|Shares Out. (in M):||158||P/E||0||0|
|Market Cap (in $M):||32||P/FCF||0||0|
|Net Debt (in $M):||130||EBIT||0||0|
Disclosure: This probably won’t work. 20 cent stocks usually don’t work. When it doesn’t work, don’t cry to me as you’re the subordinated equity stub behind the subordinated debt which is subordinated behind a lot of other claims and it should have been obvious that it probably wouldn’t work given that the debt trades at impaired values. If it does work, there could be more than two dollars a share of residual equity value on a current equity value of 20 cents—hence why I’m writing this. Financial engineering could further increase the returns to equity holders. At least EMGC isn’t a Mongolian company (ie. there’s a fighting chance you can make money here)…
“That's what I love about these high school girls, man. I get older, they stay the same age” (David Wooderson in Dazed and Confused)
“Invert, always invert” (Charlie Munger)
“That’s what I love about EMGC, man. Every time I look at it, the insureds get older and the balance sheet is leaking less” (Me)
You know that clichéd line about death and taxes, well, if no one dies soon at Emergent Capital (EMGC), you won’t have to worry about taxes because they won’t make it long enough to pay any. I sort of suspect that they will survive and whatever residual equity remains when this whole process terminates is likely to have some value—potentially substantial value—maybe even extraordinary value. Or maybe not. Besides, how else can you find a way to hedge your portfolio against a zombie apocalypse?
EMGC invests in life settlements and appears to be in run-off. It currently owns 27.5% of a portfolio of 576 policies with a total death benefit in excess of $2.7 billion (though there is $46.2 million of receivables from settlement maturities that should be the property of the hold-co along with $8.7 million of cash net of some expenses). Unfortunately, a whole lot of people need to get paid before equity holders see a penny of this death benefit. By my count, you have;
$132.5 million in hold-co debt
$105 million of annual premium payments (could be more or could be less based on maturities) within this SPV
$12 million of annual SG&A (likely dropping)
Basically, there’s a nasty waterfall that these future maturities need to pass through with lots of rapids along the way. Fortunately, there’s $2.7 billion of eventual maturities that will pass through this waterfall. Let’s just say the equity is a very out of the money instrument today—but by my math, it shouldn’t necessarily be.
Life settlement investing ought to be a reasonably good place to invest. You are buying policies off individuals who bought these policies for estate planning in the first place and are not able to accurately price them, you have predictable actuarial modeling, discount rates used in modeling the current policy values are in the teens (giving you huge accretion over time), you can build a very diversified portfolio to shield yourself from statistical noise, you have a tax shield as you pay premiums before you recoup returns on policy maturities and you can finance these policies with relatively affordable debt. It is the sort of thing that should allow you to easily create a whole lot of value inside of a public company with minimal SG&A.
Unfortunately, Tony Mitchell (of recent FFI LN value destruction fame) was the one running the company. Corporate SG&A was stubbornly high, Tony scared off potential funding partners and the business mainly acted as a stock promote focused on convincing investors that maturities would be imminent and that the portfolio was more valuable than it actually was. In retrospect, the whole thing was a debacle and hundreds of millions of shareholder capital was lit on fire.
A well-constructed life settlement portfolio has a certain percentage of policies in each age range so that you can expect a steady stream of maturities in order to finance premium payments on policies that aren’t expected to mature for many years. EMGC did the opposite. They bought a portfolio of policies that was unlikely to have many maturities. Why do this? Because the discount rates are higher and expected ROA’s were attractive to a shareholder base that doesn’t understand life settlements. This works fine if you have the liquidity to fund the premiums. Unfortunately, EMGC did not have the liquidity runway. They were hundreds of millions short of where they needed to be. In the process of finding themselves liquidity, they sold equity, issued expensive debt and in a last gasp of stupidity—sold 45% of the future maturities to Andrew Beal at Beal Bank (while also taking on more expensive debt from Beal). If you’ve ever read The Professor, the Banker, and the Suicide King: Inside the Richest Poker Game of All Time, you’ll recognize that Beal is damn smart and loves game theory. Tony Mitchell, was in over his head. When he ran out of rope on that noose, adults finally stepped in to untangle the mess he created.
In March of 2017, EMGC announced a recapitalization of the business where a number of investors including Patrick Curry (current CEO) injected $23 million of equity (92 million shares at 25 cents with 34 million 8-year warrants at 25 cents) along with exchange offers for outstanding debt, and new issuances of senior secured debt, leading this investor group to own over 70% of the equity in EMGC. Surprisingly, even this capital was insufficient and various members of this recapitalization group have had to buy additional newly issued senior secured debt in Q1/2019 in order to support the company. This has all been made worse because of a run of bad luck. Despite a US life expectancy of 78.6 years, Emergent somehow found 576 individuals that are so healthy that it’s statistically impossible for this cohort to exist.
If it sounds like a mess, that’s because it is. What has changed? To start with, the average age of the insureds is now 85.1 as I write this. During Q2 ending May 31, 8 policies with $45.6 million of face value matured. Quarterly premiums are a bit over $26 million. For the first time ever, EMGC is finally getting more cash in than going out—even including corporate SG&A and interest expenses.
More importantly, Patrick Curry has done a great job of “protecting the golden goose,” as he calls it. He cut SG&A to the bone. Inexplicably, Tony Mitchell kept an underwriting staff on payroll to find new policies despite his inability to make premium payments on existing policies. They had fancy office space. They spent too much on legal. All of this is gone. The office space has a sub-lease. Payroll has been cut to the bone. The whole point is to have EMGC out-last the policy-holders. Curry should care as his investment vehicle owns 14.4 million shares and warrants on an additional 8.75 million shares.
Most importantly, Curry has played a game of “chicken” with Andy Beal and somehow won. Curry bankrupted EMGC’s main source of value, 99.99% owned Lamington, owner of the White Eagle SPV (with 574 of the policies in it) and forced Beal to the table. As a chartered bank, Beal had been too aggressive and had to back off. A settlement was reached and Jade Mountain (JM) will take out Beal’s debt. EMGC gives up a lot of upside, but also dramatically protects the downside.
Under the deal JM purchases 72.5% of the SPV which is enough to fully repay Beal’s bank debt and remove the 45% waterfall liability. JM has also agreed to pay all future policy premiums (with an interest rate of 11%), advance EMGC hold-co $15.25 million at a 11% interest rate and takes over all management of the SPV for a 85 basis point management fee ($4.5m on current $530 million NAV). Basically, EMGC no longer has any cash liabilities to the SPV (which is good because EMGC has perennially been broke). Once the premiums advanced by JM and the $15.25 facility have been paid off with interest and the premium funding facility have been topped up, EMGC gets 27.5% of all policy maturities through a waterfall (there are a few other features but I want to simplify this here). Effectively, EMGC is now a publicly traded investor in a 27.5% owned SPV managed and funded by someone else.
I’m going to tell you to throw everything you know about GAAP out the window here. There are actuarial estimates that lead to MTM values of these policies based on lots of estimates. There are actuarial estimates that claim that a very high percentage of these policy holders will live past 100 based on how the cohort has done thus far. If you go by GAAP, the equity doesn’t have a prayer here. Instead, I’m going to tell you to put your logic hat on. People who are 85.1 die. If the average insured is aged 85.1, there are many individuals who are older (many who are younger too). Nature is going to take its course here. That’s unfortunate for the insureds, but good for equity holders. Given the four tiers of operating costs here (premium payments/SPV operating expense/hold-co interest expense/hold-co operating expense), as more money starts coming in than going out in premiums, all of these cash out-flows should begin to decline. In particular, premium payments and SPV operating expense will drop rapidly. As maturities begin to waterfall through to EMGC, they should be able to pay down debt as well.
Let’s use back of the envelope math here;
The average policy maturity value is $4.722 million
Annual premium cost is $105 million
Therefore, you need 22 insureds to expire each year to keep up with premium payments.
Add in assumed SPV SG&A of $10 million and a $4.5 million management fee and you need 25.3 maturities a year at the SPV level to tread water. Will 4.4% of people aged 85.1 die each year? With this cohort, who knows, but if you can sort of tread water for 5 more years, by the time this cohort is 90, you really should be getting lots of maturities. If you tread water over 5 years (over that time frame maturities cancel out premium payments and expenses), you have 127 total maturities with a cash neutral effect (in theory).
Hold-co annual interest expense is $8.6 million (though some of that is PIK). You also have hold-co operating expenses, let’s assume they drop to $3 million as JM is now doing all the management of the vehicle. In that case, over the next 5 years, you have an additional $58 million hold-co cash outflow (($8.6 + $3) X 5 years).
Let’s say you make it to the summer of 2024, which is 5 years from today. Your average policyholder is now 90.1. You still have 450 policies remaining (576-(5*25.3)). These policies will have a death benefit of $2.147 billion.
EMGC’s cap structure in summer 2024 looks like;
$590.5 million is EMGC’s 27.5% share of $2.147 billion death benefit
-$58 million of hold-co capital outflow
+46.2 million of settlement receivables on the Q2/2019 balance sheet
+$8.7 million of SPV cash to the hold-co before the JM transaction
-$132.6 million of hold-co debt
= $454.8 million of equity value discounted by some lowish discount rate to account for the average policyholder now being 90.1
Divided by 158 million shares and 34 million warrants exercisable at 25 cents
$454.8 million equity value + $8.5 million warrant exercise value divided by 192 FD shares (158m + 34m) = 2.41/shr in value
At this point, you have about $81.9 million in premium payments each year (450 policies at $182.3k each). You may have a few more years of paying this but the number of insureds should really start to trail off at age 90. If EMGC gets to 2024, it should really be in the money. Between the $15.25 million that JM will loan EMGC and settlement cash from before the deal, along with the PIK option on a lot of the debt, I think EMGC can get to the promised land without further dilution.
However, I think this is something of a worst-case scenario. There are a number of things that EMGC intends to do to improve the returns;
-There are a number of policies that are low NPV and will likely be sold or lapsed given the SPV’s stated cost of capital is 11%. This should remove some cash burn at the SPV level and lead to a quicker waterfall of proceeds—even if it lowers the ultimate death benefit to the hold-co.
-There have likely been additional maturities since the end of May. These maturities are 100% owned by EMGC. Even a few maturities could dramatically change the economics here for EMGC as they’ll have a lot more hold-co cash to pay interest on debt or even start doing accretive things. This is all offset by bankruptcy fees that are likely substantial.
-I have kept the annual premium payments constant at $105 million for the sake of conservatism. As maturities occur, the premiums will decline. At 450 policies, you have $81.9 million of premiums in year 5. Assuming a constant 25.3 policy decline each year, the SPV saves $46.1 million in premiums and EMGC’s share of that is another $12.7 million.
-Policy maturities really should accelerate before year 5. In fact, they should have accelerated a few years ago and they have up-ticked in the past quarter. It would seem likely that by 2024, you have fewer than 450 policies, hence a lot more cash has gone through the waterfall to EMGC and they’ve been able to retire debt faster.
Basically, there are a lot of factors at play and some work in EMGC’s favor and some work against EMGC. As cash comes into EMGC, it should be used to pay down debt or be used to repurchase shares—which will further increase the per share value.
Then again, this company has been cursed since inception. Maybe it all doesn’t work… (Remember, 20 cent stocks don’t work.)
I’m betting there’s likely to be value here.
-Father Time doing his thing