Internal rate of return (IRR) is a common measure of performance in life settlement investing, but Beat Hess, Managing Partner of AA-Partners, argues that Distributed to Paid-In (DPI) is a better judge of realised performance. Greg Winterton caught up with Beat to learn more about why he favours this approach in this month’s Q&A.
GW: Beat, DPI is a well-used metric in a range of private market asset classes/categories. Why do you prefer it to IRR, which arguably has been used for longer, particularly in life settlements?
BH: The target IRR of a fund is used in the private markets as well as in the life settlement market for pricing assets at the point of purchase. But, at the same time, the IRR is a marketing instrument, because that IRR is used in communications with investors.
But once a life settlement portfolio is running, investors want to know how it is performing, both generally and compared to their target IRR. One way to describe ongoing performance is the IRR – by combining the realised cashflows so far, together with a valuation of the policies not yet matured. The issue with this approach is that the valuation is based on assumptions, so the IRR of a current investment or fund can paint a rosier picture, even if the investment is actually not performing.
A second way, and one we prefer, is to describe the ongoing performance using DPI. Investors want investable cash back; the return of capital is what matters, and this is measured by the DPI. The DPI does not depend on assumptions, making it difficult to ‘skew’. It is purely about cashflows which makes it easy to understand – and tangible.
The DPI is a great metric to report the performance of a life settlement investment, and the necessary information is readily available via standard bookkeeping tools.
GW: DPI proponents argue that it bypasses valuations and prevents skewed assumptions. What is a hypothetical scenario where a life settlement fund shows a strong IRR, but its actual DPI paints a drastically different, riskier picture?
BH: A life settlement portfolio generates two types of cashflows: cash-in from collected death benefits and cash-out from premium payments and cost. Thus, the balance of the two cashflows is decisive for the success of the investment, which is what the DPI measures.
Imagine a life settlement portfolio where the cash collected from mortalities does not, or does not significantly, exceed the cost (the payments of premiums to keep the other policies in-force). The DPI of such a fund would paint a dire picture, since the investment would not be going well at that point in time. And rightfully so, since the ultimate risk of this investment is a partial (or even total, in an extreme situation) loss for the investors if the cash-in does not continue to exceed substantially the cash-out.
The same portfolio can show, however, an attractive IRR since the value of the remaining portfolio, which depends on a range of assumptions, is considered in the IRR calculation, together with the to-date realised cashflows.
Again, we think this is why the DPI is so useful. Valuation assumptions can affect the reported value of the portfolio and lead to a rosy IRR, but they cannot create cash distributions. DPI cuts through that distinction by showing how much capital has actually been returned to investors.
GW: Because life settlements require ongoing premium payments before death benefits are collected, early-stage DPIs can look low. How should investors fairly evaluate a fund’s DPI during those initial hold-to-maturity years?
BH: Yes, this is correct. The DPI of a young portfolio can indeed look ‘unattractive’ while the portfolio is actually on track to deliver acceptable returns. But in this case, looking at the actual-to-expected (A/E) – the metric used by institutional investors and actuaries to measure the accuracy and quality of medical underwriting and life expectancy (LE) estimates – would tell the true story. A portfolio can be considered to be on track, even though the DPI does not appear to be strong, if the A/E confirms that policy maturities in the early years are happening as or close to when they are expected to.
GW: What specific standards or metrics do you think should be required of life settlement asset managers to report to investors to reduce the risk of an incomplete performance picture?
BH: At a minimum, we think that investors should receive a clear quarterly picture of the actual cash flows of the portfolio: cash-in from collected death benefits and cash-out for premium payments and other costs. This, on top of the actual-to-expected ratio (which should be included anyway in all documentation) would help to provide investors with the information they need to more effectively judge the performance of a portfolio at that particular time.
GW: What do you think is needed in order for life settlement asset managers to adopt DPI as a preferred performance measure, and how should the industry go about achieving this?
BH: The cash-in and cash-out information of every fund is available via standard bookkeeping tools and processes, so data availability is not the issue.
And I don’t think the industry needs another complex reporting framework. For us, DPI is straightforward; it’s based on information every manager already has, and it’s well-known. Thus, we think that other managers confident in the cash performance of their portfolios have little reason not to provide it.
Beat Hess is Managing Partner at AA-Partners
