Credit: 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 0.75x book value. Upside to book value, an obvious valuation factor for most financial companies, would result in a greater than 40% 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 $13 per share.
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.
Background
" 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
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:
- Lapse on his policy. He will no longer pay premiums but will lose all benefits to his policy.
- 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.
- Go to a life settlement broker and see if outside institutions are willing to bid on his policy.
John is no dummy. John chooses No. 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
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. Consequently, 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
The decline in capital can be traced to the financial crisis, changes in underwriting, and the disappearance of STOLI policies. The changes in underwriting have not been favorable for the industry and have resulted in longer life expectancies. Just ask T. Boone Pickens how his predetermined time of death worked out for his alma mater. 21st Services and AVS are the industry leaders and whenever they perform life expectancy ( LE ) revisions, the life settlement IRRs adjust accordingly. For example, in September 2008 21st Services revised their LE tables and the result was longer expected lives.
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 Dec. 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, we have 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, thereore 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 fourth quarter 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. As of May 15, 2014, shares were priced at $6.50 per share and 21.218 million shares were outstanding, resulting in a market cap of $137.9 million, versus a fiscal 2013 book value of $193.4 million, implying a price-to-book value of 71%. 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, while book value would rise about $70 million from the resulting loss of the convertible liability. 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 Dec. 31, 2013, Imperial discounted their policies at 19.14% and a 1% swing would alter stated fair value by about $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 we have spoken with, is roughly the industry average.
If Imperial were to mark its policies according to industry averages, its 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 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.
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 U.S. 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 U.S. 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 fourth quarter 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 four to eight 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 greater then 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 must have read 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. 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% to 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 two to three years away from mortality events, Imperial will see quicker cash flows accrue to equity holders than simply holding onto its life settlement portfolio. Make no mistake, I believe its 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.
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 less than 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.
- The US Attorneys' Office stormed their office.
- The IRS is investigating the company over the structured settlement subsidiary.
- 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 No. 2 and No. 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 10-K. 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 to 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
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.
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.
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:
- The life settlement market may never fully revive because STOLI policies are all but extinct.
- The IRS investigation proves to be very costly and causes a long-term impairment to the business.
- Imperial fails to secure financing for policies outside the White Eagle subsidiary.
- Continued erosion of LE calculations.
However, I believe investors are more than compensated for this and the positives include:
- Smart money is starting to move back into the space, looking to deploy capital into situations promising 18-22% (estimated) IRRs.
- 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.
- The new LIFO facility appears to be near-term cash flow catalyst that may delineate from mortality events in the Imperial-owned portfolios.
- 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 rerate. 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 your 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 this research is at your own risk and proper due diligence should be done prior to making any investment decision. It should be assumed that the author and or its clients, has an active position, either short or long, in the security mentioned in this report. The author 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. All expressions of opinion are subject to change without notice and the author 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. The author 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.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
