Crossing Into New Markets, Part 2
Prime Meridian launched its latest fund, Special Opportunities Fund, in June. With that, it entered into two new markets – litigation finance and life settlements – and included existing sectors it currently invests in such as: marketplace consumer, small business and real estate loans. Don Davis, CEO and portfolio manager at Prime Meridian, spoke about the marketplace lending space as well as the new markets they’ve entered. Here is part one of the conversation.
Q: The Special Opportunities Fund features new markets for Prime Meridian. What is so compelling about litigation finance and life settlements markets?
A: There are a lot of similarities to litigation finance and life settlements. You can almost group them together even though they are very different. Mathematically, how you manage the risk is very similar. What we like about them both, as included in the Special Opportunities Fund, is that they are very low correlation to the funds we are currently managing. And it has little or no correlation to a recession because in a recession people still die and people still get sued. And there are some studies that show that people die more often and are sued more often in a recession.
So it’s nice to have something in your portfolio, when the S&P is falling 50 percent and maybe you have some commodity futures strategies where some are making money and some are losing. And maybe you have a great loan portfolio where defaults are rising and yields get compressed. But it is nice to have something that is totally uncorrelated to that and buck the trend. That’s first and foremost why we liked it a lot.
And there was organic demand from existing clients, who suggested we start looking into a fund like this. That was close to a year ago and we had familiarity and knew some of the players in this space. We just said, “Let’s research this a bit more and develop a fund that we want to build around it.” And we got really into it, did the due diligence with all the players and we really liked the space. And like our other funds, we wanted to do it better than any other fund in those assets and very different and unique.
Q: How so?
A: In life settlements, typically you have funds that do life settlements only. Most commonly, it’s a private equity structure. So as these policies are paid, you might get your money back over time. And in litigation finance, you might get a private equity structure, which is the most common. Or it may have a very long lock-up of three to five years and then very restrictive liquidity after that. And usually, it’s only life settlements in one fund and only litigation finance in a fund. So we said, let’s combine these two together.
The other thing is where they make mistakes. This points to where certain types of expertise are important in being a successful hedge fund manager. It’s not being an expert in law or in life insurance. That doesn’t make you an expert hedge fund manager but that is where a lot of people try to go with it. What is your expertise in that one industry? And we have seen that, where a fund manager has an expertise in this industry and then decide to be a hedge fund manager and then they screw everything up and lose investor money.
One area where they can screw it up is by choosing durations that are too long or too short on the assets, and they value them incorrectly. So they estimate that if everyone in their life settlements portfolio dies in a certain time frame, then their ROR is going to be 20 percent per year. And then they don’t build up enough diversification- geographically or the right number of policies in the portfolio. If you don’t have that, then you are looking at a very speculative policy and valuing it more speculatively, and then all of sudden, reality happens and people live longer than what was assumed. Or the litigation takes longer to settle. So now you have to revalue the portfolio. And if you are starting off the portfolio with a 20 percent ROR and have to revalue it to a 10 percent ROR, not only does that knock off points to your future returns but you have to go lower than that to sort of, overcome the over valuation from the past. That’s where you see people who said “Geez, I haven’t made any money on these things.” And if you ask enough questions, you can see exactly where these managers went wrong. Or even, sometimes, it’s an advisor in a family office who just did it on their own, held them for five years and nothing’s happened. That’s not a portfolio. You need hundreds of policies and you gotta get your duration right. The duration we focus on is five to seven years for life settlements and litigation finance. Even that is materially longer than our marketplace lending portfolios. We just think those are the sweets pot for risk and reward.
Q: How would you describe the life settlements market?
A: It’s a very mature, very regulated, very transparent and very ethical industry. I want to say that because sometimes there is some misinformation out there that the industry is shady and unethical. Some people have a picture in their mind of a broker going to an old lady’s house and strong-arming her into selling her policy for 5 cents on the dollar. There were one or two cases like that 20 to 25 years ago. And just like every industry there are shady people who do shady things. But the industry is very regulated right now and these policy holders are participating by their own choice.
We are familiar with cash value policies where you have universal life policies that build up cash value that is invested in mutual funds. Those have always had a cash value you could always just sell or redeem with your insurance company. But a term-life insurance policy has never had a cash value historically until now. And it only applies to a policyholder who wants to cash in that policy. If someone has a $1 million life insurance policy and has been diagnosed with cancer and they have a five to seven-year life expectancy, have to quit their job and focus on treatment, it is their choice to go to an exchange and sell that policy. Say they get 35 cents on the dollar and they get $350,000 in cash on the policy now instead of waiting until they pass away. They have the choice. Maybe they have multiple insurance policies and just want to sell one of them.
We’re holding hundreds of these diversified policies and over time they’ll pay off. When you factor it out and value it correctly and they will pay off over time if you have the patience and you do it right.
Q: How big are these markets?
A: These markets are big $50 billion for marketplace lending and $ 200 billion for life settlement.
Q: What does niche real estate have in common with the marketplace lending space for consumer or business lending?
A: The other elements of the Special Opportunities Fund have a lot in common with each other. They all use marketplace lending originators. With the real estate fund, that is just a different vertical. We have small business, consumer and real estate. With real estate, it is all bridge loans. We have six different consumer originators in that fund with three objectives: geographic diversification, diversification of properties and 100 percent first liens. There are no second liens, no equity, 100 percent personally guaranteed, the average LTV (loan-to-value ratio) is 65 percent. So this is a very strong fund. It is the most diversified and best risk/reward real estate fund I’ve seen anywhere. Usually, they are concentrated geographically in one area, concentrated on one property type and usually have a higher LTV. They often have second liens and equity and use leverage. And we’re just the opposite of all those areas.
And if you look at why the banks failed or got in trouble. It wasn’t because real estate was a dangerous or bad asset class. It was about how the asset class was managed. They carried high LTVs of 95- to 100 percent LTVs with borrowers that were not creditworthy in many cases. And then banks used substantial leverage behind the scene, with 30-to-1 leverage on real estate books. Pepper in a little bit of fraud here and there and the real estate market falls 30 percent from top to bottom and they had not chance. It was a bubble and had to be bailed out by the government.
We do the exact opposite. We say, “Let’s say the worst real estate crisis in 100 years is the new normal and it happens every seven years for the rest of our lives, and the market falls 30 percent top-to-bottom every seven years. What kind of portfolio can withstand that?” So instead of 95 percent LTV, we do 65 percent. Instead of doing second liens and subprime, let’s do first liens and prime. Instead of 30-to-1 leverage, let’s do no leverage. Instead of loading up on certain areas around the country like Miami or Vegas, let’s go full diversification around the country. Let’s do all types not just single family. Let’s do commercial, single family and multi-family. And with that type of diversification, without any leverage, it is very strong. We have no lock-ups and we have monthly liquidity on a best-efforts basis.
And we do 12-month bridge loans for the majority of the portfolios. And a lot those are pre-paid earlier than that, so it’s a very short duration portfolio. If these borrowers get in trouble, we have the first-lien on the property. The value of the property may ebb and flow over time but the real estate isn’t going anywhere. And we have control of that real estate until we are paid back 100 percent, plus interest, plus penalty interest.
Q: How has that performed?
A: It’s been phenomenal. Since inception, it has been about 8.5 percent per year but yields have been higher. If you look at the last rolling 12 months, it was 8.05 percent. The current market estimate this year is that we’ll probably do high 7 percents. In 2019, it might be mid-7s. Yields are drifting down a bit. But 7.5 percent to 8 percent is net to the investors after fees and expenses. And it’s a secure diversified portfolio.
Q: And what kind of returns are you looking for in litigation finance and life settlement?
A: Gross, before fees and expenses, 13 percent is where we think the sweet spot is on that. After fees of 1-and-20 and expenses, the target is 9 percent to 10 percent to investors. Those types of assets are a little less liquid, so we ask for a one-year commitment with quarterly liquidity and a best efforts after that. So it’s a little less liquid than the other Prime Meridian funds. But you are giving up liquidity for higher targeted returns.
Q: Who is your target audience for the Special Opportunities Fund?
A: It’s the same as our other funds generally speaking. Most of our clients are family offices or multi-family offices and asset managers globally. We have a couple divisional institutional customers as well. Institutions have historically favored the consumer lending fund (Income Fund) because dealing with consumer, you have the biggest originators in the space. Those have very strong institutional controls, all the boxes are checked and so historically large institutions have had a preference for those but that is starting to shift as well.
Q: As you look at alternative markets what are you looking at? What are the criteria you are looking for?
A: First and foremost, it comes from our clients. What are their needs? I learned years ago, being a great fund manager is not about having a one-size-fits-all strategy. It’s about listening to your clients, figuring out what their needs are and delivering on that.
Q: I noted in a recent interview that you had no interest in the student loan market?
A: Student loans tend to be low yielding. And I look at tail risk. It happens very rarely, but when it happens, it can be game over. I just think there is a lot of tail risk in the student loan market. Every politician in office is talking about deferments, lower yields, capping yields and forgiveness on defaults. As an investor, I just don’t like those kinds of terms.
Q: I cannot have a conversation these days without having a conversation about cryptocurrencies. Do you have any interest in that space?
A: I follow that space quite closely, almost since inception, believe it or not. I’ve participated in it in a small way. It’s one of the most speculative markets and should only be a very small portion of your investments.
I like what it stands for, but there are risks of hacking. A lot of new controls have been put in place. But it is a very high-risk investment. If you look at the past seven months, the market is down 75 percent on average.
There are some things we can do to be involved in that space but we wouldn’t launch a fund to just be in cryptocurrencies. I don’t see that on the horizon. But if we saw some other tokens out there in illiquid assets to make them more liquid, we’d take a look. You could get tokens that are backed by Prime Meridian funds and if someone wanted to invest $100k or whatever the number is they could just sell the token. There are firms out there looking to get involved in that space and partner with different fund managers. We wouldn’t be an issuer of tokens but would be one of the fund managers but more like a fund-of-fund. That concept is very interesting.
Q: The innovation in terms of products that are out there is interesting. Prime Meridian has been at the forefront of that in peer-to-peer lending. We seem to be entering a new frontier now in terms of product innovation. How do you see it?
A: If you look back at the past 20 years, we’ve seen a lot of innovation, from ETFs to alternative ETFs. I think there is going to be another wave of innovation come through with securitized tokens, tokenization of illiquid assets, even just marketplace lending and our Prime Meridian funds. It’s a good time to be looking around right now.
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