Adventures In Structured Finance
Scenario: A successful Developer has a large tract of entitled but unimproved land worth, for illustration purposes, over $30,000,000. He is keen to sell it but the offers he has received are nowhere near what he believes to be its true value. In addition, another potentially high return investment opportunity has arisen which he is optimistic would be very successful.
Unfortunately, he is cash strapped and unable to take advantage of it without immediate liquidity.
Because of the high value of the land he has the ability to get a substantial loan against it.
While he initially thinks that even a hard money loan with its high rates would make sense given the promise that his new investment opportunity holds, he soon starts to fear the worst case scenario - failure of the new investment and he being unable to repay the loan.
Following is a structure that allows him to take advantage of the opportunity while addressing his fears.
Owners of large, dormant or specialized capital assets often have difficulty in finding a market to readily sell their assets at fair market value. They typically face a long time on the market, a need to discount the assets, a combination of both, or not infrequently, tiring of the process and taking it off the market until conditions improve.
Following is a structure that would allow the investor to quickly raise the cash needed without having to fire sale his property or risk his principal in the new investment.
Solution: Take out a loan of say $9,000,000 and invest $4,500,000 in a portfolio of life settlement policies with $9,000,000 face value as principal protection and the remaining $4,500,000 into the potentially high return investment opportunity. The result: certainty against loss of principal with venture capital potential returns.
An investment in a life settlement pool is essentially the equivalent of a 0% coupon bond (no American insurer has ever failed to pay out a valid claim on a death benefit). Industry returns average 7.9% IRR with a range from 1.5% to over 24%, but with the purchase of longevity risk insurance, the IRR range can be narrowed to approximately 4.5% on the low, and 12% on the high side, with an average of 7.9%.
Source: Data from “Empirical Investigation of Life Settlements: The Secondary Market for Life Insurance Policies”, London Business School, Afonso V. Januário and Narayan Y. Naik, January 10, 2014.
Life settlement transactions begin with brokers suggesting that individual policyholders sell their life insurance policies to a life settlement provider. The brokers collect medical and other information from the insured individuals, and offer or “bid” the policies to life settlement providers. Life settlement providers are specialized intermediaries who purchase large numbers of life settlements for sale to investors or a securities issuer. Providers often employ actuaries and underwriters to evaluate the life settlements being offered by brokers, who in some cases are affiliated with a life settlement provider.
Insurance carriers do not pay claims on approximately 88% of life insurance policies. Most lapse either because policy owners no longer need, or no longer can afford, the policies. As a result a substantial, and now rather mature, industry has developed to acquire and maintain in force such insurance policies to be held for investment purposes. Industry forecasts project an average annual gross market potential for life settlements of $180 billion from 2014-2023 (out of over $12 trillion individual life insurance in force). The acquisition cost of the policies average approximately 20% of face value.
As indicated above, the assymetric market of
carriers pricing policies assuming a very high lapse rate and life settlement companies keeping purchasing policies at a steep discount provide a competitive investment return. Because of the certainty of payment and the fact that it is not correlated to the stock market, institutional investors have increasingly invested in these portfolios (life settlement purchases were up 32% in 2015 over the previous year).
In the context of a high yield investment opportunity, a pool of life settlements can represent principal protection on the investment, as all people die and A rated carriers always pay claims. In the meantime, the hoped for investment returns while significantly diluted, can still offer considerable upside.
In this type of structure, an investor enjoys the best of both worlds - downside protection and substantial upside. Thus, under the traditional benchmark in the venture capital industry of generating a 10x return in 5 years (an IRR of 58%), in this example, an investor may generate some $40,000,000 in venture capital returns, in addition the continued appreciation of the original $30,000,000 asset.
Many investors and business profiles can benefit from this type of strategy, from large infrastructure projects, to partially funded startups to fixed income investors. Other use cases for such a similar strategy include:
Capital Raise by securitizing the portfolio and selling the bond to investors.
Complete Buyout of asset by leveraging against the portfolio and the asset and making additional installment payments from the investment returns.
Credit Enhancement by including the portfolio value in a project for underwriters / lenders to consider in financing decisions.
Venture capital and real estate developers make high risk and highly leveraged bets on a regular basis. The foregoing strategy allows asset owners interested in these or other potential high return opportunities to gain liquidity while eliminating the ‘all or nothing’ downside risks that typically accompany these investments.
When structured properly, there are a myriad of real world applications for these tools which can have a very substantial impact on an investor’s opportunities and outcomes.
Mike Bishop, JD