|Shares Out. (in M):||21||P/E||NA||NA|
|Market Cap (in $M):||115||P/FCF||NA||NA|
|Net Debt (in $M):||-20||EBIT||0||0|
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A Non-Correlated, Sixty-one Cent Dollar Compounding Asset Value at an Estimated 12%-15%
Imperial Holdings is a specialty finance company participating in the life settlement industry. Based on our estimates, investors are currently creating IFT shares at 61% of YE2014 book value ($8.86 per share). Moreover, we believe the company's readily definable growth initiatives will allow book value to compound at 12%-15% a year. We regard risk/reward in the equity to be highly asymmetric at current levels and estimate 72% upside to our year-end 2015 price target of $9.32 per share, representing an IRR of 34%.
For the past two years, Imperial Holdings has been under constant liquidity pressure, triggered by the very costly September 2011 DOJ investigation into its legacy premium finance business. Following the completion of the recent $70 million convertible offering (which closed yesterday), however, we believe the path has been cleared for the company to turn to building and unlocking shareholder value. We expect the company to deploy its sizable cash balances into transaction structures offering 25%-35% IRRs. Importantly, we believe these investments will begin throwing off cash at some point in 2015. As investors gain increasing visibility into this cash generation, we expect IFT's valuation to expand materially, and we expect the stock to re-rate accordingly. We look for IFT equity to converge to book value at some point in 2015. We see further optionality in the stock from the potential evolution of the company into an asset manager.
Though the convertible financing diluted year-end 2013 estimated book value per share (which is based on fair market value methodology) by 9%, from $8.96 to $8.14 (on a fully converted basis, based on 32.4 million shares), we estimate that book value will recover to about $8.86 by year-end 2014. Notably, the $8.14 year-end 2013E fully-converted book value is anchored by: (1) $100 million or $3.08 per share in cash; (2) $50.1 million or $1.55 per share in value for 100%-owned life settlement policies that are expected to be monetized in 2014/2015; and (3) $127.5 million in value ($3.94 per share) for IFT's share (net of minority interest) in the White Eagle/Beal portfolio. We believe this asset composition is highly supportive of our view of asymmetry in the equity.
Over time, we believe the company will become a natural acquisition target given the quality and predictability of its cash flow stream.
A brief note about the recent IRS investigation. This write-up was penned prior to this week’s announcement regarding the IRS investigation. We have modified our write-up in the important places throughout, including our model, and believe, based on due diligence and conversations with management, that the IRS investigation should prove to be relatively benign economically. The larger issue is how much it will impact prospective new investors' appetite to buy the stock at what we believe is a depressed valuation. The structured settlements business never generated any money in the years subject to investigation. The company only bought court approved structured settlements, so excise taxes shouldn't be an issue. The DOJ has been investigating the company for over two years and has not found anything other than that previously disclosed. We think they would have likely discovered a massive tax fraud if there was one. For those reasons, and our view that management has high integrity, despite the DOJ investigation, lead us to believe this will eventually be a non-issue. We recommend that anyone that finds the underlying economics of the business compelling, but worried about the IRS investigation, to contact the company. They are very forthcoming and receptive to investor questions.
Company Description and Background.
Imperial Holdings is a major participant in the life settlement industry. The company owns 622 life settlement policies with an aggregate death benefit of $3 billion. Of the 622 policies, 164 are wholly owned (with a carrying value of $50.1 million as of September 30, 2013) and 458 are consolidated, but held in an off-balance sheet financing arrangement with LNV Corp (a subsidiary of Beal Bank). These policies are carried at $127.5 million, net of minority interest.
CEO Antony (Tony) Mitchell and Jonathon Neuman (former President & COO) founded Imperial in 2006. Imperial was the team's third specialty finance company (Peachtree Holdings and Singer Asset Finance) and became its second IPO.
Over time, the focus of the company’s operations has evolved substantially. Between 2006 and 2009, the company’s principal operations consisted of making premium finance loans (targeting insureds over 75 years of age with large policies of $4-5 million) to policy holders in need of financing to fund the payment of insurance premiums. With its capital base bolstered by its February 2011 IPO, the company expanded into two other areas: (1) structured settlements, a business where Mr. Mitchell enjoyed historical success; and (2) outright purchases of life settlements in the secondary markets.
Under the terms of a DOJ Non Prosecution Agreement (NPA - April 2012), IFT was required to exit the premium finance marketplace (see DOJ investigation below.) In addition, in October 2013, to buttress its balance sheet position, the company sold off its structured settlements business to Blackstone for $12 million.
Going forward, we believe Imperial will capitalize on its greatly strengthened balance sheet to partner with institutional holders of life settlement portfolios. We expect the company to target seasoned portfolios with older insureds (i.e. 83 to 85 years of age, on average.) IFT is seeking to fill a much-needed void of short-term financing for insurance premiums in exchange for modest back-end participation in the death benefit. This segment of the market holds significant opportunity for the company. Specifically, we expect the lending and partnering program to deliver material near-term projected cash flows and IRRs in the range of 25% to 35%. Similar partnership opportunities are available at the individual level as well.
Life Settlements: A Large and Distressed Market with Highly Favorable Investment Attributes.
While historically stigmatized as an asset class, the life settlement market has some notable positive investment attributes. Life settlement policies are non-correlated and not sensitive to the economy. Moreover, policies carry minimal counterparty risk. The insurance carriers are by and large strong credits. In addition, while there are some notably large participants in the life settlement industry (i.e. Apollo, Fortress, Amtrust, and GWG Holdings), the sector remains largely distressed and fragmented, with only 10 to 15 large scale players in the market. We believe the re-entrance of Berkshire Hathaway as a buyer of the Coventry First policy portfolio in July 2013 (its first acquisition since 2006) should go a long way to validating the legitimacy of the sector. Berkshire acquired the $300 million face value portfolio for $60 million.
We see the opportunity for high IRRs on acquired policies/portfolios. Notably, we see the potential for even greater returns on partnered policy portfolios.
The industry's historical stigma has kept traditional sources of capital from participating in the market, thus keeping the rates of return (as well as the cost of capital) high. Where many have failed in the industry is in regards to underestimating life expectancies. Longevity risk has proven to be particularly acute over the past decade, as many life settlement portfolios were constructed and funded without an adequate cushion to protect against a mismatch in the timing of cash flows. In addition to the historical inaccuracy of life expectancy assumptions, portfolio owners have also suffered from lack of diversification in portfolio pools; small policy pools are highly susceptible to short-term funding gaps. We believe these concerns represent ripe opportunities for well-capitalized companies.
The table below shows just how much the life settlement market has shrunk over the past five years. Although the market anecdotally improved significantly in 2013, the asset class remains distressed.
We believe the overall life settlement market should benefit from state government legislation that is increasingly supportive of this asset class. Texas passed a law in 2013, the first of its kind that enables individuals with a life insurance policy to enter Medicaid without having to cash surrender or abandon their life insurance policies for little or no value. Those insured’s are now permitted to enter Medicaid if they obtain a life insurance settlement and use the proceeds specifically for long-term care. Similar laws are being considered in several other states - California, Florida, Kentucky, Louisiana, Maine, Montana, North Carolina, New Jersey, and New York. This arrangement is mutually beneficial to the consumer, budget-strapped states, and the life settlement providers. It effectively validates the life settlement market. Additionally, many states have passed consumer disclosure laws mandating that life insurance providers inform insured's of their options, including life settlements, in the event they miss a premium payment. Laws have also been passed that provide a grace period from the time of missed premium payment to when the policy lapses. These developments should prove to be a secular tailwind for Imperial and the life settlement market overall.
Shareholder Aligned Management with Demonstrated Capital Allocation Skill.
During the past two years, CEO Tony Mitchell has done an excellent job of preserving shareholder value. The company has weathered the storm of the DOJ investigation, executed a complicated value-unlocking financing transaction, and assembled an attractive portfolio of assets. In the process, management has substantially increased the size and diversification of the life settlement portfolio. The addition of Phil Goldstein to the board has been a material positive for the company as well.
Mr. Mitchell has always said that he serves at the pleasure of the board and the company’s stakeholders. He recognizes there are multiple levers to pull to create value for shareholders and is keenly focused on creating value. We regard management as highly credible and have witnessed that credibility first hand over the last 2+ years.
Collectively, insiders own 3.2 million shares, or 15% of shares outstanding. Of this amount, management owns 750k shares, representing 4% of total outstanding shares. Management also holds options on an additional 900k shares, and 1.41 million warrants at strike prices ranging from $12.90 – $16.13. On a fully converted basis, including out of the money options, warrants and the recent convertible bond issue, management owns almost 8% of the company. We believe management is incented to increase shareholder value.
The company has three primary sources of current and future value: wholly owned policies, off-balance sheet policies (net of minority interest), and the value from its expected investments in partnered policy portfolios. We estimate fully converted book value will grow to $8.86 and $9.32, respectively, by year-end 2014 and 2015.
There are two critical inputs into determining the carrying value for the wholly owned and the off-balance policies: (1) discount rates and (2) life expectancy assumptions.
The company applies a discount rate to each individual policy based on several factors, including: (1) prevailing rates in the secondary market for comparable policies; (2) the age of the policy; (3) the age of the insured; and (4) the sourcing of the policy. The weighted average discount rate for the total portfolio (wholly owned and off-balance sheet policies) was 19.63% as of 9/30/13. The company uses a blend of two outside firms’ reports (AVS Underwriting and 21st Services) for its life expectancy evaluations.
Wholly-owned policies: Current value = $50 million ($1.55/share)
As of 9/30/13, Imperial held on its balance sheet 164 policies with an aggregate death benefit of $717m and a fair market value of $50m. We expect the wholly owned policies to be monetized in 2014 and 2015 for close to this carrying value. With liquidity no longer an issue, Imperial should be able to get a fair price for the policies, which are all well past the generally accepted two-year contestability period. While these policies have significant terminal value, they are a net current drain on cash. We believe they should be monetized, with the proceeds reinvested in the high IRR, cash generative partnered policy lending program.
White Eagle off-balance sheet policies: 2014/2015 value = $153.5 mil. ($4.74/shr.) & $177.6 mil. ($5.48/shr.)
Imperial’s White Eagle subsidiary holds an interest in an off-balance sheet entity with Beal Bank subsidiary LNV Corp., which is collateralized by 458 policies with an aggregate death benefit of $2.28 billion. These policies were carried at a net fair market value of $127.5 million as of 9/30/13. We estimate Imperial's interest in these off-balance sheet policies, net of minority interest, to be worth $153.5m ($4.74/share) at the end of 2014 and $177.6m ($5.48/share) at the end of 2015. Imperial isn’t expected to generate cash from White Eagle until the 2018 or 2019, at which point the company will receive a $76.1 million preferred distribution. Imperial has no capital commitment requirements for these policies as all of the premiums are paid out of LNV’s credit facility (the “White Eagle” facility).
Partnered policy portfolios: 2014/2015 value = $68mil. ($2.10/shr.) and $128.8 mil. ($3.98/shr.)
The opportunity to invest and recycle much of the recently raised capital at 25-35% IRR's in partnered policy portfolios should create significant value. These investments should begin throwing off cash within 1-2 years, enabling IFT to redeploy that capital. Using the net proceeds of $67m from the convert, along with the sale of wholly-owned policies, offset by operational cash burn, we think Imperial will be able to invest at least $44 million in partnered policies in 2014, all the while leaving the company with plenty of excess liquidity. We expect the NPV (using a 15% discount rate) of that $44m investment to be worth ~$68 million ($2.10/share) by the end of 2014, for a net accretion to book value of $0.73/share.
In 2015, reflecting proceeds from the sale of the wholly owned policies, we estimate the company will be able to make $35m of additional investment in partnered policy portfolios. We project accretion from that investment of roughly $19 million ($0.58/share) and $128.8 million ($3.98/share) in year-end 2015 net present value for the cumulative investments in partnered policy portfolios.
During 2014 and 2015, we are forecasting a reduction in operating expense, reflecting the sale of the structured settlements business and rationalization of certain other cost items. We assume $23m and $15m of combined legal and operating expenses in 2014/15, respectively. We also forecast roughly $9m and $2m of respective premium payments for the wholly owned policies under the assumption they are sold by the end of 1Q:15.
Putting the pieces together, we arrive at a fully converted book value of $8.86 and $9.32 in 2014 and 2015, respectively, based on a share count of 32.4 million shares. The stock appears quite inexpensive at 61% and 58%, respectively, of projected 2014/2015 book value. We believe that as IFT’s partner lending program approaches cash generation, the stock’s discount to book will increasingly narrow and we look for the equity to trade to parity with projected BV by the end of 2015. From Friday’s closing price of $5.43, that represents upside of 72%, a 34% IRR.
Assuming the partner lending program proves successful, we believe Imperial will be able to raise unsecured straight debt by 2016 and have modeled $20m of 15% paper that year. We see book value of $12.44/share by 2017 and believe that at that time, the stock may even trade at a premium to book value. We believe there are multiple ways for the company to create value in addition to partnered policy portfolios, including the ability to partner on individual policies, act as an asset manager, and buyback shares (though we find reinvestment to be a more compelling use of capital right now).
On September 27, 2011, Imperial was notified by the US Attorney's Office in New Hampshire that it was being investigated for its involvement in the making of misrepresentations on life insurance applications related to its premium finance business (DOJ investigation). The SEC soon followed with an investigation of its own, and shareholder lawsuits followed soon thereafter. On October 4, 2011, Imperial announced the DOJ investigation was focused on the company’s premium finance business and certain of its employees. Importantly, on December 15, 2011, less than two months after the commencement of the formal investigations, the DOJ announced that CEO Tony Mitchell was no longer a target of the investigation. On January 3, 2012, the DOJ confirmed that Jonathon Neuman was the only member of the senior management team under investigation. The DOJ also confirmed that the investigation did not focus on the company's accounting and finance departments.
The DOJ investigation ended up being very costly for the company, both in terms of its impact on the stock and the impact to the balance sheet. The announcement triggered a one-day decline of 65% in the company's market capitalization as the stock fell from $6.30 to $2.19. The share price ultimately bottomed at $1.48 soon thereafter. At the end of the third quarter of 2011, the company had a reported book value of $9.87 per share and $95m ($4.49 per share) of cash.
More problematic was the alarming rate at which cash was burned (in no small part due to the actions of the independent directors) during the investigation. The independent board members took it upon themselves to hire independent counsel to conduct their own investigation. The company had hired Latham Watkins and the independent directors hired Dewey & LeBoeuf.
The company ultimately settled with the DOJ on April 30, 2012 for $8 million, removing an enormous overhang for the equity. However, cash balances dwindled from $95 million on 9/30/11 to $50 million on 6/30/12, representing $2.25 per share at the time.
Under the terms of the non-prosecution agreement, Imperial agreed to shut down its premium finance business, cooperate with the DOJ, and refrain from any criminal conduct. The non-prosecution agreement extends until April 30, 2015. The DOJ continues to investigate the actions of former employees, including Mr. Neuman, and Imperial remains responsible for all of his legal expenses via an indemnification agreement. This is the main legacy expense outstanding related to the DOJ investigation.
Activist Phil Goldstein.
One of the hidden assets of Imperial is its board structure, and, specifically, its non-staggered board. This structure ultimately enabled a change in board composition, which has been critical to preserving the value of the business. In the first half of 2012, Bulldog Investors, led by Phil Goldstein, launched a proxy fight. The board ultimately settled with Mr. Goldstein. IFT elected three members of Bulldog's group to the board, and ousted two independent directors. Under the terms of the unusual agreement, the shareholder aligned CEO Tony Mitchell remained in place and Mr. Goldstein was elected Chairman.
Notably, this is the only case of shareholder activism, that we are aware of, in which the independent directors acted as non-fiduciaries and the CEO acted as a shareholder steward.
Mr. Goldstein has helped reign in frivolous spending and also helped to arrange a $45m bridge loan while the company was negotiating terms for new long-term financing, described in detail below.
One of Bulldog's write-ups on IFT can be found here: Bulldog Letter
Watershed Financing and Acquisition of AIG/CTL Policies
On April 30, 2013, Imperial Holdings completed a watershed $300 million long-term financing with LNV Corp. (a subsidiary of Beal Bank.) Equally important, the company simultaneously acquired a total of 416 policies.
LNV Loan (Beal Bank)
The loan is structured as a 15-year $300m revolving credit facility in an off-balance sheet vehicle. Imperial subsidiary White Eagle contributed 459 policies with an aggregate death benefit of $2.28 billion to serve as collateral for the credit facility. LNV Corp (Beal Bank subsidiary) is the lender. The credit facility is being used to pay all the premiums associated with those policies, eliminating Imperial's need to fund those premiums.
Under the terms of the agreement, Imperial is entitled to the following: (1) an initial advance of $83 million (which was taken at close); (2) a priority payment of $76.1 million, after paying down principal + interest; and (3) a 50-50 split on remaining net cash flows from death benefits. The initial advance, net of the acquisition payments of $55.5 million discussed below, yielded $27.5 million net to Imperial.
The AIG/CTL Policy Acquisitions
Imperial used $55.5 million of the $83 million initial advance to simultaneously purchase two large life settlement portfolios, almost tripling the size of its policy book. The largest portfolio (323 policies) was acquired from Imperial's principal LPIC provider AIG for $48.5 million and the other 93 policies were acquired from CTL via the acquisition of Monte Carlo Securities, LTD's interest in CTL. The policy portfolios were all premium financed.
In total, the company acquired 416 policies with an aggregate death benefit of $1.68 billion for only 3.3% of face value. Although these policies are substantially younger than the Coventry First portfolio acquired by Berkshire Hathaway last July, it is worth pointing out that Berkshire’s purchase price was at 20% of face value.
The impact of the financing and the acquisition of the policies should not be understated. The financing essentially locked-in the terminal value on 459 policies with an aggregate death benefit of $2.28 billion by eliminating the liquidity risk associated with paying annual premiums on those policies.
Convertible Note Offering; Liquidity Risk off the Table.
The company raised $70.7 million ($70 million +$743k overallotment option) for net proceeds of $67 million in a private placement to mostly existing shareholders. The company issued 5 year, 8.5% convertible notes with a strike price of $6.76, and mandatory interest payments for three years. For a company with a pre-deal market cap of substantially less than $150 million, it was a huge offering. Following completion of the offering, we estimate year-end 2013 book value per share decreased by 9%, from $8.96 to $8.14 (on a fully converted basis, based on 32.4m million shares.) In completing the offering, we believe the company has put liquidity risk to bed.
Investing for Growth - The Imperial Lending and Partnering Program.
Inspired by the value created by Beal as the lender to Imperial, Management has decided to embark on a portfolio partnering program whereby it will act as the lender to other institutional holders of life insurance settlement portfolios who are experiencing short-term funding gaps. We expect IFT's lending program to generate 25% to 35% IRRs.
Similar to the Beal structure, Imperial will merely be funding premiums, not buying policies outright. Imperial expects to be the first-in, first-out capital. Incoming cash from the partner's policy portfolio will first be used to pay back amounts drawn under the facility. After all interest (estimated at 8%-9%) and principle is paid back, Imperial will then receive a back-end 10-20% participation in each death benefit. The interest income received from acting as a lender should help offset the interest payable on the convertible note.
Where we expect Imperial’s strategy to differ, and what we find to be most appealing, is that the company will likely partner on older average portfolios (83-85 years old). At that age, the portfolio should be cash flow positive within 1-2 years. With this kind of cash flow profile, management believes that it will be able to recycle its current excess cash balances as much as 3x over the next five years in large scale portfolio partnering transactions. We expect this to be the single greatest driver of growth in book value over the next five years.
Once a facility is cash flow positive, Imperial is able to withdraw excess capital (usually a reserve of 1 year of premiums is required), and repeat the process all over, each time creating a step-change in book value. The total amount of capital originally committed to the facility should be paid back and brought back on balance sheet within three years, possibly sooner. This is due in part because the gross amount committed and contributed to the facility by Imperial will be greater than the amount actually drawn down, so once a mortality or two occurs, or it is evident the facility is self-funding, there will immediately be excess cash able to be withdrawn. The strategy also creates a consistent cash flow stream back to Imperial.
We think this new strategy is a better one than buying policies outright because it doesn’t tie up capital for a long period of time. We believe there is no dearth of opportunity to deploy capital in this nature and believe Imperial is well positioned to capitalize on these opportunities.
Detailed Valuation and Assumptions
We forecast Imperial will have a book value of $283.3 million ($8.86 per FD/FC share, $10.01 GAAP book value) by the end of 2014 and $298.2 million ($9.32 per FD/FC share, $10.71 GAAP) by the end of 2015. We believe the intrinsic value of the business is higher than forecasted book value given its positioning in what we perceive to be a large, underpenetrated addressable market that should offer the potential for 25-35%+ gross IRR investments. We think by the end of 2015 the stock should trade at parity to book value as the business starts generating cash from its growth investments while growing book value.
At our $9.32 2015 price target, the stock offers the potential for a compelling 34% annual return. With an estimated $100m ($3.08 per share) of cash on the balance sheet at the end of 2013, pro-forma the convertible note proceeds, an off-balance sheet portfolio that requires close to zero ongoing investment and currently worth $3.94, and a balance sheet policy portfolio worth $1.55, we think the risk-reward asymmetry is very compelling.
So how do we get to $8.86 in book value by 2014 and $9.32 by 2015? Book value as of 9/30/13 was $177.4m and cash (including at White Eagle) was $23.5m. The company disclosed on February 11, 2014 that it had $22.7m net of restricted cash as of 12/31/13. It sold the structured settlement business in 4Q13 for net proceeds of $11.3m (carrying value was close to zero). We estimate $7m of cash operating and legal expenses in 4Q (after stripping out the expenses for two months from structured), and $2.5m of premium payments. That means there was a cash infusion of $7.4m, which we ascribe to mortalities and the sale of policies (some of which may have occurred in White Eagle).
We then estimated the change in FMV of the balance sheet policies using a 10% discount rate and the change in the net FMV of White Eagle using the reported discount rates (which results in net annual growth of ~16%). Note that because the discount rate is used to value the portfolio as of only a static date, and because the portfolio is actually valued using a probabilistic non-linear cash flow projection, it isn’t appropriate to compound the FMV of the assets at the last reported discount rate of 19.63%. For lack of a better way to forecast the change in net present value without knowing those probabilistic cash flow assumptions, we cut the discount rate in half and used a 10% growth rate for the balance sheet policies. We used the reported discount rates for the asset (19.63%) and liability (23.66%) side of White Eagle. Since the liability will be growing at a faster rate than the asset, we are relatively comfortable this should be somewhat conservative Combined, our year-end 2013 on and off-balance sheet policies had an estimated fair value of $183.7m.
That brought our 2013ending pre-convert book value to $192.7m, or $8.96 per fully diluted share (includes options and related proceeds up to $6.94 strike). See below for our bridge calculation:
Adjusting book value for the dilution from the convertible notes we arrive at a pro-forma fully diluted/converted book value per share of $8.14. At the recent price of $5.43 per share, IFT is trading at less than 67% of 2013 estimated pro-forma book, and that is even before the accretion we expect as a result of investing those proceeds.
Our pro-forma 12/31/13 book value serves as the base for our forecast. In the details that follow, our forecasted book values will all be the year-end 12/31 values. We also assume all of our investments occur on 12/31 of the year noted.
Below are our detailed cash flow assumptions that drive our balance sheet values. The tricky part about modeling this type of business is that it is iterative and cumulative. Higher cash flow from earlier investments will obviously result in higher future cash flows able to be reinvested. But if our forecasted returns on our early investments are lower than we expect, it will have an magnified detrimental impact on future book value. That makes the company’s first investment most important. We believe that given the distressed opportunities available right now in the market, the risk of making a bad first investment is mitigated. We think our assumptions are somewhat conservative, specifically in regards to the amount and timing of cash flows for the portfolio bridge loans. Our pre-tax assumptions imply IRR’s right around 25-35%.
Below is our summary balance sheet previously shown in the “Valuation summary” section:
Our 2014 assumptions:
Adding all of the above together, we estimate Imperial will have $69 million of cash available to invest in partnered policy portfolios. Given its liquidity struggles over the last few years, and the uncertainty of the IRS investigation, we think Imperial would prefer to have more liquidity than less this year. After backing into a target year-end 2014 cash balance of $25 million, our forecast assumes Imperial will invest $44 million in 2014 in one or a series of partnered policy portfolios earning 25-35% pre-tax IRR’s.
Partnered policy portfolio assumptions
Adding all of the 2015 assumptions together results in year-end 2015 cash available for investment of $40m. With the balance sheet portfolio sold, Imperial shouldn’t need as much of a liquidity buffer as in 2014. We estimate $5m should be enough and back into $35m that can be reinvested in new partnered policy portfolios.
This process continues through 2018 using similar assumptions with one exception. In 2016, as cash from operations becomes positive, we anticipate Imperial being able to take on some leverage. We modeled $20m of 15% paper with the proceeds invested in new partnered policy portfolios. We think our assumptions are mostly conservative throughout and laid them out clearly above.
Share repurchases: We did not include share repurchases in our model. Counter intuitively, buybacks are actually not the best use of capital, even with the stock trading 63% below 2014E book value. After the convert deal and expected sale of balance sheet policies, the company should conceivably have the ability to buyback shares below book for a low-risk, high return on investment. We ran the numbers, and based on our assumptions for the returns earned on partnered policy portfolios, and the ability of those investments to generate cash that can be subsequently recycled into future investments, share buybacks are actually not the best use of capital right now.
Why the Stock Should Trade at Book Value by the End of 2015:
Understanding the Legacy Premium Finance Business.
Imperial's legacy premium finance business entailed providing loans, generally with a two-year term, to fund life insurance premiums. Imperial targeted yields, including origination and agency fees, in the 40-65%+ range (July 2011 Presentation) Most of that return was composed of fees, with a significant portion of the yields captured from the referring agent.
Traditionally, life insurance brokers collect a large fee (the equivalent of the first year of premiums) for underwriting policies. Those fees are often subject to a claw-back provision by the insurance carrier if a policy defaults within a year. Accordingly, insurance brokers actively monitor policies during the first year. If at any point during the term of owning a policy, a policy holder is not able to continue with premium payments, he/she, typically through their broker, could seek financing for the insurance premiums from a provider of premium finance loans.
In the case of Imperial, all loans were underwritten with family members as beneficiaries, ensuring proper insurable interest.
Prior to the financial crisis, the vast majority of IFT’s premium finance loans were paid back, either directly by the borrower or with the proceeds of selling his/her policy on the secondary market. Before liquidity dried up, the secondary market for life policies was vibrant, and the insured would generally receive more than the outstanding loan amount when the policy was sold.
The Company arranged credit facilities to originate the premium finance loans. But as the credit crisis escalated, so did default rates on its premium finance loans. During the 2008 to 2010 period, borrowers (excluding those that passed away) willingly repaid only 17 out of 506 maturing loans representing a default rate of almost 97%. Due to the high default rates, Imperial’s lenders not only charged it a high interest rate (18% in 2009), but they also demanded that the company obtain lender protection insurance (LPIC) for each loan originated under the credit facilities. Under the terms of the LPIC, if the borrower defaulted, Imperial could file a claim for the fair value of the policy (calculated by the LPIC).
IFT’s principal LPIC provider (AIG) then took control or had the right to direct control of the policies. In the case of the AIG LPIC policies that defaulted, IFT held the underlying titleto the policies. Under this arrangement, AIG continued paying premiums on the policies and, in return, retained salvage collection and subrogation rights. After netting these costs, the remaining part of any death benefit would go to Imperial. Since AIG controlled whether or not the premiums would continue to be paid, these policies did not appear on Imperial's balance sheet and, in fact, were a hidden asset until April 2013 (more details in "AIG and Watershed Financing" below).
As the financial crisis escalated and financing became more expensive, Imperial's cost of financing began to materially increase, going from 14.5% in 2007 to over 30% at points during 2010. The required use of LPIC coverage also became a hindrance in that the terms of the coverage limited the types of loans Imperial could originate (the older the insured, the more restrictive due the higher probability of default). To improve its cost of capital and simultaneously take advantage of the distressed opportunities in the market, Imperial came public in February 2011, raising net proceeds of $174 million at $10.75 per share in an initial public offering.
Following completion of its IPO, the company no longer needed LPIC insurance. As a result, Imperial stopped originating loans under its credit facilities on Jan 1, 2011. Additionally, with no more restrictions on the type of loans it could originate, Imperial was able to target older policies, with the intention of retaining them on balance sheet.
Additional Detail on White Eagle Portfolio.
We estimate the average age of insured in the White Eagle portfolio of 79 to 80, with an average life expectancy of about 11-12 years. Imperial expects the White Eagle portfolio to start generating positive cash flow at the policy level by about 2015. At that time, the portfolio should be close to self-funding.
Once self-funding, the Beal loan will start to be paid down (121m of undiscounted principal and interest as of 9/30/13), after which the excess cash (above a minimum floor for future premium payments) will flow back to Imperial. Imperial is not expected to get its first cash advance until about 2019.
The waterfall on the White Eagle facility for incoming death benefits, after paying premiums on outstanding policies, is as follows:
a) Payment of outstanding principal and interest (L+400) to Beal
b) $76.1m to White Eagle (Imperial)
c) The remaining split 50/50 between Beal and White Eagle.
To model this phenomenon is somewhat difficult without the policy-by-policy actuarial assumptions, but it doesn’t take much of a leap of faith to believe that at an average age of about 80-81 in 2015, the mortality rate should start to accelerate and incoming cash flows will be higher.
In the calculation below, we attempt to put a rough undiscounted value on White Eagle over the life of the entity, along with the associated split in value that will accrue to Imperial and Beal. This calculation is a very simple one from a high level, and it shows the significant amount of value Imperial preserved by entering into the White Eagle arrangement. It also shows the amount of value that Beal created by providing what essentially amounts to a term loan with an equity kicker.
Fair Market Methodology and Sensitivity Analysis Impact.
Before we get into our detailed valuation, some background on how the company's portfolio of assets is valued is required. As noted elsewhere, IFT’s policy portfolios (wholly owned and White Eagle) are marked at fair value on the balance sheet. White Eagle is consolidated in Imperial's financials. Unrealized changes to fair market value are recorded as income, similar to an investment portfolio.
The company uses life expectancy estimates and premium payment schedules for each policy to formulate a blended probabilistic cash flow scenario over the life of the portfolio. The company then applies a discount rate to each policy. That discount rate is primarily a function of the type of policy (premium financed/non-premium financed), macro interest rates, and what type of discount rates the secondary market is currently commanding. Premium financed loans obviously carry a higher discount rate (15.72 – 28.72%) versus non-premium financed (13.72 – 20.72%) due to the higher associated non-payment risk. After the DOJ investigation, Imperial raised the discount rate on all of its premium financed policies to reflect this higher perceived risk. It has been trending downwards since. IFT's blended discount rate was 19.63% as of 9/30/13 (down from a high of 25.49% in 1Q12). Recent secondary market policy sales have taken place at discount rates of 15 to 17%.
Life expectancy and discount rate are the main variables in valuing the portfolios. Change in life expectancy has a far greater impact on FMV than the discount rate because it impacts not only the timing of incoming cash, but also the amount and timing of premiums paid.
As time passes, the overall weighted average discount rate applied to the portfolio will trend lower by virtue of the fact that as the portfolio becomes more seasoned and the average age of the insureds increases into the 80s, the asset increases in value. The following shows the sensitivity to the fair value of the policy portfolio assets (on balance sheet and White Eagle combined) assuming a change in the weighted average life expectancy and blended discount rate:
The company uses a blend of two outside firms’ reports (AVS Underwriting and 21st Services) for its life expectancy evaluations. In 1Q13 21st Services revised its underwriting methodology, which generally had the impact of lengthening the life of each policy (not owned by Imperial) it evaluated by 19%. As of 9/30/13 the company had received new LE reports from 21st Services on 175 of its 622 policies. The LE’s on those policies were lengthened on average by 15.43%, so Imperial proactively increased the LE’s on the rest of the portfolio by 15.43% prior to blending it with AVS' LE’s. This has prevented book value from accreting as much as expected in the last two quarters. But because all the LE's were already adjusted upwards, the impact on each individual policy's reappraised LE should be smaller going forward. Offsetting the impact of higher LE's was a reduction in the discount rate from the highs right after the DOJ investigation.
Because Imperial consolidates White Eagle in its financials, it also needs to mark the note payable at fair value. It uses a similar methodology as that used to value the assets. Embedded in the fair value calculation of the note payable are the estimated interest and premiums/principal payments to Beal throughout the life of the entity. There is a difference between the discount rates and life expectancies used in the valuation of the liability and the asset. The company is conservative in its life expectancy assumption for the note payable; using 11.4 years versus the 11.9 for the asset (lower LE makes the liability bigger). But it uses a higher discount rate (23.66% versus 19.63%), which makes the liability smaller. If the company were to use the same LE and discount rates for both the asset and the liability, the liability would be valued only $6m higher on 9/30/13 ($0.27 of book value). Below is the sensitivity to a change in the discount rate and LE for the note payable:
When Imperial starts to lend to other portfolio owners, it will mark its interest in that portfolio at fair value using similar methodology. The initial mark to fair value should result in a step change to book each time money is lent to a new portfolio (fair value will be higher than the amount of cash contributed). Additionally, by virtue of the fact that the incoming cash is front-end weighted, the NPV should accrete more at the beginning of the loan structure than the end. So book value will continue to grow at a reasonable pace over the next 1-3 years from each loan.
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