Primus Overview

Do you like buying a dollar for 90 cents?  What if I told you you’d get that dollar (for sure) in less than a year?  What if I told you your return has minimal risk and should be uncorrelated with the market?  Unfortunately, due to very limited liquidity in the stock this idea is likely only actionable for personal accounts.

Primus Guaranty is that idea(ticker PRSG).  Primus is a “liquidation.”  Primus is in wind-down and began returning capital in the 4^th quarter of 2013.  I expect the return of the remainder of the cash to shareholders in 2013 and perhaps early 2014.  You can buy Primus today at $8.20 per share.  Book value or what the Company describes as “Economic Results book value value per share” was $8.92 as of March 31, 2014.  I expect book value to grow slightly through the remainder of this year from the small amount of premium and interest income the Company is currently collecting (and that income to be in excess of the Company’s expenses.).  I expect book value at the 2014 (the Company’s “life) to be ~$9.10/share.

I expect the Company to make multiple (more than 1) distributions (based on the Company’s own public statements) in the next year and be out of business by the end of the year or early 2014.  As such, based on my expectations around the timing of the distributions (a guess admittedly but based on the maturity schedule of the expiring credit default contracts) I model Primus as a high teens IRR investment opportunity.  There are also a couple of reasons to think you might expect a better outcome than the IRR illustrated that I will explain shortly.

See an illustrative base case below:

Primus Financial is a Delaware limited liability company that, as a credit derivative product company, was established to sell credit protection in the form of credit swaps primarily to global financial institutions, referred to as ‘‘counterparties,’’ against primarily investment grade credit obligations of corporate issuers.

In exchange for a fixed quarterly premium, Primus Financial has agreed, upon the occurrence of a defined credit event (e.g., bankruptcy, failure to pay or restructuring) affecting a designated issuer, referred to as a ‘‘Reference Entity,’’ to pay to its counterparty an amount determined through industry-sponsored auctions equivalent to the notional amount of the credit swap less the auction-determined recovery price of the underlying debt obligation. Primus Financial may elect to acquire the underlying security in the related auction or in the market and seek to sell such obligation at a later date.

Credit swaps sold by Primus Financial on a single specified Reference Entity are referred to as ‘‘single name credit swaps.’’ All of Primus Financial’s single name credit swaps have matured as of December 31, 2013.

Primus Financial also has sold credit swaps referencing portfolios containing obligations of multiple Reference Entities, which are referred to as ‘‘tranches.’’

During 2009, the Company announced its intention to amortize Primus Financial’s credit swap portfolio.

Under the amortization model, Primus Financial’s existing credit swap contracts will expire at maturity (unless terminated early) and it is not expected that additional credit swaps will be added to its portfolio, unless associated with a risk mitigation transaction. Risk mitigation transactions may include the termination of selected credit swap transactions as well as portfolio repositioning transactions with individual counterparties.

During the first quarter of 2014, two of Primus Financial’s tranche credit swaps

matured with a combined notional principal of $300 million. Primus Financial’s credit swap portfolio now comprises nine tranche swaps with a notional principal of $3,025 million. Primus Financial’s remaining tranche swap transactions are scheduled to mature during 2014.

I have evaluated Primus swap portfolio and believe that Primus will not have to make any payments to counterparties during the remainder of 2014 (i.e. never).  Why am confident in that belief?  It is because Primus has provided transparency as to the underlying credits in the tranche portfolio and the overwhelming majority of those credits have a very strong credit profile.  The only two credits that present any significant degree of risk are JC Penney and MBIA and even if both Companies were to default in the next year it would NOT result in Primus making any payments to the counterparties because the tranche contracts require a large number of borrowers to default before Primus becomes responsible for paying counterparties.  That threshold is referred to as Primus “attachment point” and the attachment point on the tranche contracts in question is significantly above where Primus would stand even were JC Penney and MBIA to default in the next year.

You can find the details of the credit swap portfolio listed here:

http://ir.primusguaranty.com/phoenix.zhtml?c=179637&p=irol-IRHome

The last few years have seen a continued decline in the size of Primus’ credit swap portfolio and a significant reduction in risk in the portfolio.  Management’s primary goal and actions have been to continuing the process of returning Primus’ capital to its shareholders.  In December of 2013, a $2.00 return of capital distribution was made.  In the most recent shareholder letter of May 12, 2014 management said “Subject to the availability of distributable capital and Board approval, we anticipate paying additional distributions in the course of 2014.”

What are the potential sources of upside to the 18% IRR I have modeled above? 

First, Primus may be able to slightly increase book value by continuing to buy back (as they have historically done) stock below book value. 

Second, and more importantly, Primus has $14 mm of NOLs and a prospective acquirer may see Primus as a valuable shell/acquisition target – a Company with close to $200 mm of cash, a public listing, and NOLs (although small).  As such, they may see Primus as a Company that is worth more than their book value because of the public listing of the Company and its NOLs.  Although Primus has said they intend to continue to liquidate there is always the possibility that a suitor decides to take a substantial stake in Primus (see what happened in Capmark several months ago) for the reasons I have mentioned.

Third, I believe Primus is likely to attend to terminate the tranche CDS contracts with counterparties before their various maturity dates in 2014 (the last 1.375 bn of contracts matures on 12/2014).  Primus would forego the minimal premium income (I estimate about $5 mm for the remainder of 2014) but would be able to return capital to shareholders more quickly under hat scenario.  Returning capital sooner of course would have significantly positive IRR implications for current shareholders allowing them to receive their money sooner rather than later.