Life Partner Holdings: Too Good to Be True?

| About: Life Partners (LPHI)
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Life Partner Holdings Inc. is a financial intermediary that facilitates the sale of life insurance policies (also known as life settlements). Elderly folks that feel they no longer need their life insurance policies can sell them to investors thereby gaining access to the capital (much more than the surrender value). Investors who buy the policies get paid the death benefit at “maturity” (i.e., death of the insured). Life settlements can be a nice complement to an investment portfolio since the returns are uncorrelated to movements in the financial markets. As long as the insurance company is solvent, the face value will be paid upon maturity regardless of the direction stocks, bonds, commodities, or gold move.

At the surface, LPHI looks like a great investment. Specifically, the company:

  • Trades at an enterprise value of only 7 times free cash flow
  • Yields nearly a 6% dividend! (with a payout ratio well under 50% indicating a fair amount of buffer for continued dividends).
  • Has consistently paid increasing dividend since 2002, and as they say, “you can’t restate dividends”.
  • Has been profitable and fairly consistently grown revenue and EPS for nearly a decade.
  • Generates 42% operating margins and over 50% return on invested capital.
  • Is a leader in its market, with ~10% market share. The network effects of being a leader in an intermediary business where you are matching buyers and sellers should provide a nice moat.
  • Participates in a market with favorable secular trends. In particular demographics should boost policy transactions as baby boomers retire and seek alternative ways to finance their sunset years. In fact, Conning Research projects the face value of life settlements will grow from $10B in 2010 to $15B in 2016.

Please speak up if you can direct me toward stocks with this strong a profile. What’s not to love? Heck, with the double digit returns that LPHI touts to potential settlement investors, I’m inclined to invest in LPHI’s stock AND some life settlements.

Is it too good to be true?

I won’t recount all the recent negative publicity, but here is a flavor of the interesting claims floating around the message boards and elsewhere about this company. Note: I am not representing any of these claims to be true (or not true) just providing some background.

  • Pardo is a fraud and frauds don’t change their stripes”. Yes the CEO (Brian Pardo) was ACCUSED by the SEC in 1989 improperly recognizing a few $100K of likely uncollectable revenue, but was never convicted.
  • He hides his money in an offshore tax-haven” (Gilbraltar). Sounds like a good idea to me.
  • He has LPHI pay for his private jet”. True, but fully disclosed, and not so uncommon, particularly given the guy owns 50% of the company.
  • Neptism is rampant”. Yes, his daughter and son-in-law are LPHI executives, but that too is fully disclosed…and again, he owns 50% of the company.
  • He uses LPHI to fund his dinosaur bone collection”. Yeah. OK. They spent some $400K on “relics” in 2005 according to their annual report. A bit odd, but their offices look pretty frugal, so I’ll let that one slide too.
  • This company is a magnet for lawsuits” Yes, they have had their fair share of lawsuits. However, as of their most recent 10Q the company reports NO outstanding material legal actions.
  • He’s in cahoots with the escrow agent”. OK. He donated $500K to renovate a school and had the building named after his “best friend”, the Sr. Partner in LPHI’s escrow agent. Isn’t philanthropy a noble thing? Plus the escrow money is actually held at JPMorgan.
  • They have a revolving door of auditors”. Yes, they have changed auditors three times in the past five years. But they now use E&Y. Wouldn’t a big four auditor be an upgrade?
  • They sell these things through a multi-level marketing scam” Hmm. Well they do have a wholesale organization that helps promote sales via brokers, but I don’t see more than two “levels”?
  • He’s been dumping his shares via a family trust”. Well he did sell some shares two years ago at $44/share (nice move), but more recently he’s been buying at $19/share.
  • The SEC is going to regulate these transactions and put them out of business”. Yes the SEC recently commissioned a taskforce to review whether or not these transactions should be deemed “securities”. The taskforce recommended the SEC “consider” asking Congress to amend three of the major Federal securities laws. Sounds like a high hurdle to me given other things on the new republican House’s to do list.
  • And finally… “These guys are buying policies with long life expectancies (LEs) and then repackaging them and representing them to buyers as having much shorter life expectancies”. In other words, the life settlement investors THINK their returns will be double digit but are then surprised 5 years down the road when an insured who was expected to only live 2 years has taken up water skiing and running marathons. As a result the investors returns are now well into the single digits and by the way, they need to put up more money to pay the premiums (since the escrow money has been exhausted).

Michael Lewis’ recounts a great story in “The Big Short” where a young pair of fledgling investors (who called themselves Cornwall Capital) with a $100K Schwab account correctly conclude that the allegations of fraud against Capital One executives were unfounded. They proceeded to 20x their money by betting via options on a rebound once the allegations were proven to be unfounded.

I had that story in my mind as I tried to determine whether or not Brian Pardo and his team were really running some kind of a Ponzi scheme as portrayed by the shorts. “Hmm” I thought, “this thing is either dramatically undervalued or going to zero”. Unfortunately, the truth is usually not so black and white.

In an effort to try and figure out which way it is going, I tried to become a life settlement investor. It’s not as easy as I expected to buy a life settlement. The participants don’t want life settlements to be regulated by the SEC as a security, so they seem to only sell discretely through brokers to accredited investors.

Of all the concerns above, it’s the last one about LEs that represents, in my opinion, the most potential for some kind of catastrophic Enron-style collapse. Is LPHI really mis-representing LEs in order to attract investors and capture those gargantuan margins by selling the policies for less than what they might sell for in a more transparent market? I was unable to find a smoking gun or other lens into the inner workings of this business. Nonetheless, what I did find scared me enough to sell my small long position in LPHI.

I won’t disclose too much, since the nice agents I worked with were very helpful, seemed very honest, and truly believe in these products (to the point where they put their own money into settlements). Nonetheless, the lack of transparency or coherent answers reminded me of a Warren Buffett quote: “Indecipherable disclosures tell us which emperors are naked”.

I have tried to obtain via the company directly as well as via agents anything resembling a comparison of LPHI’s predicted versus actual life expectancies. The company has been in business for 20 years and transacted over 6000 policies. Surely someone can whip together a quick comparison table?

In fact, here is one from a competitor that does just that. Looks pretty good.

Instead, from LPHI what you get are strange, twisted analytics and wording that obfuscate what at its heart is a simple question. For example, below you can see their attempt to explain that returns will still be high even if people live 2-4 years past LPHI’s LE estimates. First of all, LPHI’s filings indicate they have settled over 1,300 policies in this time frame. So why are they only showing data for 579?

Similarly, note the CEO’s comment that lower than actual LEs happen “throughout the life settlement industry”. To me this is more of an admission of fault than evidence of no wrong doing.

LPHI argues that it is the discount at which it acquires the policies that determines returns. Hmm. I would think LPI must pay something approximating fair market value for these policies, since the sellers are wealthy presumably well-represented folks that would seek multiple bids no? I was able to calculate the IRRs on one of the policies provided. If the insured lived just a few years beyond the LE, returns rapidly drop to the mid to low single digits. Small sample? Maybe, but these were the policies provided in LPHI’s marketing materials!

All three policies I was able to view had very short LEs (2-5 years) for people who according to the case histories seemed to lack any life threatening medical conditions. I’m no expert here, but I will point out that CDC tables suggest the life expectancies for people of these ages (79 to 84 years old) would be 7-10 years. In all three cases the LEs represented on LPI’s policy case histories were less than half what you’d expect from the CDC tables (again on policy case histories provided in their marketing materials).

Another thing caught my eye. All three of these policies were purchased by the insured when they were in their mid to late 70s. Again, I’m no expert here, but it strikes me as odd that people in their late seventies would buy life insurance policies (except perhaps for estate taxes, but then why sell it?). I saw claims that LPHI doesn’t deal with STOLI policies. After reading about this case, I can’t help but wonder if there is people have invented a “STOLI-Lite” variant that is technically not “stranger owner”. Or perhaps I am overlooking perfectly logical reasons why wealthy 79 year olds would buy a life insurance policy and then turn around and sell it four years later.

Perhaps we’ll never know what’s going on behind the scenes. In fact, the company claims they have plenty of sellers. And the Agents suggest they have plenty of buyers. So maybe everyone is happy. But then again, maybe class action lawsuits like this newly announced “investigation” will shine a closer light on these practices.

Prediction: I suspect LPHI will continue to find investors willing to buy these policies. In fact, I bet they have a solid quarter (the Wall Street Journal article didn’t come out until after the close of their last quarter). That said, until the executive team comes clean and discloses its historical LE performance as well as the mechanics of their fee, I’d say this stock has a shorter than desired life expectancy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I used to have a small long position ($2K), but sold last week. (I had been lured in by the hefty dividends.) I’m not brave enough to go short because this machine could keep operating longer than I can stay solvent