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Arrow Global Short Thesis

7-Mar-18

Subject: Arrow Global plc (ARW LN or Arrow) “The Red Pill” Short Thesis
To: The Sohn Conference Foundation Investment Idea Contest
From: Antonio Gurrea | antonio.gurrea@gmail.com | +44 077 3437 2615

Executive Summary
Arrow’s market capitalisation is only justified if you believe, going forward, NPLs will be purchased at prices that will yield much higher
returns than those achieved since the immediate aftermath of the global financial crisis. Arrow is levered in excess of its enterprise value,
destroys value, burns cash and faces an increasingly hostile regulatory and macroeconomic environment. I invite you to understand how
investors have been let down by regulators, accountants, rating agencies and sell-side research, resulting in valuations supported by a
flawed logic justified by complex accounting, sector-specific acronyms and misleading ratios used in investor presentations.

Introduction
Arrow is a European Debt Purchaser(1) with receivables in the UK (37%), Portugal (20%), Benelux (16%), Italy (18%) and Ireland (9%)
founded in 2005 by Zachary Lewy, (1.8% stake) and listed on the London Stock Exchange. Potential triggers for a re-rating in 2018 include:
- A decline in collections as older, more profitable, portfolios run off demanding even higher portfolio acquisitions to keep Expected
Remaining Collections (ERC) flat, further exposing the flawed business model and accounting inconsistencies.
- Moody’s, S&P and Fitch could decide to address the shortcomings flagged to them in their ratings methodologies in Q2’17.
However, drafting and publishing of new methodologies is likely to take some time.
- Several hedge funds are short across European Debt Purchasers and are becoming increasingly vocal.
- High levels of consumer credit, collection practices that fail to treat customers fairly and information asymmetries between buyers
and sellers have drawn the attention of regulators and will be addressed with new rules in 2018, resulting in a more competitive
and less profitable market both in the UK and across the European Union.
- Extraordinary expenses, redress, fines, higher collection costs and other operational disruptions(2) driven by changes to the
business model imposed by the Financial Conduct Authority’s (the FCA) final rules and regulations (expected in 1H 2018).
- Collection Costs in the UK are set to rise driven by FCA regulation and the increase in the National Living Wage(3).
- Capital markets events (Cabot IPO in Nov-17, Lowell 2L note refinancing, etc.) will keep media focused on the sector.
- Rising interest rates or a turn in the credit cycle could also negatively impact collections and the value of legacy portfolios.
- A decline in the London residential real estate market in 2018 could cause a “wealth effect” shock to consumers.
- Political uncertainty and instability across European Member States (e.g. Brexit, Cataluña) could erode consumer confidence.
- Other / unknown.

Increased competition and the depletion of the NPL stock resulting from the crisis have driven up portfolio prices (from 7p in the £ in ‘13 to
13p in H1’17 in the case of Arrow), driving down money multiples from 3.0x to 2.0x. Arrow and its competitors have continued to pay higher
prices for portfolios as they attempted to gain a competitive advantage through lower funding costs and higher leverage. While initially the
sector paid a premium vs. high yield, with a current 3.5% cost of funding, going forward, there is little more Arrow can do to in this respect.

The European post-crisis recovery has also created an adverse selection in the quality of Non-Performing Loans (NPLs). In scenarios of
increasing unemployment, otherwise creditworthy people may fall behind on payments. However, in benign economic environments such
as the present one, it is only the low-quality creditors that default. As a result, at present, there are fewer positive surprises to be expected
from European NPLs than in the years immediately after the global financial crisis. It is in this lower expected returns context that Arrow is
ramping up its NPL portfolio acquisitions.

Notes:
1
Cabot, which is expected to list on the London Stock Exchange in Nov-17 with a market capitalisation of £850m to £900m is the largest Debt Purchaser in the UK.
2
Provident Financial Group plc posted two profit warnings (link, link) related to operational disruptions caused by changes introduced to meet regulatory requirements.
3
The UK National Living Wage is being phased in between Apr-16 and Apr-20, with the aim of reaching 60% of median UK earnings by 2020 (link).

1
Background to Credit Management Services Companies
Credit management services companies are Non-Bank Financial Institutions (NBFIs) active in the NPL market and can be broadly classified
into (i) companies that acquire NPL portfolios (the Debt Purchasers) and (ii) companies that service NPL portfolios for third party investors
(the Debt Collectors, 3rd Party Servicers or 3PS). Most credit management services companies operate a business model which is a mixture
of the Debt Collector (asset light) and Debt Purchaser (asset heavy). Credit management services companies share characteristics with
banks (NPL assets) and corporates (liabilities(4)), requiring a multi-disciplinary approach to understand the business model and the financial
reporting (accruals accounting). The key market consensus arguments for why European Debt Purchasers are attractive and their respective
counter-arguments apply not only to Arrow, but also a number of other European Debt Purchasers.

Market Consensus Key Arguments & Challenges to Market Consensus Key Arguments
1A. EBITDA margins are high (> 70%);
1B. EBITDA is overstated due to the under-amortisation of portfolios. EBITDA is not recurring and is generated by a depleting asset base;
2A. Leverage, when calculated as Net Debt / EBITDA is moderate (3.9x);
2B. Leverage is high (Net Debt / EBITDA adjusted for under-amortisation > 6.0x);
3A. Asset coverage is high, with Loan-to-Value (LTV) metrics calculated as Net Debt / ERC 60%;
3B. Net Debt / ERC net of Collection Costs > 100% before adjusting for the over-statement of ERC due to under-amortisation of portfolios;
4A. Capex is low (3% - 5% of revenue);
4B. Capex is low if reinvestment in portfolios to keep ERC flat is ignored (50% of Collections would be consistent with 2.0x Money Multiples);
5A. Debt Purchasers have historically accurately forecasted collections 10 years into the future with ±3% margin errors;
5B. Debt Purchasers report aggregated quarterly collections (i.e. not by portfolio or vintage), which can be gamed by acquiring more
portfolios or working the accounts harder (which may entail greater costs than collections). The profitability across NPL vintages varies
significantly. Anyone who claims they can forecast NPL collections nine, ten or fifteen years down the line with < 5% error is highly suspect;
6A. Low interest rates support continued ability to repay;
6B. Rate hikes in the short term in the EU and in the UK are increasingly likely;
7A. Cash conversion is high due to collections being 2.0x purchase price;
7B. Free cash flow generation is de minimis or negative once collection costs, overhead expenses, legal costs, portfolio replacement capex
and interest are taken into consideration;
8A. Deleveraging is quick if collection proceeds are not reinvested (Collections in the next 12 months are 30% - 35% of the book value);
8B. Failing to reinvest in portfolios would ensure a steep decline in Collections and EBITDA;
9A. European Debt Purchasers are a growth story, with double digit year-on-year growth in EBITDA and ERC;
9B. EBITDA and ERC growth has been entirely funded by debt. Spreads have declined while leverage has increased;
10A. Rating agencies will never change the methodologies;
10B. Rating agencies regularly review and amend methodologies. Having spoken to the analysts covering the sector, I know they fully
understand the arguments herein and largely agree with them;
11A. The European NPL market is a growing market as additional jurisdictions become mature markets;
11B. Whether the NPL market grows or not is irrelevant if the business model does not create value or generate cash;
12A. The NPL market is countercyclical;
12B. Collections are correlated to GDP, employment and confidence. It is only after a crisis that NPLs acquired before a crisis outperform;
13A. European Debt Purchasers have outperformed their benchmarks in the recent past (debt and equity);
13B. Credit outperformance has been achieved due to payment of “make-whole” as bonds were refinanced at lower spreads. With certain
European Debt Purchasers funding 5-year unsecured notes at less than 3%, there is little room left for credit outperformance. Equity
outperformance has driven IPO exits and insiders to sell their holdings. Arrow shares are no longer at all-time-highs; and
14A. “There is a ton of equity in these businesses, look at the market cap. What will make them implode? There is no catalyst!”
14B. Scrutiny from investors, regulators, auditors, rating agencies and the press will trigger a loss of confidence in European Debt
Purchasers as the flaws underpinning current valuations are exposed. A recent article in Grant’s Interest Rate Observer has been followed
by articles in Bloomberg and mainstream media.

Notes:
4
European Debt Purchasers have issued in excess of €10bn in bonds since 2013 according to Bloomberg.

2
Overview of the Economics of Debt Purchasers
Illustrative Cash Flows Although the analysis presented on the left is an oversimplification(5) of a Debt Purchaser’s
84 Month ERC 100.0
Collections 100.0 economics over a seven-year period, it illustrates that:
Collection Costs 30% (30.0)
EBITDA 70.0 - Revenue, EBITDA, Net Profit, ERC and the Book Value of Portfolios can be overstated
EBITDA Margin (%) Money Multiple 70%
Purchase Price 2.0x (50.0) by under-amortising portfolios (i.e. If Portfolio Amortisation over 7 years < Purchase
Free Cash Flow Before Financing Interest Yrs. 20.0
Less: Interest 3.5% 3.5 (6.1) Price). This concept is similar to depletion for oil drillers;
Free Cash Flow Before Capex, Tax… 13.9
- Keeping Collection Costs under control (below 30% of Collections) is vital; and
Net Debt D / (D + E) 100% 50.0
EBITDA per Annum 10.0 - The margin for error, as measured by the average annual ROE 4%.
Net Debt / EBITDA 5.0x
FCF Bef. Fin. / Interest 3.3x
Net Debt / 84 month ERC 50.0%
Equity Yield / Margin of Safety 4.0%

Accounting Inconsistencies and Pitfalls – The Role of the Auditors


IFRS gives Debt Purchasers leeway to game their results via mark-to-model accounting of the book value of portfolios. Portfolios are valued
at purchase price the first year, and subsequently valued upwards or downwards based on management’s assumptions going 10 to 15
years into the future. Revenues are computed using the Expected Interest Rate (EIR) method and are equal to the difference between
Collections and Portfolio Amortisations net of Write-ups. Write-ups are calculated by “adding one more year of collections” to the tail (implying
NPL cash flows are perpetuities with a certain rate of decay). Hence mark-to-model providing significant leeway to game Revenue, EBITDA,
Net Profit, ERC and the Book Value of Portfolios. Across European Debt Purchasers, the average Money Multiple Debt made on portfolio
acquisitions is 2.0x, however, the amortisation rate used on Arrow’s portfolios is closer to 30%. The amortisation rate of portfolios that would
be consistent with a 2.0x Money Multiple is 50%. As a result, Arrow’s Revenue, EBITDA, Net Profit, ERC and the Book Value of Portfolios
are all overstated. Over 100% of Arrow’s Net Profit since 2010 can be attributed to under-amortising portfolios and Loans Receivable may
have been overstated by c.£250m from Jan-10 to Dec-17.

Rating Methodologies – The Role of the Rating Agencies


The methodologies used by S&P, Moody’s and Fitch for rating Debt Purchasers are inadequate. These methodologies were developed for
a broad range of business models and fail to capture Debt Purchasers’ leverage and cash flow generation due to a rigid focus on misleading
metrics. Rating agencies also fail to adjust for distortions caused by under-amortising portfolios. I have explained to the rating agencies the
importance for them to develop a separate methodology with focus on meaningful balance sheet and cash flow metrics. I believe the purpose
of S&P’s CCC rating is precisely to identify companies such as Arrow that burn cash, destroy value and are not able to meet their financial
commitments other than through additional capital raising. Rating agencies argue this is not the case as they believe Arrow is unlikely to
default in the next 12 months, a requirement for CCC rating.

Regulation of Consumer Credit – The Role of the Financial Conduct Authority and Other Regulatory Bodies
In Apr-13, the FCA replaced the Financial Services Authority and became responsible for the conduct supervision of all regulated financial
firms in the United Kingdom. The main goal of the FCA is to ensure the relevant markets function well. To support this, it has three operational
objectives: (i) to secure an appropriate degree of protection for consumers; (ii) to protect and enhance the integrity of the UK financial
system; and (iii) to promote effective competition in the interests of consumers (6). Since 2013, numerous rules and regulations relevant to
UK Debt Purchasers have been implemented. For example, the Pre-Action Protocol for Debt Claims came into effect in the UK in Oct-17,
limiting the circumstances in which proceedings may be commenced in the UK. Additional rules and regulations are expected to be published
by the FCA in the coming months.

Historically, one-off settlements have accounted for c.30% of Arrow’s collections, the balance being collected through long term payment
plans. The FCA’s new rules and regulations view long term payment plans more favourably than one-off settlements. A change in the mix
driven by regulation could push out collections on portfolios that have already been acquired and further erode returns.

Notes:
5
The analysis gives full credit to management’s 84-month ERC. Cash outflows such as Capex and Tax, for example, have been excluded for simplicity. Interest is assumed to accrue
for 4.0 years, reflecting a reduction in gross debt inconsistent with capital structures funded with bonds.
6
Please refer to the Financial Conduct Authority’s Consumer Credit Sourcebook 7.3.2 (link).

3
Regulation of Listed Companies – The Role of the Financial Conduct Authority
In addition to the use of accounting inconsistent with the true economics of the business, certain metrics included in Arrow’s Investor
Presentations are irrelevant and / or misleading. The market consensus is clearly misinterpreting them and mispricing securities on the back
of those metrics. I believe this issue should be brought to the attention of the regulator(7). Examples of such metrics include:
- LTV metrics based on gross ERC such as “Secured Net Debt / 84-month ERC”;
- Leverage metrics such as “Secured Net Debt / Pro-Forma LTM Adjusted EBITDA”;
- Interest Coverage metrics such as “LTM Cash Interest Cover”;
- The “Cost-to-Collect percentage”, which considers only “Collection Activity Costs” and excludes (i) “Other Operating Costs”, a
significant part of the costs which are directly or indirectly related to collections and (ii) “Portfolio Expenditure and Recoverable
Litigation Expenses” (£23m in 2016), which are capitalised and therefore only go through the P&L gradually as they are amortised.
- The methodology proposed by management for obtaining replacement capex implies NPL portfolios are perpetuities with a decay
rate as opposed to being assets with a finite life. A replacement capex equal to 50% of collections would be consistent with the
2.0x Money Multiples that Arrow and management of other European Debt Purchasers say are obtainable in current markets.

Valuation
I value Arrow using a Sum-of-the-Parts approach in the range of £952m and £1,156m. Whether we consider balance sheet (i.e. Book Value)
or Expected Remaining Collections metrics, there is significantly less value (if any) in excess of Arrow’s net debt than what equity price in.
- 100% of Expected Remaining Collections are assumed to be collected in 7 years (84 months);
- The £250m potential overstatement of the receivables book resulting from historic under-amortisation is not considered;
- 30% collection costs rate, adjusting Arrow’s LTM 63% collection costs(8) as a percentage of collections for implied 3PS costs;
- I assume Arrow repays gross debt with collection proceeds result in in a duration of debt of 3.5 years vs. the 7 years of collections;
- I assume a stable Weighted Average Cost of Debt at 3.9%; and
- I value the 3PS business (generously) at £43m assuming two rather toppy assumptions: 10% EBITDA margin for what is
essentially business process outsourcing and a 6.0x EBITDA multiple. The value of this segment is so small, even the most
absurd valuation metrics would not support Arrow’s current market capitalisation.

120m 84m Book


(£ in millions) ERC ERC Value
Expected Remaining Collections (ERC) %of Collections Duration Gross 1,780 1,517
Collection Costs (Excluding 3PS Costs) 30.0% (Years) Debt (534.1) (455.1)
Interest 3.90% 3.5 975.7 (133.2) (133.2)
Net Value to Noteholders from Portfolios 1,113.0 928.7 951.5
LTM 3PS Est imat ed 3 PS EB IT D A xEB IT D A

Revenue M argin (%) Amount 6.0x 6.0x 6.0x


3rd Party Servicing (3PS) 71.1 10.0% 7.1 43 43 43
Enterprise Value 1,156 971 994
Net Debt (941) (941) (941)
Implied Equity 215 30 53

Loan-to-Value 81% 97% 95%


ARW LN Share Price Dow nside Potential (65%) (95%) (91%)

Conclusion
I recommend shorting Arrow equity as I believe it is not only an attractive alpha-generating absolute-return trade in its own merit, but also a
good macro hedge against the economic cycle in the UK and the credit cycle. Arrow is the most compelling trade in European Debt
Purchasers, but it is not the only one. Arrow is but the tip of the iceberg; to varying degrees, similar conclusions can be drawn from Axactor,
B2Holdings, Cabot, Get Back, Hoist, Intrum, Kruk, Lowell, MCS as well as American peers encore and PRA. It will only take a misstep in
one of them for the rest to follow. Call to discuss.

Notes:
7
The FCA’s stance on misleading investors can be summarised in the following quote from Andrew Bailey, CEO of the FCA “Dissemination of information that gives a false or
misleading impression as to traded securities harms the integrity of our markets. The FCA is committed to UK markets being fair, transparent and thus competitive”. The Financial
Conduct Authority has previously fined companies for misleading investors (link, link).
8
Collection costs including the reported “Collection Costs” and “Other Operating Expenses”.