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J.G. Wentworth IPO: Down the Pre-Crisis Rabbit Hole

Liquidity isn't the only risk J.G. Wentworth faces in its financial arrangements.

When it comes to leverage, J.G. Wentworth's private equity owner JLL Partners doubled down after firm's bankruptcy emergence.

In a January leveraged recapitalization, the company took out a $425 million term loan that paid its private equity owners $309 million in dividends. Moody's (MCO) rated the deal "Caa1," a deeply non-investment grade rating and characterized the company's financial management as "aggressive" and with "high cash flow leverage."

In May, J.G. Wentworth increased the term loan by $150 million to pay out additional dividends to its PE-owners.

The company expects to have $421.3 million in total debt outstanding, including the IPO proceeds, which are expected to allow the company to repay $151.9 million in debt and give the company a further $29.2 million for general corporate purposes. Current investors will be paid $47.0 million through the offering; however, JLL Partners will remain a majority holder, owning roughly 56% of the company's outstanding shares.

Discount Rates and Paper Earnings

J.G. Wentworth's earnings, meanwhile, are derived from an opaque spread that it generates in buying individual settlements and selling them as a bundle, in addition to quarterly marks the company takes on investments it makes in the subordinated tranches of the asset-backed securities it sells.

The marks J.G. Wentworth takes on its earning assets are based on discount rates the company uses to value its settlement assets and financing liabilities. Most of those assets and liabilities are held in variable interest entities (VIE's) and are characterized as Level 3 -- those whose value is unobservable and reflect the company's own assumptions.

As of 2012, J.G. Wentworth carried $3.61 billion in residual VIE assets at a discount rate of 3.99% and $3.23 billion in liabilities at a discount rate of 3.43%, according to its S-1. Changes to those discount rates and VIE asset and liability balances are a significant piece of J.G. Wentworth's overall earnings and cash flow.

"Our ability to monetize our structured settlement, annuity, and lottery payment stream purchases and pre-settlement funding depends on our ability to obtain temporary and/or permanent financing at attractive rates, especially relative to our purchase discount rate," J.G. Wentworth states.

"If the cost of our financing increases relative to the discount rate at which we are able to purchase assets, our profits will decline," the company notes, highlighting rising interest rates or its own corporate credit spreads as key sensitivities of its discount rates.

As of June 30, J.G. Wentworth would post a near $50 million loss were interest rates to rise 1%, according to a pro forma sensitivity analysis appended to its S-1. Most of the impact would come from negative fair value marks to its residual interests. Unfortunately, the company has financed the acquisition of those residuals, ultimately leveraging a crucial element of its earnings and cash flow.

A balance sheet loaded with Level 3 assets and significant long-term debt doesn't just pose a risk to J.G. Wentworth's earnings. It also is an issue of solvency.

Since J.G. Wentworth's asset and liability values and consequently its equity are derived largely from the discount rates that the company uses, investors have few tangible assurances that the company will be able to pull though a market disruption.

Were the company to be forced to sell its settlement or lottery assets on the open market, there is no guarantee that proceeds would match carrying values on its balance sheet. J.G. Wentworth's $421 million in pro-forma debt, its warehouse credit facilities and its interest rate swap contracts, however, represent real financial commitments.

"If we are required to sell our residuals to pay down debt or to otherwise generate cash for operations, we may not be able to generate proceeds that reflect the value of those residuals on our books or that are sufficient to repay the related indebtedness. In addition, a sale of the residuals under those circumstances would likely generate taxable income without sufficient cash to pay those taxes," J.G. Wentworth states.

"[The] esoteric nature and illiquidity of JGW's financial assets may impact time to sell and pricing if the Company needs to sell assets to cure or prevent debt covenant breaches. Moreover, the Company's assets are encumbered and its cash flows are highly leveraged, with the vast majority of cash flows utilized to support securitization structures' debt servicing requirements, further restricting its operating and financial flexibility," Moody's said in its August ratings report.

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