash to use and the institution
will now pay the premiums to Big Insurance Co and receive a large check upon
John’s death. This institution hopes that the cash paid to John, plus the
premiums paid while John is alive, are (significantly) less than the value of
John’s contract. The table below shows a grossly oversimplified example of the
cash flows.
Table 1. Cash Flows for a Life Settlement Institution
Policy Purchased
|
Premiums Paid to Big
Insurance Co
|
Death
|
||||||
Year
|
1
|
2
|
3
|
4
|
5
|
6
|
7
|
8
|
Cash Rec. (Spent)
|
$(20)
|
$(2)
|
$(2)
|
$(2)
|
$(2)
|
$(2)
|
$(2)
|
$100
|
IRR
|
20.9%
|
|||||||
Net Cash Received
|
$68
|
|||||||
Two
of the three parties in these transactions loved the mathematics behind life
settlements and as long as the insured died when projected, all was well. Consequentially,
the asset class took off and by 2007 more than $12 billion of policies were
sold on the secondary market. Most of these were manufactured policies and were
originated solely to be sold to a fund (otherwise known as Stranger Owned Life
Insurance, or STOLI polices). From there though, things did not go so smoothly.
Chart
1. Estimate of Life Settlements Sourced from The Deal
So with those changes, the financial
crisis, the withdrawal of major investment banks, and public company litigation (more on Imperial’s issues later),
life settlement funds are currently stuck in-between a rock and a hard place.
If these groups have underestimated the life expectancy for their policies, who
will fund premiums if everyone is running for the exits? This is the issue many
funds and institutions are finding today. Imperial though, is largely able to
avoid this financing issue.
A New Financing Option
The old model for the life settlement
industry was to go out, raise some capital, and hope that the capital lasted
you until your policies were cash flow positive. In 2013 Imperial shifted this
with a new subsidiary called “White Eagle.” White Eagle will be funded via a
credit facility backed by a subsidiary of Beal Bank, LNV Corp. Thanks to the
facility, Imperial was able to acquire 459 life insurance policies that had an aggregate death benefit
of $2.28 billion.
The downside for Imperial was that
the $2.28 billion won’t accrue to them in whole. The agreement stipulates that
any death benefit received first goes towards paying down principal and
interest. After the credit facility is paid off, White Eagle receives $76.1
million, and finally, the remaining proceeds are split 50/50 between LNV Corp
and Imperial. Of the 459 policies, 25%
of them are pledged as collateral.
The significance of this credit
facility cannot be understated. It helped Imperial get rid of 12% term notes,
eliminated the majority of future financing issues, and added another 459
policies. As of 12/31/2013 the company managed a portfolio of 612 life
insurance policies. The fact that Imperial owns 612 policies is very important,
as any fan of statistics knows, the law of large numbers rules. An idea of the
impact can be seen in the picture below.
Picture 1. Apollo Estimated IRR vs.
Number of Lives Source: Oregon
Investment Council
In the past, Dichotomy Capital has
invested in peer-to-peer loans and while the asset classes are very different,
the statistics for life settlements and peer-to-peer loans are very similar.
That is, both follow the law of large numbers. The more loans/policies, the
closer to the statistical expectation the portfolio will perform. In the case
of life settlements, some people may die before their LE, some may die well
after, but with enough lives in the pool these should even out. With more than
600 policies, Imperial should see a distribution between the upper two curves
in Picture 1. This eliminates a lot of the risk seen in smaller life settlement
pools where one or two mortality events can shape the financial well-being of
the firm.
One obvious problem is the credit
facility only funds 459 policies leaving 153 policies to fund. These 153
policies are Imperial’s legacy policies and must be paid for via cash from the
balance sheet. These could present an issue to the company but there are
several options. In the Q4 2013 conference call management noted their options
and objective.
“We are currently undertaking a strategic
review of the remaining life settlement assets we own that are not financed in
the credit facility. Over the past few quarters, we have opportunistically sold
some policies and lapsed a few others, which did not meet our investment
objectives. We are reviewing all options, including selling the entire
portfolio or potentially entering into a financing arrangement, which would
eliminate our ongoing premium burden. We expect to reach a final decision in
the next one to two quarters. Rest assured, our decision will reflect the best
combination of return on capital and best meeting of the company’s liquidity
needs.” –Tony Mitchell March 10, 2014
Conference Call
It appears that the company knows
these policies must be taken care of in some manner. How exactly is unknown but
the method could impact the fair value of the company.
Valuation of Imperial
At face value Imperial appears to be
undervalued. At current prices of $5.95/share and 21.218 million shares
outstanding the company has a market cap of $126.2 million, versus a book value
of $193.4 million, implying a price-to-book value of 65%. Even if one includes
the convertible notes, 10.45 million additional shares will be tacked onto the
share count if shares rise above $6.76. In that case fully diluted share count
rises to 31.68 million shares and at the convert price market cap rises to $214.15
million, implying a fully diluted price-to-book value of 110% at the convert
price. I believe that book value is materially understated though and that book
value will grow far in excess of the rest of the market, meaning a premium to
book value is warranted.
The first reason for undervaluation,
excessive discount rates, has to do with several factors including: the age of
the underlying insured, likelihood of a policy sale, market conditions,
litigation likelihood and numerous other factors. As of 12/31/2013 Imperial discounted
their policies at 19.14% and a 1% swing would alter stated fair value by ~$18
million. If this rate seems high, Amtrust Financial Services has an effective discount rate of 14.2% (page F-28), which, according
to industry experts, is roughly the industry average.
If Imperial were to mark their
policies according to industry averages, their discount rate would drop by
almost 5%, increasing fair value by approximately $90 million. In that case, book
value would go from $193.4 million to $283.4 million. The comparison on an
unconverted and converted basis can be seen below. The next question is why are Imperial’s
policies marked with such a high discount rate?
Primarily the high discount rate is
because Imperial intends to sell certain policies, if a good price can be
found. Since the life settlement industry is currently experience trough like
trading levels, discount rates are high. If the market comes back, discount
rates will fall.
Table 2. Book Value vs. Market Cap
for Imperial
Current Metrics
|
Fully Converted In-The-Money
|
|||
Current Share Price
|
$5.95
|
Share Price
|
$6.76
|
|
Shares Outstanding(M)
|
21.22
|
Shares Outstanding (M)
|
31.68
|
|
Current Market Cap $(M)
|
$126.2
|
Market Cap $(M)
|
$214.16
|
|
Current Book Value $(M)
|
$193.4
|
Current Book Value $(M)
|
$193.4
|
|
Current Price to Book
|
65%
|
Fully Converted Price to Book
|
111%
|
|
Adjusted Book Value
|
$283.4
|
Adjusted Book Value $(M)
|
$283.4
|
|
Current Price to Adjusted Book Value
|
45%
|
Fully Converted to Adjusted Book Value
|
76%
|
The other reason for the high
discount rate is Imperial’s historical legal issues. Of the 612 policies in
their portfolio, 569 were previously premium financed. In the past these types
have met the wrath of regulators and in 2012, the US Attorney and armed
officers thought Imperial’s premium financing arm was not proper. Those issues,
explained later, are largely behind them and the company has a non-prosecution
agreement with the US Attorney.
There is no single clear answer for
why discount rates are so high. An investor must remember that these policies,
if held to a mortality event, will yield the face value of the policy. So no
matter what the discount rate is, an investor who buys a $5 million face value
policy will receive $5 million upon the death of the insured.
Why Should Imperial Trade At or Above Book
Value?
Going forward, whether or not
Imperial trades at (or above) book value is solely reliant on the returns that
will be generated. I believe that Imperial will generate market beating returns
over the next few years and therefore should trade at a premium to book value. Broadly
speaking, this premium will be driven by short-term cash flows and long-term
cash flows.
In the long-term mortality events on
the portfolio will happen and the cash will accrue to Imperial. The larger
portfolio is already helping them, and according to the Q4 2013 conference
call, one $6 million policy was collected in full in December. The proceeds
were applied to the credit facilities outstanding balance. With such a large
portfolio, these events should be a somewhat regular occurrence for the next few
years. Given the average life expectancy of 11.6 years, mortality events should
begin to accelerate in the next 4-8 years. Since 2010, the expected IRR,
according to Coventry and Apollo, for acquired policies has been north of 14%.
Investors in Imperial should feel fairly confident that the acquired policies
will generate IRRs greater than 14% and perhaps in excess of 18%.
Over the long-term, there is no
reason that a book generating >15% IRRs should trade below equity value.
Over the short-term though, investors should be even more enthused.
New Financing Model
In an 1892 article in The Gentleman’s Magazine, W.H. Davenport Adams remarked “Great poets
imitate and improve, whereas small ones steal and spoil.” The management team
of must have read Mr. Adams article because when LNV Corp offered them the
credit facility, management saw a good thing and is in the process of repeating
it.
As a reader may recall, the LNV
facility offered Imperial policy financing with little to no money down. LNV
would receive interest at LIBOR +4% plus a 10% interest in any policy financed.
Upon mortality events the principal and interest advanced is paid off first. Imperial saw that this could be a really good
deal for smaller funds that LNV has no interest going after. The convertible
offering (referenced in the Valuation section) added $67.9 million of cash to
Imperial’s balance sheet and diluted shareholders by almost 50% if the shares
convert. All this cash will be going towards a program that mimics LNV’s
facility. So who is Imperial stealing and spoiling from, shareholders or the
life settlement industry?
Management has stated that they
expect “north of 25% IRRs” from this new facility and based on internal
calculations, this seems reasonable (See Appendix 1). Interviews with several
life settlement fund managers confirm the attractiveness of this facility
compared to selling policies in today’s market. Overall, I believe that the
market and most investors are not focusing enough on the potential for
near-term cash flows to accrue from the facility.
There are many funds out there that
purchased life settlement policies before 2008. These funds utilized data from
AVS and 21st Services that was adjusted materially longer. On
average the new mortality tables increased life expectancy by 15-20% in 2008
and then another 20% when the tables were updated in 2013. Thus a fund that had
enough capital in 2008 to fund a portfolio with an average LE of 120 months
would now need to pay premiums for another 3-5 years. Is it any surprise that
so many distressed sales are occurring 5 years after the 2007 peak? Many funds
simply need the capital and with the lack of financing available from
traditional outlets, the only options are letting the policy lapse, take on
financing at usurious rates, or sell into a life settlement market that is
clearly distressed.
Imperial saw the potential in all
this and figured out that many of these policies were only a few short years
away from being cash flow positive. As one fund manager told us “in your 80’s,
nature starts to take over, it’s that simple.” Imperial intends to fund older
policies that are closer to mortality events. Given the attractive nature of
their financing (8-9% interest and a 10% equity stake), Imperial should have no
problem finding prospective lenders. My research indicates that this will
happen just as management has indicated in conference calls and public filings.
By funding policies only 2-3 years
away from mortality events, Imperial will see quicker cash flows accrue to
equity holders than simply holding onto their life settlement portfolio. Make
no mistake, I believe their portfolio is very valuable, but I believe deploying
cash that generates IRRs in excess of 25% is very attractive as well. I suspect
the market will believe it when they see it.
To wrap up the valuation portion of
this investment, I hope I have convinced readers that Imperial is trading at a
marked discount to fair value and has several opportunities to produce market
beating returns, providing upside to an investment. The table below shows a
summary of the potential share appreciation I feel is achievable for Imperial
given the high IRRs of the portfolio and LIFO facility.
Table 3. Price Potential
Adjusted
Book Value/share
|
$8.95
|
Current
Price
|
$5.95
|
Upside
|
50%
|
Hypothetical
|
|
1.5X
Price to Book Share Price
|
$13.42
|
Upside From Current Price
|
126%
|
It should be obvious that the
asymmetry present in this investment is quite appealing. Investors also appear
scared of another revision by LE providers. Interviews with a managing director
at 21st Services led me to believe that large swings in mortality tables
should not be as common. Going forward, 21st Services expects to
release data every year and the expected swings in mortality are in the “low
single digits” instead of >15% every few years. This should add some
predictability to the space; however it is not the only reason Imperial trades
at a distressed valuation.
Why is this Available?
The stock and bond bull market since
2009 has been a relentless march upwards. Any company that hasn’t participated
in this probably had a reason for this lack of investor enthusiasm. There are
several reasons why Imperial fell and hasn’t improved since. Each issue will be
addressed separately.
.
The life
settlement industry has fallen out of favor and remains highly litigious
2
The US
Attorneys’ Office stormed their office
3
The IRS is
investigating the company over the structured settlement subsidiary
4
The business
has been shuffled and there is no direct public comparison
While it is obvious that the industry
has fallen out of favor, any sort of reversion to mean will help companies like
Imperial. In the hey-days manufactured policies were originated quite
willingly, this is not the case now, but there is still plenty of opportunity
for investors. Primary research has indicated that several well known
institutions are looking to raise large sums of money to purchase life
settlements on the secondary and tertiary markets.
Many of these institutions have
already gone through the process and understand that this is a litigious space.
However, I believe the litigation risk is relatively low and becoming lower
every day based on interviews with several lawyers that represent life settlement
funds. The path forward in states such as California, New York, and Florida, is
fairly straightforward and well understood in the courts. Furthermore, states
like Delaware are taking steps to create a more predictable
acquisition process for secondary and tertiary participants.
Investors like predictability.
Investors like high IRRs too. This asset class should be considerably more
boring and predictable now. Combine that predictability with high IRRs and
gradually capital will flow back into the asset class.
Points #2 and #3 both have to do with
Federal investigations. Make no mistake; these are not to be taken lightly. The
US Attorneys’ investigation was quite dramatic and there was a serious risk to
the long-term health (or simply survival) of the business. Luckily for investors,
and management of Imperial, the Attorneys’ office entered into a Non-Prosecution Agreement with Imperial for the paltry sum of $8
million. The agreement was predicated on the decision to terminate the premium
finance business, but it put to rest any future negative consequences.
The IRS investigation was launched in
2014 and was disclosed in the 2013 10K. Unfortunately for investors there are
no real hard facts to go off of since no formal charges have been filed.
However, it is known that the investigation centers on the discontinued
structured settlements business. It has been speculated that Imperial
could face 40% excise taxes on factoring discounts plus legal fees. The
investigation centers around the years 2010-2013, so investors can narrow down
the potential penalties.
The excise tax is determined by the taking
the undiscounted amount of the payments being acquired and subtracting out the
total amount actually paid, then multiplying that by 40%. The table below shows
these amounts.
Table 4. Potential Excise Tax,
sourced from 2013 and 2012 10K report
In
Millions
|
2010
|
2011
|
2012
|
2013
|
Total
|
Face
Value
|
$
47.21
|
$
96.63
|
$
130.14
|
$
86.54
|
$
360.51
|
Amount
Paid
|
$
12.51
|
$
20.30
|
$
24.57
|
$
17.64
|
$
75.02
|
Difference
|
$
34.70
|
$
76.33
|
$
105.57
|
$
68.90
|
$
285.49
|
40%
Excise Tax
|
$
13.88
|
$
30.53
|
$
42.23
|
$
27.56
|
$
114.20
|
The total, $114.20 million, is my
estimate for the maximum amount due to the IRS. Sprinkle in some legal fees,
and I estimate that this could be a $120 million penalty to the company if
every single structured settlement was forum shopped. This is absurd. According
to structured settlement experts I spoke with, forum shopping is common but it
does not take place in every transaction. I speculate that a few percent of
Imperials transactions were forum shopped and the end fine will be less than
$10 million. However, this is a risk to the thesis. Insider actions indicate
this may not be that big of a deal (explained later) and the structured
settlement business was sold in 2013, limiting future damages.
Also, the leader in the structured settlement space, JG Wentworth, shows little excise tax penalties in their 10K's. As I have got to know the structured settlement space better (the Fund and clients maintain an investment in JGW), I believe that this is not that big of a risk.
Also, the leader in the structured settlement space, JG Wentworth, shows little excise tax penalties in their 10K's. As I have got to know the structured settlement space better (the Fund and clients maintain an investment in JGW), I believe that this is not that big of a risk.
In 2011 when the company launched an IPO
they had a life settlement business that acquired policies via premium
financing and a structured settlement business. Investors bought into the
company with the expectations that those two businesses would create
shareholder value. After the aforementioned investigation of the premium
financing business and the sale of the structured settlement business,
investors are now left with a business that is far different than the S-1
indicates. I believe that this is creating some of the valuation disconnect.
Imperial stands alone too. There are
no publicly traded comps, only one sell-side analyst covers the company, and
the closest associated company, Life Partners Holdings, is stuck battling
lawsuits and trying to stay afloat. Comparing Life Partners to Imperial seems
ignorant and is the equivalent of comparing a broker like MF Global to an asset
manager or banking firm like Jefferies. Sure, they operate in similar spaces,
but does improper behavior at one indicate that an entire asset class is toxic?
I believe the answer is no, but I will leave it up to the reader to decide.
As the market gets more comfortable
with Imperial I suspect that people and institutional money will stop looking to
the past for future results. With no public company counterpart, Imperial
stands alone right now and most investors are uncomfortable analyzing a company
without a long history and/or the necessary anchoring bias that accompanies
most relative valuation (“life settlement company ABC trades at X book value,
therefore Imperial should trade at X book value”). Imperial investors should be happy with one relative metric compared
to the general market, insider buying. Insiders have been buying plenty of
Imperial stock recently.
Management
It is oft-repeated that there is only
one reason insiders buy, they believe their stock is going to go up. To that
point, I am encouraged by insiders Tony Mitchell and Bulldog Investors and
their recent purchases.
Tony Mitchell is the CEO and he
recently purchased more than $200,000 worth of stock on the open market. This
compares favorably to his 2012 base salary of $525,000 (since raised to
$625,000), which was the only compensation received in 2012. Financially
speaking, Mr. Mitchell would need to be suicidal if he bought stock on the open
market and knew that the ship was sinking. Mr. Mitchell has the rights to more
than 2.0 million shares, split between shares owned and warrants/options. I
believe he is motivated to increase the share price in a responsible manner.
The most discouraging compensation piece is his severance, which is a little
more than $3.0 million.
Philip Goldstein is the Chairman of
Imperial, and became Chairman in
2012. In his June 2012 letter Goldstein
thought the “intrinsic value is at least $8 per share.” He was no less bullish
six months later in a video interview. Given his position as Chairman, Goldstein
has a better view of the business and its prospects, than outside investors. It
is interesting then that Goldstein purchased convertible notes (page 36) and increased
his stake in Imperial by more than 213,628 shares, assuming the conversion
happens. It could be argued that Goldstein views Imperial undervalued at
today’s price, why else would he purchase a security that converts to common
shares at a price more than 13% higher than prices today?
I believe it is safe to assume that
Goldstein believes shares are worth materially more than the strike price and
would only be purchasing convertible shares if he was bullish on the long-term
prospects of the company. The counterargument to that is he simply wants to
clip an 8.5% coupon. While this is a possibility is seems a bit unlikely given
his large position in common shares. Goldstein and other insiders have also been buying shares on the open market in June, leading up to the dismissal of the the Sunlife lawsuit.
Conclusion
Having followed the life settlement
space for several years I can understand why investors stay away from the space
altogether. The asset class is rife with legal difficulties, a litigious past,
and a secondary market that is 1/6th the level it was in 2007.
Groups who contemplate buying shares of Imperial get to contend with all of this
plus a DOJ investigation, an IRS investigation, and an unknown business model going
forward. The main risks to an investment
in Imperial are:
1.
The life settlement market may never fully
revive because STOLI policies are all but extinct.
2.
The IRS investigation proves to be very
costly and causes a long-term impairment to the business.
3.
Imperial fails to secure financing for
policies outside the White Eagle subsidiary.
4.
Continued erosion of LE calculations.
However, I believe investors are more
than compensated for this and the positives include:
1.
Smart money is starting to move back into the
space, looking to deploy capital into situations promising 18-22% (estimated)
IRRs.
2. Purchasing shares of Imperial allows access
to these high IRRs at a 35% discount to GAAP book. As explained above, GAAP
understates true book value, if industry averages are used.
3. The new LIFO facility appears to be near-term
cash flow catalyst that may delineate from mortality events in the Imperial-owned
portfolios.
4. Insiders seem to agree that shares are cheap
and are well incentivized to drive shareholder returns.
As increased knowledge of the
business surfaces investors will recognize Imperial and I believe the stock
will re-rate. I have a fair value in excess of $12 per share and believe a
patient investor will see even better returns over the long-haul. An investment
in Imperial is hairy, convoluted, and fraught with previous missteps, a perfect
position in Dichotomy Capital’s portfolio.
Disclaimer: This research report
expresses our opinion and is for informational purposes only. Any investment
involves substantial risks, including the complete loss of capital. Any
forecasts or estimates are for illustrative purpose only. Use of Dichotomy
Capital LLC's research is at your own risk and proper due diligence should be
done prior to making any investment decision. It should be assumed that
Dichotomy Capital and or its clients, has an active position, either short or
long, in the security mentioned in this report. Dichotomy Capital does not
undertake to update this report or any information contained herein.
This is
not an offer to sell or a solicitation of an offer to buy any security.
Dichotomy Capital LLC is not registered as an investment advisor. All
expressions of opinion are subject to change without notice and Dichotomy
Capital LLC does not undertake to update or supplement this report or any of
the information contained herein. All the information presented is presented
"as is," without warranty of any kind. Dichotomy Capital LLC makes no
representation, express or implied, as to the accuracy, timeliness, or
completeness of any such information or with regard to the results to be
obtained from its use.
