EMERGENT CAPITAL INC EMG
September 02, 2016 - 4:04pm EST by
clancy836
2016 2017
Price: 3.82 EPS 0 0
Shares Out. (in M): 28 P/E 0 0
Market Cap (in $M): 106 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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  • Value trap

Description

This is an event-driven microcap idea ($106 million market cap, 75000 shares average daily volume) which currently trades at a deep discount to reported GAAP book value, and has recently filed an 8-K announcing that the Board is evaluating strategic alternatives in response to receiving multiple unsolicited inquiries. EMG is controlled by noted activist value investor Phil Goldstein of Bulldog Investors LLC, and substantial ownership (and significant recent insider buying above the current price) by Goldstein and other Board members increase the probability that a potential sale of the company could unlock significant value for shareholders.

 

Executive Summary

EMG is an investor in viatical settlements (life insurance policies which the company purchases from elderly beneficiaries at a discount in exchange for being assigned the benefit payment upon the beneficiary's death). This niche alternative asset class has long been out of favor with investors due to the lumpy and unpredictable timing of cash flows on policy maturities over short time intervals, past regulatory scrutiny of related practices such as life insurance premium lending, and perhaps also due to a subjective aversion to the somewhat morbid nature of investing in an asset class that pays out following a person's death.

The potential advantages include the fact that viatical settlements can provide returns that are entirely uncorrelated with the market, and that over long time periods and large numbers of policies, average life expectancy and the timing of policy maturities can be predicted with reasonably confidence by professional actuaries (or the life insurance industry would not exist).

As of the latest 10-Q, EMG currently owns a portfolio of 625 life insurance policies representing an aggregate death benefit of approximately $3.0 billion. This represents an average of approximately $4.8 million in benefit value per policy, implying that many of the selling policyholders may be high net worth individuals wanting to access their equity in high-value policies during their retirement. The covered policyholders have an average age of 82 years, and EMG's independent third-party actuaries have determined a value-weighted life expectancy of approximately 10 years. The fair value of the policy portfolio is fairly sensitive to actual average life expectancy, with a overall change in average expectancy of 6 months across the portfolio representing approximately $80 million in NPV. The nature of EMG's assets (an out of favor illiquid asset class with lumpy short-term cash flows) are not well suited to a small public entity. As a standalone entity, EMG has persistently faced a high cost of capital, has historically relied on expensive equity and debt financing, and values its assets and liabilities using unusually high discount rates.

In valuing the portfolio, the company currently applies a discount rate of 16.5%. This is not a typo, and is clearly a very high discount rate in the current environment, which ostensibly reflects the illiquid and out-of-favor nature of this asset class. The company states that the discount rate is based on "current information about market interest rates, the credit exposure to the insurance company that issued the life insurance policy and our estimate of the risk premium an investor in the policy would require", but there is likely no clear objective basis for selecting this specific number. Importantly, an investor with a required rate of return less than 16.5% would value these assets more highly than current GAAP book value - decreasing the discount rate by just 0.5% would increase reported GAAP book value by $13 million.

The company holds a majority of policies through two subsidiaries financed by revolving credit facilities (White Eagle and Red Falcon) secured by the policies pledged to each facility. The actual interest rates on White Eagle and Red Falcon facilities are LIBOR based and currently have an effective rate of only 6.0% and 5.5% respectively, although the lender also receives a share of any eventual policy proceeds based on a waterfall arrangement. Confusingly, the company also uses high and variable discount rates to value revolving credit facility liabilities themselves. In the past, the company has also issued a smaller amount of fixed-rate debt at high rates, including 12.875% and 15% senior secured notes and 8.50% Unsecured Convertible Notes. This results in a complex situation where it is clear EMG is facing a high cost of capital, but it is very hard to objectively or precisely value EMG as a standalone entity. Added to the somewhat stigmatized nature of the asset class, this complexity likely further contributes to the high costs of capital and low P/B multiples that EMG has persistently faced.

EMG was previously known as Imperial Holdings (IFH), and has been the subject of two VIC writeups several years ago under that name: an exceptionally thorough February 2014 writeup by rhianik at $5.43, and a much shorter (but very successful) March 2012 post by lindsay790 at $2.50. Rhianik's writeup was particularly thorough and high-quality, and I encourage you to read it. If you want to wade into the details of the discount rates currently applied to assets and liabilities, these are more fully discussed in the footnotes to the 10-Q:

https://www.sec.gov/Archives/edgar/data/1494448/000149444816000036/emergent2q16form10-q.htm

To be honest, this is a 3% position for me and I work a full-time job. I had to value hypothetical insurance portfolios on an HP12C in the CFA level 3 exam, but in the end that kind of false precision was one thing that made me realize I was happier in a mostly non-financial career. I think the recently announced review of strategic alternatives is the most critical piece of information that makes this the right thesis at the right time, and because of this I am not going to wade into the weeds of attempting to value existing assets and liabilities as if EMG were going to perpetually continue as a standalone entity and try to value its assets and liabilities the way it historically has.

Instead, my basic thesis is this:

  • The nature of EMG's assets (an out of favor asset class with lumpy short-term cash flows) are clearly not well suited to being held in a small independent public entity. This has resulted in EMG having to bear very high equity and debt costs of capital.
  • The recent announcement that the company has received a number of unsolicited inquiries and is exploring strategic alternatives should be taken seriously. As skilled value investors and major stockholders, Goldstein and the Board recognize the point above, and will diligently search for an optimal financial or strategic buyer, ideally one who requires expected rates of return less than the 16.5% discount rate currently used to value EMG's assets.
  • In a ZIRP environment, 10%-20% discount rates on either the asset or liability side stick out like a sore thumb. There are many investors (endowments, life insurance companies, pension plans, HFs) who would love to earn an expected return far less than the 16.5% discount rate currently being applied to EMG's assets - perhaps all the more so if these returns are generated by a niche alternative asset class that is entirely uncorrelated with the market (and entirely uncorrelated with any other alternative asset class).
  • To my mind, an ideal strategic acquirer could be an insurance company liable for some of the policies held by EMG. Transamerica and Lincoln National each are liable for policies representing approximately 20% of the aggregate death benefit held by EMG. Thinking outside the box, a potential buyout of EMG by an insurer or consortium of insurers could create significant value in excess of current GAAP BV, by enabling the buyer to eliminate statutory liabilities at a discount.
  • To any potential acquirer who requires expected rates of return less than the 16.5% discount rate currently used to value EMG's assets, and may be willing to hold viatical settlements on its balance sheet while requiring a return anywhere less than 16.5%, a purchase of EMG could create substantial value by wholly or partly retiring the company's costly debt financing. To such a buyer, the value of EMG's portfolio could reasonably be expected to approximate at least the current reported GAAP book value, and potentially higher.

 

Management, incentives and announced review of strategic alternatives

On August 1, Emergent announced that the Board had received "a number of unsolicited inquiries from several interested parties"  has formed a special committee to explore strategic alternatives. The company stated it does not intend to provide any further updates until such time as it has entered into a definitive agreement. The stock has not reacted significantly, initially trading up to $4 but subsequently easing back to its recent base near $3.50-$4.00.

https://www.sec.gov/Archives/edgar/data/1494448/000149444816000028/a8-kstrategicalternatives.htm

As large shareholders themselves, Phil Goldstein and the other Board members are well aligned with shareholders' interests, and should be highly motivated to explore a sale that can relieve the current standalone company of its high costs of capital, and deliver value to shareholders substantially in excess of the current price. Goldstein has a long track record of value-oriented shareholder activism at other public companies and closed-end funds, and has repeatedly written in shareholder letters that he believes fair value at EMG to be significantly higher than the current price. Several Board members (including Goldstein and James Michael Chadwick of the value-oriented investment firm Ancora Advisors) have purchased almost 500,000 shares on the open market since December 2015 at prices as high as $4.43, in addition to the company's buyback of 608,000 shares during 2015 at an average cost of $4.17.

http://www.marketwatch.com/investing/stock/EMG/insideractions

 

Additional potential value from Sun Life settlement

The company has been involved in litigation with Sun Life Assurance Company of Canada, which had filed suit against EMG/IFH in 2013 claiming that 28 life insurance policies issued by Sun Life and owned by the company were invalid. EMG ultimately prevailed in this initial suit and all of Sun Life's claims were dismissed with prejudice. EMG filed a separate complaint against Sun Life alleging breach of contract and fraud, seeking compensatory damages of no less than $30.0 million in addition to punitive damages. A trial of this countersuit is scheduled for October of this year; if the company ultimately prevails, potential cash proceeds of $30 million could create some significant additional upside relative to the $100MM market cap. A favorable ruling may still be appealed by Sun Life, but a favorable ruling occuring during the announced strategic alternatives review process could certainly increase the expected value to a potential acquirer.

 

Conclusion

As a standalone entity, EMG has historically faced a very high and unsustainable cost of capital, and has valued its assets at what appears to be an unusually high discount rate far above the cost of capital for many financial and strategic buyers. The recent announcement that the company has received a number of unsolicited inquiries and is exploring strategic alternatives should be taken seriously given the significant ownership of common and convertible stock by management and the Board. I believe the Board will actively search for a financial or strategic buyer, and in the current ZIRP environment is reasonably likely to find one who requires expected rates of return less than the 16.5% discount rate currently used to value EMG's assets. In such a scenario, a potential transaction at or near GAAP book value (approximately $200 million, or almost 2X the current market cap) would not be unreasonable.

With a deep discount to GAAP book value based on an unusually high discount rate applied to assets valued by independent actuaries, sustained recent insider buying by shareholder-friendly management, and an active review of strategic alternatives recently announced, EMG shares should make an attractive and timely addition to a microcap value portfolio.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Review of strategic alternatives results in a buyer requiring expected rates of return less than the 16.5% discount rate currently used to value EMG's assets

Continued buybacks and insider buying by shareholder-focused management

Potential for additional windfall from Sun Life litigation

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    Description

    This is an event-driven microcap idea ($106 million market cap, 75000 shares average daily volume) which currently trades at a deep discount to reported GAAP book value, and has recently filed an 8-K announcing that the Board is evaluating strategic alternatives in response to receiving multiple unsolicited inquiries. EMG is controlled by noted activist value investor Phil Goldstein of Bulldog Investors LLC, and substantial ownership (and significant recent insider buying above the current price) by Goldstein and other Board members increase the probability that a potential sale of the company could unlock significant value for shareholders.

     

    Executive Summary

    EMG is an investor in viatical settlements (life insurance policies which the company purchases from elderly beneficiaries at a discount in exchange for being assigned the benefit payment upon the beneficiary's death). This niche alternative asset class has long been out of favor with investors due to the lumpy and unpredictable timing of cash flows on policy maturities over short time intervals, past regulatory scrutiny of related practices such as life insurance premium lending, and perhaps also due to a subjective aversion to the somewhat morbid nature of investing in an asset class that pays out following a person's death.

    The potential advantages include the fact that viatical settlements can provide returns that are entirely uncorrelated with the market, and that over long time periods and large numbers of policies, average life expectancy and the timing of policy maturities can be predicted with reasonably confidence by professional actuaries (or the life insurance industry would not exist).

    As of the latest 10-Q, EMG currently owns a portfolio of 625 life insurance policies representing an aggregate death benefit of approximately $3.0 billion. This represents an average of approximately $4.8 million in benefit value per policy, implying that many of the selling policyholders may be high net worth individuals wanting to access their equity in high-value policies during their retirement. The covered policyholders have an average age of 82 years, and EMG's independent third-party actuaries have determined a value-weighted life expectancy of approximately 10 years. The fair value of the policy portfolio is fairly sensitive to actual average life expectancy, with a overall change in average expectancy of 6 months across the portfolio representing approximately $80 million in NPV. The nature of EMG's assets (an out of favor illiquid asset class with lumpy short-term cash flows) are not well suited to a small public entity. As a standalone entity, EMG has persistently faced a high cost of capital, has historically relied on expensive equity and debt financing, and values its assets and liabilities using unusually high discount rates.

    In valuing the portfolio, the company currently applies a discount rate of 16.5%. This is not a typo, and is clearly a very high discount rate in the current environment, which ostensibly reflects the illiquid and out-of-favor nature of this asset class. The company states that the discount rate is based on "current information about market interest rates, the credit exposure to the insurance company that issued the life insurance policy and our estimate of the risk premium an investor in the policy would require", but there is likely no clear objective basis for selecting this specific number. Importantly, an investor with a required rate of return less than 16.5% would value these assets more highly than current GAAP book value - decreasing the discount rate by just 0.5% would increase reported GAAP book value by $13 million.

    The company holds a majority of policies through two subsidiaries financed by revolving credit facilities (White Eagle and Red Falcon) secured by the policies pledged to each facility. The actual interest rates on White Eagle and Red Falcon facilities are LIBOR based and currently have an effective rate of only 6.0% and 5.5% respectively, although the lender also receives a share of any eventual policy proceeds based on a waterfall arrangement. Confusingly, the company also uses high and variable discount rates to value revolving credit facility liabilities themselves. In the past, the company has also issued a smaller amount of fixed-rate debt at high rates, including 12.875% and 15% senior secured notes and 8.50% Unsecured Convertible Notes. This results in a complex situation where it is clear EMG is facing a high cost of capital, but it is very hard to objectively or precisely value EMG as a standalone entity. Added to the somewhat stigmatized nature of the asset class, this complexity likely further contributes to the high costs of capital and low P/B multiples that EMG has persistently faced.

    EMG was previously known as Imperial Holdings (IFH), and has been the subject of two VIC writeups several years ago under that name: an exceptionally thorough February 2014 writeup by rhianik at $5.43, and a much shorter (but very successful) March 2012 post by lindsay790 at $2.50. Rhianik's writeup was particularly thorough and high-quality, and I encourage you to read it. If you want to wade into the details of the discount rates currently applied to assets and liabilities, these are more fully discussed in the footnotes to the 10-Q:

    https://www.sec.gov/Archives/edgar/data/1494448/000149444816000036/emergent2q16form10-q.htm

    To be honest, this is a 3% position for me and I work a full-time job. I had to value hypothetical insurance portfolios on an HP12C in the CFA level 3 exam, but in the end that kind of false precision was one thing that made me realize I was happier in a mostly non-financial career. I think the recently announced review of strategic alternatives is the most critical piece of information that makes this the right thesis at the right time, and because of this I am not going to wade into the weeds of attempting to value existing assets and liabilities as if EMG were going to perpetually continue as a standalone entity and try to value its assets and liabilities the way it historically has.

    Instead, my basic thesis is this:

     

    Management, incentives and announced review of strategic alternatives

    On August 1, Emergent announced that the Board had received "a number of unsolicited inquiries from several interested parties"  has formed a special committee to explore strategic alternatives. The company stated it does not intend to provide any further updates until such time as it has entered into a definitive agreement. The stock has not reacted significantly, initially trading up to $4 but subsequently easing back to its recent base near $3.50-$4.00.

    https://www.sec.gov/Archives/edgar/data/1494448/000149444816000028/a8-kstrategicalternatives.htm

    As large shareholders themselves, Phil Goldstein and the other Board members are well aligned with shareholders' interests, and should be highly motivated to explore a sale that can relieve the current standalone company of its high costs of capital, and deliver value to shareholders substantially in excess of the current price. Goldstein has a long track record of value-oriented shareholder activism at other public companies and closed-end funds, and has repeatedly written in shareholder letters that he believes fair value at EMG to be significantly higher than the current price. Several Board members (including Goldstein and James Michael Chadwick of the value-oriented investment firm Ancora Advisors) have purchased almost 500,000 shares on the open market since December 2015 at prices as high as $4.43, in addition to the company's buyback of 608,000 shares during 2015 at an average cost of $4.17.

    http://www.marketwatch.com/investing/stock/EMG/insideractions

     

    Additional potential value from Sun Life settlement

    The company has been involved in litigation with Sun Life Assurance Company of Canada, which had filed suit against EMG/IFH in 2013 claiming that 28 life insurance policies issued by Sun Life and owned by the company were invalid. EMG ultimately prevailed in this initial suit and all of Sun Life's claims were dismissed with prejudice. EMG filed a separate complaint against Sun Life alleging breach of contract and fraud, seeking compensatory damages of no less than $30.0 million in addition to punitive damages. A trial of this countersuit is scheduled for October of this year; if the company ultimately prevails, potential cash proceeds of $30 million could create some significant additional upside relative to the $100MM market cap. A favorable ruling may still be appealed by Sun Life, but a favorable ruling occuring during the announced strategic alternatives review process could certainly increase the expected value to a potential acquirer.

     

    Conclusion

    As a standalone entity, EMG has historically faced a very high and unsustainable cost of capital, and has valued its assets at what appears to be an unusually high discount rate far above the cost of capital for many financial and strategic buyers. The recent announcement that the company has received a number of unsolicited inquiries and is exploring strategic alternatives should be taken seriously given the significant ownership of common and convertible stock by management and the Board. I believe the Board will actively search for a financial or strategic buyer, and in the current ZIRP environment is reasonably likely to find one who requires expected rates of return less than the 16.5% discount rate currently used to value EMG's assets. In such a scenario, a potential transaction at or near GAAP book value (approximately $200 million, or almost 2X the current market cap) would not be unreasonable.

    With a deep discount to GAAP book value based on an unusually high discount rate applied to assets valued by independent actuaries, sustained recent insider buying by shareholder-friendly management, and an active review of strategic alternatives recently announced, EMG shares should make an attractive and timely addition to a microcap value portfolio.

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Review of strategic alternatives results in a buyer requiring expected rates of return less than the 16.5% discount rate currently used to value EMG's assets

    Continued buybacks and insider buying by shareholder-focused management

    Potential for additional windfall from Sun Life litigation

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