An Investment To Die For..

Wednesday, Nov 21 2012 by
6

Cash/bonds just bore me… Event-driven investing is a far better alternative. It’s low risk, low correlation, and it offers attractive annualized returns. But the safest short term event-driven investing is time & research intensive, and low absolute returns present a risk (‘picking up pennies…‘). Longer term event-driven/catalyst investing usually offers far better absolute returns, but at a price: i) increased market/economic correlation, and ii) no assurance your returns will be positive. I’ve written about thishere.

My solution: All I want is a low risk & uncorrelated investment which guarantees significant increases in intrinsic value over time. That’s like asking for the sun, moon & stars…but here’s a snap-shot of the ultimate in event-driven investments:

Recognize that? It’s an example of this gentleman’s calling card. Yeah, the Grim Reaper, our constant companion, as he patiently waits for our own ultimate event. The chart above was the evolving Life Expectancy (LE) curve in the US. Clearly, in the past century, we’ve learned to (on average) delay the Reaper’s gratification. But with little success in extending the bounds of our mortality, and zero success in shifting that 0% survival rate. Death really is even surer than taxes…

But this very predictability brought forth a life insuranceindustry centuries ago. For a small/regular premium, people could assure themselves of an increasingly valuable financial asset which transforms into a large lump-sum payment upon death. Buying these life insurance policies from the original owner (and insured) is known as a life settlement – it offers an investment that steadily increases in value, is uncorrelated with the market/economy, and has a relatively predictable (& ultimately certain) value realization event.

But…find a perfect investment, and inevitably the promoters & brokers ruin it for everybody. And life settlements proved a real cess-pit: LEs were under-estimated, miscalculated, or simply falsified. Investors/funds over-leveraged themselves, and/or lacked the resources to maintain premium payments (in which case the policies would lapse!). Viatical settlements were all the rage, only for the insured to live another decade or two as new drugs & treatments were developed. Regulations were ignored, legal corners cut, and buyers sometimes discovered title was never perfected. I could go on…but the long gap between purchase & pay-out was a perfect invitation for fraud & misselling. Traded Life Interests/Policiesare now, by popular opinion, a pretty dodgy & despised asset class.

Which sounds pretty interesting to me… When you discover a hated (but cheap) sector/asset class, hold your nose & ask: Is this a value trap…or a value opportunity? ‘Til recently, potential investment opps. appeared to be sub-scale, unreliable, non-transparent, and suffering from poor liquidity and/or leverage. But one investment company attracted – and repulsed me – its leverage & premium obligations could have snuffed it out! But recently it’s marched out of this Valley of Death. Let me introduce:

Alternative Asset Opportunities PCC Ltd. (TLI:LN)

TLI owns a portfolio of US Traded Life Interests (TLIs), all of which are universal/whole-of-life (no viatical) insurance policies. No policies have been purchased since the original portfolio was assembled (in 2004-06). TLI’s managed by SL Investment Management, who specialize in life settlements. Investec Asset Management is a key shareholder with a 21.7% stake. Directors have a negligible 0.3% holding – unfortunately, quite common for investment co’s.

As of the year ending Jun 2012 (FY 12, from here on), TLI holds 109 policies with a $165.6 mio face value & a current $65.4 mio valuation. The insured are 66.3% male - avg. age is 88.7 yrs, implying a remaining LE of 4.9 yrs. The company has $29.2 mio of debt, but (counting cash/investments & some outstanding policy receivables) underlying net debt was actually $14.2 mio. The company’s annual premium obligation is $8.4 mio for FY 13.

The investment thesis here is pretty simple & compelling: At end-FY 12, TLI’s market cap. was only $30 mio. But the company will inevitably collect on $166 mio of policy maturities! Remember it still has to continue funding premium payments, and has $14 mio of underlying net debt outstanding. But we’re still looking at that $30 mio growing into, say,  a $100 mio+ in due course! OK, woaahh, we’re getting ahead of ourselves & there’s some fudging of the math there… But you get the general idea! 

 Let’s work our way through this properly, starting with the FY 12 B/S:

Note GBP is TLI’s functional currency, but since the majority of (unhedged) net assets are actually in US dollars, I’ll mostly stick to tracking figures in USD. NAV’s based on 40 mio shares. The GBP 81.2p NAV compares to a share price of GBP 47.25p at the time, a huge 42% NAV discount! Now, let’s track the B/S evolution since (via outstanding debt), up to end-Oct:

As you see, we’ve got a $14 mio collection of policy receivables, 3 new maturities totaling $3.35 mio, 4 mths of estimated premiums & admin/interest expense, and then we solve for a $0.6 mio increase in cash. Finally, we’ve got $15.6 mio of net placing proceeds. This was the result of a pretty bone-headed placing recently of 32 mio shares (at GBP 32p per share), precipitated by the company’s aversion to debt, and the lending bank’s (AIB, London) intransigence. I shouldn’t be surprised (and I’m sure dealing with the UK branch of an Irish state-owned basket case bank is no fun), but why on earth didn’t the company:

Call AIB’s bluff: They’ve extended the loan before & underlying net debt’s down to $14 mio by end-Jun. Maturities have exceeded premiums for the past 4 yrs, so clearly the loan would continue to steadily decline.

Switch the loan to another bank: Underlying net debt was only 22% of the current policies valuation. Investment companies investing in (far riskier) equities can usually obtain a facility amounting to 10-25%of total assets, so it’s difficult to believe this loan couldn’t have been re-financed elsewhere.

Sell more policies: Some policies were sold earlier in the year for $10.7 mio, over 95% of their corresponding B/S valuation. Fresh sales, even at a larger discount, would have produced far less dilution than a placing at such a high NAV discount.

But what’s done is done…

Two saving graces here – at least all investors (not just select institutions) could participate at the discounted placing price on a 4 for 5 basis & net debt’s now eliminated. The B/S should now look something like this:

The TLIs valuation reduces by about $1.3 mio to reflect 3 subsequent policy maturities, increases by $2.8 mio to reflect premiums, and we then solve for an estimated $2.9 mio of LE adjustments. These adjustments have been an ongoing process, but the future impact should begin to diminish as a majority of policies have been re-assessed in the past 2 years. Net equity jumps by $14.1 mio, due to the placing, but NAV drops to GBP 56.0p (or 56.7p at the current FX rate) per share (based on 72 mio shares). With the share price trading at GBP 38.5p, TLI’s now on a 32% NAV discount. It has no net debt, and owns 106 policies with an estimated current valuation of $64.0 mio, 39.4% of their $162.3 mio face value. Average age is now 89.0 yrs, with a remaining LE of 4.6 yrs, and we’ll assume the same male/female ratio. Hmmm…I’m sure you’re dying to look this gift horse in the mouth – let’s tackle any potential concerns (this chart will prove useful):

 

 

Leverage:   Zero net leverage! And based on the placing, AIB’s agreed to extend a $24.2 mio loan facility until Mar-14.

Liquidity:   The no. & face value of maturities is steadily accelerating, and has exceeded premiums paid for the past 4 yrs. Even if we project a totally improbable scenario (zero maturities for next 3 yrs), TLI can still fund the premiums from its current cash & loan facility.

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Policy Lapses/Denials:   None since inception, and no reason to ever suggest any denials. If a premium was missed, for whatever reason, the insurance co’s have a reminder process in place (and there’s plenty of fund admin. agents & advisers to sue!).

Tax Risk:   TLI’s flagged a $4.7 mio risk of potential US taxes on its pre-Sep 2009 maturities. The merits, or potential success, of a possible IRS claim appear doubtful (and amounts to only 7% of current NAV).

Life Expectancy:  Current LE of the insured is 4.6 yrs. This is easy to check here. I’ve used the white male/female tables (p. 18-21) in my model (below). As you’ll note, an 89 yr old white male has a remaining 4.2 yrs LE, while a female has 5.0 yrs. This equates to a weighted avg. of 4.5 yrs which (allowing for rounding) is dead-on with TLI’s estimate.

My model predicts 14.3 maturities in the next year. This might seem steep, but the pace of maturities is accelerating from 5.5-6 per yr in FY 09-11, to 8 in FY 12, to 9 in the LTM. But the model also predicts$21.9 mio of maturities in the next yr, which looks achievable vs. the recent FY 12 acceleration to $16.9 mio of maturities. Ultimately, I suspect the impact of any potential delay in maturities would likely beoffset by an improved discount rate on valuations.

Valuation:   Investors sometimes complain policy valuations are opaque. TLI can’t be accused of that – they use a 12% discount rate, and provide sufficient info. to easily check valuations. Taking the current $64.0 mio valuation, and a current annual $8.4 mio premium, it’s back of the envelope easy to reach a $162.3 mio FV over a 4.6 yr LE, when using a 12% IRR.

Distressed policy sales have been seen in the market with implied 16% IRRs. I don’t consider that IRR level is valid here, or a source of concern: i) zero leverage, and ample liquidity, means TLI has no need for distressed sales, ii) TLI’s valuation methodology was endorsed by the pricing achieved on policy sales earlier this year, and iii) the latest annual report modeled a 16% IRR would knock 14% off NAV – certainly no disaster in light of the current NAV discount & upside potential.

Credit Risk:   66% of TLI’s insurance counter-parties policies have an A.M. Best rating of ‘A+‘, or better, while over 99% have at least an ‘A‘ rating.  Exposure’s spread across 29 insurance co’s, with 54% of policies held with AIG (AIG:US)Lincoln National (LNC:US) & Aegon (AEG:US). I’m confident the risk of policy default is remote for a couple of other reasons:

US state insurance regulators offer an excellent line of defence (they have a far better record than bank regulators!). With weak insurance co’s, they’ve tended to be far more interventionist – for example, demanding capital raises and/or seeking & forcing mergers with stronger competitors. And God forbid US pols. would ever allow media reports of widows & orphans going hungry because some insurance company defaulted on its policies..!? With AIG, the whole vampire squid frenzy obscured the fact a bailout was also considered necessary to protect AIG’s insurance subs. (which were in perfectly good shape). This Eric Dinallo article is revealing.

FX Risk:   TLI no longer hedges its USD exposure. This should grab US investor attention: Sure, you’ve got to buy TLI in GBP in London (don’t tell me that’s difficult to execute these days!?), but otherwise it’s a USD stock/exposure. For non-US investors, what’s the big deal? Currency diversification’s an important component of portfolio diversification. Considering the US share of world GDP, and its reserve status, USD exposure remains perfectly sensible in your portfolio (even without a positive USD perspective). In reality, FX losses you might experience are sure to be far smaller than the potential stock upside you hope to realize.

Continuation Risk: TLI originally had a fixed life, ending Mar-12, but has switched to an annual continuation vote (most recently, on Nov 14th). Noting the current shareholder base (who mostly appear to be investing on behalf of private client portfolios), the remaining 4.6 yr LE, and the expected ramp-up in maturities & NAV, a vote for a wind-up doesn’t appear likely (or smart). At worst (if necessary), I’d expect the board would insist upon a prudent 2 yr wind-down period – at that pace, and anticipating further maturities, harvesting at least the then current NAV (or better) seems likely.

OK, so let’s move on to the good stuff: Again, the CDC’s latest 2008 mortality tables are key. This allows us to model a male/female death probability rate for each year out to 2025. At that point, I’m giving up on the old codgers & assuming nobody makes it past 102 yrs of age! But let’s also be kind with my Godly powers – with a click of my magic mouse, I’m granting them all an extra 0.8 yrs – which should generously reflect any potential LE improvement since 2008. I’ll also assume TLI’s policies valuation will steadily increase from the current 39% to 100% of face value over the next 13 years. This is a model of the next 6 yrs:

The following 7 yrs are pretty irrelevant, as you can see:

 

Of course, the model projects NAV, not the share price. What can we expect for that? TLI now has zero net debt, it’s a low risk & uncorrelated investment, and it guarantees significant annual increases in NAV. If those attributes don’t deserve a share price at least equal to NAV, I don’t know what does?! In fact, let’s argue a more aggressive scenario: US junk bond yields were near 6% in Sep, and still trade sub-7%, while 5 yr Treasuries are at 0.66%. Why on earth should investment grade insurance policies (with a remaining 4.6 yr LE) be discounted at a ridiculous 12%..? If TLI (and/or the market) adopts a significantly lower discount rate in due course, we may see the share price trade at a significant premium, and/or a meaningful acceleration in NAV. Let’s model estimated shareholder returns, assuming the NAV discount’s eliminated within 3 yrs:

 

The front-loading of returns is vastly more pronounced if we assume the NAV discount’s eliminated within 1 year:

Under either scenario, considering discrete annual returns vs. cumulative returns vs. annualized IRRs, there’s an obvious sweet spot around, say, the 4 yr mark. After 2016, returns become increasingly marginal, and a switch to a different investment is probably warranted. With scope for a 34-71% potential return from TLI in the next year, it makes sense to maximize a TLI portfolio allocation up-front & perhaps reduce over time.

Let’s also check in on 2 other scenarios: a) Let’s say LE is off by a full year, which we’ll also model as zero maturities for a year – plug it in, and it reduces the cumulative 4 yr return from 124% to 104% – certainly no show-stopper!, and b) TLI’s ultimate mandate is ‘to return capital to shareholders‘ – which it’s now basically ready to implement as more policies mature. Presuming the share price trades at a discount, a sustained share buyback (they already have buyback authority) will be the ideal way to return capital, enhance NAV further & boost the share price.

This investment really gives me a warm & cozy feeling…and pops a middle finger at the Grim Reaper! Every day, I think happy thoughts about those old dears just waiting ’round to pop their clogs. I like to think if you’re visiting the UES/UWS of NYC (or maybe Florida’s Gold Coast), you might even see some of these golden tickets wandering about – perhaps embarking on their weekly shuffle to church, or temple? If you do, please check up on them for me. Oh, for God’s sake, don’t creep up on them! You coulda killed ‘em with the bloody shock..! And every time I hear of a policy maturity, I plan to raise a glass – c’mon, somebody’s just finished up a pretty good run…plus it means another nice bump for TLI’s NAV!

I peg TLI’s NAV & share price at GBP 86.1p in 4 yrs time, for an Upside Potential of 124%. An amazing return for such a low risk/uncorrelated investment… I’ve gradually built my holding before/via/after the placing. My stake clearly signals the conviction level I’ve got in this stock’s unique risk/reward – TLI is now my largest portfolio position, at 11.1%.

  • Tgt Mkt Cap:   GBP 62.0 mio
  • Tgt NAV/Share Price:   GBP 86.1p (in 4 yrs time) 
  • Upside Potential:   124%
  • TLI Nov-12     (xlsx file, for reference)
  • TLI Nov-12     (xls file, for reference)

Filed Under: Value Investing,

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Wexboy Value

A blog about value investing, mostly in UK, Irish and US listed stocks. Interested in individual company stocks, investment funds, risk arbitrage, event driven/special situations, fixed income and even some natural resource stocks. ...read more or visit website »


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3 Comments on this Article show/hide all

dangersimpson 21st Nov '12 1 of 3
1

Good write up, thanks. Couple of quick Q's:

1. What's their policy for returning funds to shareholders? Do they make regular payments or will they simply pay out everything when the last person dies? Will any payments be dividends or capital? Any US witholding tax?

2. Your returns over the medium term require the discount to NAV to close - what has the discount been over time? Is there a reason why the discount is unusually large at the moment?

3. Any counterparty risk on the policies? Are they with one insurer or many? How robust are the insurers' finances to pay out on these policies?

Cheers,

Danger

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argoal 22nd Nov '12 2 of 3
2

Danger I think I can answer your questions.

There are a couple of statements in the annual report that allude to how returns will be managed.

General information

Alternative Asset Opportunities PCC Limited (the “Company”) was registered on 27 February 2004
in Guernsey, as a closed-ended protected cell company in accordance with the provisions of The
Companies (Guernsey) Law, 1994, and subsequently re-registered under the provisions of The
Companies (Guernsey) Law, 2008, as amended. It was established with one Cell known as the US
Traded Life Interests Fund (the “Fund”) which had a planned life of approximately 8 years from the date
of launch. The Company is regulated by the Guernsey Financial Services Commission as an authorised
fund under the Protection of Investors (Bailiwick of Guernsey) Law, 2008, as amended.

So a wind up around 2016 is planned which fits in with the calculations of when the increase in Nav begins to drop off.

In the meantime.....

It is intended that the proceeds of TLIs which mature are used, after the deduction of expenses:
• first, to reduce and then eliminate bank borrowings under the Company’s credit facility; and
• secondly, to return capital to shareholders as determined by the Board.

If I have understood the fantastic analysis above then the bank borrowings have been effectively eliminated by  the placing so it looks likely a return of capital via a dividend will be starting.

 Thanks for the work on this Wexboy. I love the idea of it being uncorrelated to external events.

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Wexboy 6th Dec '12 3 of 3
2

Thks, argoal!

dangersimpson, think pretty all your questions are answered above, and in the investment objective kindly provided by argoal.

Discount has been larger - as I said, TLI v nearly expired itself in the past few years as it suffered a painful squeeze between reducing valuations, increasing debt & premium payments. As a result, it has become a massively neglected share ever since. I believe that's now reversing (as you can see!), and a combination of zero debt, steady/increasing policy maturities & NAV increases, and the commencement of shareholder distributions will prove v attractive to a widening circle of investors. A premium wouldn't be extraordinary here either, at some point.

As long as share price trades at a discount to intrinsic value, a (sustained) share buyback programme makes most sense (buybacks enhance intrinsic value for shareholders, dividends don't) which would also v supportive to the share price & a reducing discount.

Thanks

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About Wexboy

My personal investing career began with an emerging markets obsession. Investing in individual emerging market stocks was a much taller order then than today, so I gravitated towards investment fund shares and warrants. Little did I know that (despite the volatility involved) this would turn out to be a very fortunate approach – it pretty much saved me from the consequences of poor/misguided stock analysis, chasing stock tips and investing in garbage stocks all the way down to zero.... Only when I learned of value investing did I finally discover a quantitative approach, plus a set of tools, that appealed to me and equipped me better for investing. And I guess it appealed to my mathematical background and perhaps my natural scepticism. It also tempered my lust to dive into investment trends – in fact, I’ve come to realize that any decent secular trend will take many many years to play out and there will be cycles of booms and busts in any related stocks to exploit, so hold your horses, stick to value investing and your chance will come…!  more »


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