Description

Summary Investment Thesis

Former Resolution PLC subordinated Tier 1 bonds (PEALLN 6.5864 Perpetual Non-Call 2016 - XS0235245205) trading at 15% of face value (Par).

Ø       Investment offers annual simple yield of 33%. Our worst case scenario shows income return of 211% while base case returns equate to around 611% through 2016

Ø       A cash generative and systemically important top 10 UK life insurer benefiting from adequate surplus capital against regulatory requirement

Ø       Healthy underlying business with visibility on 7 years of cash flows (via coupon payments)

Ø       Minimal default risk even though current price reflects worst case scenario of coupon deferrals and no bond redemption

Ø       The security in question (PEALLN 6.5864% Perpetual Non-Call 2016) ranks ahead of new acquisition bank debt and we contend its coupons must be serviced before payment to bank debt lenders and to its financial sponsors

Background:

Resolution PLC was one of the largest closed UK life insurer. A fund is defined as "closed" if no new policies are being sold, that is, it is closed to new business.

In the UK there are around 70 closed life funds with a value of more than GBP190 billion, amounting to one fifth of the long-term insurance sector. Closed life funds are cash generative and have certain advantages in the current liquidity starved environment such as earning annuity on long-term policies and no new business strain (the front loaded costs/expenses) of new contracts/policies.

Resolution PLC was taken over by Pearl Group and its investor consortium via Impala Holdings Limited - a subsidiary of Pearl Group Limited effective as of 1^st May 2008. This followed a much delayed approval from the Financial Services Authority in the UK.

However, since Pearl's acquisition of Resolution, the subordinated Tier 1 bonds for the group have plummeted in value from close to par (100) to around 15% of face value. The primary catalyst for this decline has been lack of transparency and communication from the acquirer (Pearl Group) coupled with dislocation in credit markets such that any securities with a hint of idiosyncrasy / complexity end up being heavily penalised. In part, the price decline was also triggered by the company choosing to remove its ratings which led to forced selling of bonds by traditional rating sensitive managers.

The price declines in the security are also driven by the fact that the acquiring group comprising Sun Capital and TDR is expected to undertake aggressive financial management. However, these plans were pre-Lehman watershed and will likely be significantly curtailed going forward not least because of stricter regulatory supervision.

The mitigating factor remains that the combined Pearl Group is a top 10 UK life player benefiting from meaningful scale and systemic importance to the regulatory financial system:

1)      The combined group has 7.7m UK policyholders split between its entities as follows:

a.       Pearl Assurance                   2.6m

b.       NPI                                                          0.595m

c.        London Life                                           0.149m

d.      Former Resolution                  4.4m

2)      The combined group had c£73.1 billion of assets under management (as at 31 Dec 2007)

a.       Pearl Assurance                   £13.9 billion

b.       NPI                                                          £10.2 billion

c.        London Life                                           £2.4 billion

d.      Former Resolution                  £46.6 billion

Former Resolution PLC Structure:

Prior to its acquisition Resolution PLC benefited from a strong capital position with at least £2bn of regulatory excess capital across its life businesses including Phoenix Life.  Therefore, in approving the takeover of Resolution by Pearl Group, the Financial Services Authority considered the resulting leveraged entity and any risk implications for policyholders as well as stability of the broader UK life assurance sector.

The organizational structure taken from a Pearl Group presentation shows the direct link between the Tier 1 bond and the operating life companies. Since then the Group has provided almost no clarity and more recently announced plans for dramatic restructuring of the organisational structure and assets.

The acquiring syndicate raised £2.3bn of acquisition finance via 2 SPVs - Sun Capital no. 2 Limited and Hera Investments no. 2 Limited with a 7 year term and it was explicitly made clear at the time of the acquisition that this debt would rank below the existing debt including the existing subordinated debt. The covenants related to new debt also made it clear that no interest would be payable on new debt if interest was not serviced on existing bonds. Thus the financial sponsors could stand to lose control if they did not maintain ongoing coupon payments on existing debt.

• The acquisition finance has a 7 year term which in principle ensures coupon payments for 7 years. Arguably it also raises the question as to the whether the full principal repayment of these loans should be linked to the Group meeting certain hurdles above the minimum regulatory solvency requirements and linked to timely coupon payments for bondholders beyond the 7 year horizon. The market or the bondholders have not been made aware of any such pre-conditions and/or clauses.

Analysis of Pearl Group Capitalisation (Solvency)

We revisit the basics of analysing life assurance from a credit perspective and then apply these key credit metrics to Pearl Group to try and address key issues:

Ø       Is the solvency cover (capitalisation) ratio for former Resolution high enough?

Ø       How good is the quality of capital resources? And are there sufficient resources to service coupon payments on an ongoing and timely basis

Ø       The strength of the with-profits fund

Ø       Asset mix and where they are invested and the implications of the current credit crisis for such assets

Ø       Will the bondholders still be adequately covered under the restructured Group?

Basics revisited:

Insurance companies are heavily regulated given the uncertainty of the business and the systemic long term importance to a national economy. The uncertainty in the business accrues from its reverse production cycle: the price received for the product (premium) is paid before knowing the cost of goods (claim), for example, annuities in payment. This and other factors create fundamental uncertainty as to the ultimate cash flow structure on each policy.

As such, insurance companies are required to assess likely policyholder payouts and undertake conservative assumptions to mitigate such uncertainty. Cleary, estimating future policyholder payouts is not without risks and a capital cushion provides security. Hence, capitalisation or solvency of an insurer is of paramount importance.

It is particularly important for with-profits business whereby at any given point in time the firms need to ensure adequate capital to cover all its ultimate liabilities and not just those falling due immediately.

We should emphasize here that we are not taking a view on future earnings or profitability. Instead our focus is on gaining comfort on timely coupon payments to bondholders and the certainty of these payments and any recovery value for the securities in the event of distress. We are therefore primarily concerned with solvency of the underlying life businesses. We are also not actuaries and feel that we do not have adequate depth to question the various assumptions for the businesses that have been tested by both the company's own and independent actuaries. Our analysis focuses on the levels of solvency and the buffer that affords us in the event some of these assumptions prove to be less conservative than expected.

Regulatory and realistic solvency jargon:

Updated financials for Phoenix (former Resolution life assets):

Taking into account the key metrics highlighted above, we have sourced the latest updated figures relating to Pearl Group from an Independent Expert (Deloitte LLP). The Independent Expert has been contracted as part of the process of merging the assets of the combined Group and in the process safeguarding the interests of policyholders.

The latest figures take into account the impact of falls in the prices of equities, property and corporate bonds and the resulting impact on asset shares of funds. The Independent Expert has also confirmed that the companies continue to operate their normal business processes in changing market conditions, such as adjusting MVAs to reflect reduced asset values. The valuation methodologies for assets held by the underlying companies have also been updated to reflect the increase in corporate bond credit spreads since (Lehman bankruptcy).

As can be seen in the financial tables in the next section, the capital resources for the underlying Phoenix Life Limited business (the former Resolution Life business comprised of Phoenix Assurance, Swiss Life UK and Bradford Insurance) are more than adequate even after recent precipitous declines in market values. It shows that pre-restructuring the Phoenix business had coverage ratio of 121% as at end December 2008 vs 120% as at end October 2008 and 118% as at end 2007. The tables also show that post restructuring, the coverage ratio for Phoenix is at an adequate 130% as at end 2008.

This reinforces our view that the underlying businesses continue to benefit from solid resources and on a stand alone basis should continue to service both policyholders and bondholders on an ongoing and timely basis.

KEY FINANCIALS

The financials would not fit on this paste but we have done considerable work and can make them available.

Distinguishing between Acquisition Holding Company and Operating Company

From a credit perspective, it is important to distinguish between the holding company and operating company due to structural subordination between Hold Co. and Op Co. This certainly applies to former Resolution bondholders as in our view they rank ahead of the new Acquisition Hold Co. Even after the implementation of the restructuring (merging) scheme.

The implications are that any shortfalls at the Acquisition Hold Co. level should not directly impact the bondholders since as shown in the earlier tables, the former Resolution bondholders have adequate surplus in Phoenix schemes safeguarding their coupon and principal payments.

It should be noted that as at 31^st October 2008 the new Acquisition Hold Co. of Pearl consortium had a shortfall against its group capital requirements (note not at the level of underlying businesses such as Phoenix). According to the Independent Expert, while this shortfall had no impact on policyholders, nor on the capital position, of Phoenix (it could simply arise due to certain assets at Op. Co not being admissible for calculation at Group Hold Co. level), it has since been rectified by various actions including changes to the capital structure of companies above Phoenix (former Resolution) in the Pearl Group and by rule waivers granted by the FSA. In this case, the FSA had imposed an Own Initiative Variation of Permissions (OIVOP) on subsidiary companies in the Pearl Group including the subsidiaries of PLHL. Since October PLHL has injected some £30m into Phoenix and may have put around £100m to support the subsidiaries of PLHL.

Characteristics of Former Resolution Bonds:

The subordinated Tier 1 bonds originally benefited from an Alternative Coupon Satisfaction Mechanism (ACSM) which meant that in the event of a coupon deferral brought about by distress the company had to issue and sell new shares with the proceeds used to satisfy bondholders' interest payment.

Since Pearl acquisition of Resolution this mechanism has been altered to allow the new Group to issue any Tier 1 instrument to satisfy bondholders in the event of a coupon deferral. Pearl has highlighted its private status and removal of public listing as a reason for this change. However, a number of bondholders including us believe that the change in mechanism coupled with restructuring of some assets could place bondholders' economic interest at risk.

In view of this a number of bondholders are exploring ways to safeguard bondholders economic interests including liaising with the Association of British Insurers and the regulator. The systemic importance of the life assurance sector and the need to maintain stability in a regulated asset class reinforces our view that ultimately the Group will be mindful of its obligations in this regard.

Valuation - Cash flow (coupon payments) in base case and worst case scenario:

We use relatively conservative assumptions to reflect two most likely scenarios given historic precedents, current regulatory oversight and solvency (capitalisation) of the underlying Phoenix Life business.

The new acquisition bank debt ranks lower due to structural subordination of the new acquisition Hold Co. The new debt has 7 year maturity and any servicing of new bank debt or dividends is contingent on ongoing coupon payments on existing old bonds. This underpins our worst case assumption of at least 7 years of coupon payments.

Even in the unlikely event of constrained financial flexibility, we feel that regulatory support will be forthcoming via a forced merger or sale to a larger UK life player such as Aviva or Prudential or even one of the European players such as Allianz, Generali or AXA. It could therefore be argued that our valuation does not reflect the possible upside scenarios. There is also a very remote possibility of a bond buy back such as the one undertaken by QBE - the Australian insurer.

Key Risks and Mitigants:

We have highlighted some of the key risks to our investment thesis and feel that while short-term negative news flow is a possibility, this investment does offer a positively skewed risk-reward opportunity. The main risks for us are as follows:

Ø       Regulatory Intervention - is a material risk in the event the regulatory surplus falls below capital requirement. We feel that the current surplus provides adequate protection against further market declines. We also feel that Pearl Group management would be mindful of regular servicing of coupon payments which would be a pre-requisite for any dividends or payments to the new acquisition group.

Ø       The acquisition consortium may not respect bondholder rights. This is a remote but possible risk. We would contend that ultimately the group would be forced to reconsider any such decision given the broader implications for the entire UK life sector and its own needs to be able to access the capital markets in the future.

Ø       Mark - to - market could be volatile in the event a coupon payment is skipped and it is likely that in such an event bond prices decline to high single digits - a 50% decline from current level. Again, we would contend that this would be a temporary move.

Ø       Policyholder surrender and lapses could increase significantly impacting underlying cash flows. Even at the height of concerns about the solvency of life insurance sector in the UK and Europe when high equity backing ratio (high equity investments) and the dotcom bust led to dangerously low capitalisation levels we only witnessed average policy lapses of around 9%-10%.

Ø       It is often noted when policyholders suffer financial difficulties they choose not to withdraw their policies but rather stop paying premiums into them in the hope that they can resume premiums later. This shows recognition by the policyholder that the long-term policy was set-up for a long-term need and hence they should try to fulfil it. Such policies are called 'paid-up policies' or PUPs, and on change to that status the sum assured and maturity value are reduced to reflect the lower amount of premiums paid than that expected. Restarting premiums lead to the insurer being required to work out a new premium rate or sum assured. A PUP is better than a withdrawal from the insurer point of view as the fund is left with the company and it can still collect management and possibly administration fees on it. Furthermore, there is the possibility that premiums may recommence on the policy. It is often the case that with PUP at least some profit is still made or a smaller loss compared to an outright surrender, this is particularly the case for unit-linked policies.

Catalyst

• Payment of coupon due April 25, 2009 would reinforce the Bond Holder rights and give visibility over coupon payments for the next 7 year period.
• Company response to Pearl Bond Holder Group (already formed) and confim intention to safe guard bond holders interest.
• Regulatory ruling forcing Pearl to state intent on bonds.