No Free Lunch (Death Bonds)

Businessweek does a big article on death bonds (otherwise known as life settlements). A good article, but they miss the key factor that will hold back this asset class.

First an overview. It is funny to see this concept main-stream. We looked at this concept at my prior job and predicted about three years ago that it would grow as a concept. The returns at that stage were quite high. BW explains the basic concept well.

Death bond is shorthand for a gentler term the industry prefers: life settlement-backed security. Whatever the name, it's as macabre an investing concept as Wall Street has ever cooked up. Some 90 million Americans own life insurance, but many of them find the premiums too expensive; others would simply prefer to cash in early. "Life settlements" are arrangements that offer people the chance to sell their policies to investors, who keep paying the premiums until the sellers die and then collect the payout. For the investors it's a ghoulish actuarial gamble: The quicker the death, the more profit is reaped. Most of the transactions are done by small local firms called life settlement providers, which in the past have typically sold the policies to hedge funds. Now, Wall Street sees huge profits in buying policies, throwing them into a pool, dividing the pool into bonds, and selling the bonds to pension funds, college endowments, and other professional investors. If the market develops as Wall Street expects, ordinary mutual funds will soon be able to get in on the action, too.

Here BW forgets to put on its skeptic's glasses and trace the cash...

The truth is, at this early stage, there's no way of knowing how popular death bonds might become. Wall Street's innovation machine has turned out both huge hits and big flops over the years. But the growth of the underlying market for life settlements has been torrid so far. In 2005 about $10 billion worth were transacted, according to Sanford C. Bernstein & Co. (AB ), up from virtually nothing in 2001. Industry analysts say this number rose to $15 billion in 2006, and could double this year, to $30 billion. Over the next few decades, as the ranks of retirees swell, Bernstein predicts that the face value of life settlement deals will top $160 billion a year in today's dollars. Death bonds will never approach the size of the mortgage market, which saw $1.9 trillion of securities issued last year. But if Wall Street achieves its goal of turning most of the life settlements created each year into death bonds, the market could rival the size of today's junk-bond market, where issuance totaled $128 billion in 2006, up from $56 billion in 1996, according to market watcher Dealogic.

This will not happen because life-settlements is a zero-sum game and all the gains for investors are coming at the cost of the insurance companies. In effect, investors are gambling that they are more rational about the payouts than elderly individuals (which they certainly are). That policy holder irrationality benefits the insurance companies and increases their profits. When life settlement providers come in, they are effectively stripping out some of the insurance company profit that was priced into the policy.

So as long as life settlements stay a small percentage of policies, the insurance companies will tolerate it because there is still no advantage in them publicizing the fact to their customers that their cash settlement amounts are too small.

If life settlements start to eat up too much underwriting profit, then the insurance companies will either:

a) raise premiums to make up the reduced profitability and reduce the profitability of the policy to the policy holder

OR

b) selectively raise cash settlements to the customers who are most likely to die and leave the 3rd parties with worse risks (e.g. in this model, the healthy people)

So, while insurance companies are notoriously slow to innovate and so this might run for a while, let's review the relevant facts:

a) returns to life settlement investors are coming directly out of the pocket of the insurance companies b) the insurance companies have the actuarial data that investors don't have c) the insurance companies already have the relationship with the policy-holder

Who is going to win this game in the long run?

Fan-based Financing

Love the idea. Retail investors with an emotional connection to the team are not likely to be the most demanding source of capital

What if you could spend, say, $100,000 to become the owner of two seats behind the dugout in the new Yankee Stadium, due to be completed in 2009?

We are talking not about tickets, but about the seats themselves. They would be your property for as long as the Yankees play at the stadium. And with the sale of these seats, the Yankees would have raised the entire $1.2 billion needed to build the venue.

The Yankees organization, though, isn't the author of this deal.

It's Morgan Stanley and its partner, the start-up Stadium Capital Financing Group, who are behind the plan, and they’re hoping it will become an accepted way of doing business in sports.

Full article from Portfolio

Why Private Equity Guys Are Rich And You're Not

From dealjournal.

You work hard. Are good at what you do. But you might be the first to admit it: Making big money is not the easiest thing in the world.

Unless.

Unless you happen to be part of a group of a few thousand who hold principal positions inside private-equity firms. A glimpse at Kohlberg Kravis Roberts's IPO filing shows just how breathtaking a business leveraged buyouts can truly be.

Last year KKR had expenses of $267 million. Its net income was a multiple of that € $1.12 billion.

There is a significant cost when a business has to expose to the world (customers, politicians, potential rivals) how incredibly profitable it is. That is why private equity was, well, private. We'll see how this plays out.

Kohlberg Kravis Is Back (1996)

From a WSJ 1996 article (link is behind the paid search feature). Looks so quaint. A mammoth fund:

KKR is harvesting big gains on sales of other companies it purchased in the 1980s, aggressively pursuing new investments and set to raise a mammoth new fund to rival the record $5.6 billion war chest it raised in 1987.

That can do $3B deals

So how can KKR wind up with the biggest war chest? What pension funds like is that they can invest a big wad of cash with KKR. And KKR, in turn, can do a $3 billion to $4 billion buyout, unlike most buyout firms. "Other funds create excellent returns, but we can't put the size and the amounts we want" at other buyout firms, says Jay Fewel, senior equity investment officer at Oregon state treasury, a longtime investor that is ponying up $800 million in the new fund.

And a different competitive set back then:

Thanks largely to RJR, KKR's returns appear to lag behind returns garnered by such fund groups as Forstmann Little & Co., Clayton Dubilier & Rice, Joseph Littlejohn & Levy, Morgan Stanley & Co.'s buyout group and others.