China Oceanwide’s Genworth overpay cuts through trade war noise to capture IP value

26 June 2018
In the intellectual property race between China and the US, China Oceanwide may have found the most effective tool yet: overpay for a troubled US insurer whose IP could be invaluable back home.

On the surface, Oceanwide’s run at Virginia-based Genworth Financial aims to give the real estate-focused conglomerate entry to US insurance markets. But the deal’s potential to help China keep socioeconomic pace makes the high price and risk of upsetting international tensions worth it – not only for the bidder, but also for event-driven arbitrage players along for the ride, according to multiple buyside analysts and advisors tracking the deal.

Given the geopolitical tumult at play with the Trump administration, much of the focus around a Genworth/Oceanwide deal has been on whether the transaction passes regulatory muster, especially with the Committee on Foreign Investment in the US (CFIUS), an opaque agency that has regularly smacked down foreign takeovers of US companies.

However, after multiple delays and application re-filings, CFIUS signed off earlier this month. While that wrapped up the most difficult leg of a multi-step regulatory process, the deal still has to clear hurdles with regulators in Delaware, New York, and several international jurisdictions. And the broader ambitions behind Oceanwide’s years-long pursuit – the initial offer was announced in October 2016 – could still come under scrutiny.

As the deal review process has dragged on and Genworth’s performance remains volatile, Oceanwide has had multiple opportunities to either abandon the increasingly bothersome transaction, or lower its bid for the company—but so far, it has not done so.

To that point, the firm’s connections to the Chinese government have led some investors to buy into the notion that the company has a quasi-mandate to help develop the nation’s long-term care insurance market, which currently lacks the infrastructure to keep up with a ballooning elderly population. The number of people aged 60 years or older in China is projected to hit 408m by 2040, compared to 168m in 2010, according to the United Nations.

“If Oceanwide can develop a solution for China’s long-term care problem, then the price of the Genworth deal is a drop in the bucket,” said an advisory source close to the deal. But it’s a complete loss from a deal-economics standpoint, the source said.

Old problems

Allegations of intellectual property encroachments by China have heated up this year as Trump intensifies rhetoric over a potential trade war with China.

Crucially, as part of the CFIUS negotiation, Genworth and Oceanwide agreed to set up a third party service to hold sensitive customer data amid widely publicized worries among US officials that such information could fall into the hands of the Chinese government.

Still, Oceanwide will gain access to years of experience within various insurance markets at Genworth, a company that has operated under several different names since 1871.

“Overpaying by billions of dollars is nothing for the intellectual property they'll be getting out of this,” said a US-based credit analyst, who happens to be from Beijing. “Most retirees in China are getting paid based on their salaries at the time of retirement, which has been eroded due to inflation over the last 20 years, and there's no social security. This is a huge issue in China,” where it’s increasingly difficult for the average senior citizen to afford institutional long-term care.

In addition to raw demographics, socioeconomic changes such as China’s one-child policy and rural-to-urban population movement have weakened the traditional familial system of caring for its senior citizens, according to multiple academic studies. As such, more and more elderly Chinese people end up living alone.

In recent years, the Chinese government has launched several pilot programs aiming to address the growing need for long-term care, encouraging both public and private investment in new facilities.

And as a real estate-focused company, Oceanwide has stated that it wants to construct integrated retirement communities – cities from scratch – with long-term care insurance built in, feeding into the government’s outline for how to tackle the issue, according to the source close.

The company’s chairman, the billionaire Lu Zhiqiang, is politically connected—he’s a member of the Chinese People's Political Consultative Conference, an important advisory body. In a 2010 story on Zhiqiang in Week In China, he said, “I’m not a very good businessman. I only look at the big picture.”

Insurance premium

Exemplifying the notion that Oceanwide is overpaying for Genworth is the fact that, prior to the 2016 deal announcement, Genworth was an insolvency risk: some of its outstanding bonds yielded as much as 18% earlier that year, as it stared down an ominous wall of debt maturities—including one in 2018—and a declining earnings profile stemming from miscalculations in its LTC business.

The bout with distress was due in part to the company modeling for a long-term care insurance market future that never came to be. Instead, people were living longer than Genworth anticipated, requiring the insurer to pay out more in insurance coverage to its policyholders who were now living in costly nursing homes. In 2014, for example, its overall net loss was USD 1.24bn, driven by losses and reserve charges for LTC insurance. Since then, the company has been attempting to stabilize its LTC business by increasing premiums and modifying benefits.

On top of the USD 2.7bn deal price, Oceanwide kicked in additional capital commitments to help smooth over the regulatory process and support Genworth’s capital structure. Oceanwide agreed to inject USD 600m of cash, for example, to pay off Genworth’s USD 597m 6.515% unsecured note maturing in May 2018. But as the process dragged, the prospective buyer instead opted to simply anchor a term loan that Genworth issued earlier this year to refinance the maturity.

As it stands, on a sum-of-the parts basis, given the unexpected costs in Genworth’s LTC business and the runoff of its life insurance business (Genworth also operates a third segment – mortgage insurance), the company’s equity on a standalone basis would be valued at roughly USD 3 per share in a bull-case scenario, or zero in a bear case, according to a financial sector-focused buyside analyst.

Genworth, itself, has also said in filings that, absent the Oceanwide takeover and any other commitments of outside capital, its insurance ratings would be pressured, possibly leading to lost market share and limitations on its ability to issue new policies, which would ultimately crimp liquidity needed to service and refinance the more than USD 4bn of outstanding debt at its holding company.
 


Following the CFIUS approval, Genworth stock traded as high as USD 4.80 per share, up from USD 3.80 prior to the October 2016 announcement, but has since retraced some of the gains and trades at USD 4.42 today. That’s still more than a 18% dislocation from the takeout price of USD 5.43 per share, representing the ongoing regulatory risk of the transaction.

Trading in Genworth’s debt structure has followed suit. Its USD 381m 7.2% senior unsecured notes due 2021 traded up to 105 on the day of the CFIUS announcement from 99 in early June. The notes have since lost three points, and last traded yesterday at 102.25 and a 6.257% yield, according to MarketAxess.

Following completion of the deal, Genworth debt will remain outstanding, and would likely trade higher given the company's new position within a larger, supportive conglomerate, the sources said. "Overall, Oceanwide is not going to operate like a PE sponsor, and just hand over the keys and walk away if the business runs into more problems," said a source close to the deal.

Additionally, throughout the years-long regulatory process, the takeout price was never modified, despite several developments that further hindered the deal’s economics, the sources noted.

First, just as the deal was about to be announced back in 2016, Genworth came out with a huge reserve charge in its LTC business. At that point, Oceanwide could have tried to lower its price. But speculation that a takeover was imminent had already crept into Genworth’s stock price -- it traded around USD 5 per share leading up the announcement, just below the USD 5.43 per share price – complicating Genworth’s ability to take a lower price.

As part of negotiations with insurance regulators in Delaware, moreover, Genworth Life & Annuity (its life insurance business) and Genworth Life Insurance Co. (its LTC business) will no longer be “unstacked” according to the original terms of the deal. Genworth would have separated its LTC business from its more profitable life insurance business, allowing the new parent to isolate the troubled LTC business and potentially unlock capital from the life insurance business while protecting the ratings of its mortgage insurance business.

Though Oceanwide will not have to contribute the committed USD 525m to separate the businesses, it will also not have access to the potentially lucrative future dividends out of the life insurance business, the sources noted.

Instead, the parties are developing a USD 1.5bn contribution from Oceanwide that will be used to support Genworth debt maturing in 2020 and 2021, as well as potential growth opportunities, according to management comments.

“Oceanwide is absolutely still incentivized to close this deal,” the source close said. “They are all in, and will continue to pour money into it.”

Oceanwide did not respond to requests for comment. Genworth declined comment.