American Capital: Agrees to Deal w/ ARCC, ARES, AGNC

Well this news was a bit anti-climatic, today American Capital (ACAS) agreed to a series of transactions with Ares Capital (ARCC), Ares Management (ARES), and American Capital Agency Corp (AGNC) that total up to a $17.40 stock and cash deal for the activist targeted BDC.  The deal represents about an 11% premium to Friday's close, the shares traded only marginally higher leaving the merger arbitrage spread at about 9.5% (ARCC traded down).  While the premium was initially a bit disappointing, the deal is a good one for all sides (including ACAS management) and creates a few interesting opportunities in some of the secondary entities around the deal.

Details:

• Ares Capital Corp (ARCC), the largest BDC and externally managed by ARES, will pay ACAS shareholders $6.41 in cash plus 0.483 shares of ARCC.
• American Capital Agency Corp (AGNC), the larger of the two ACAS managed mortgage REITs will internalize management and pay $2.45 in cash to ACAS shareholders.
• Ares Management (ARES) will pay $1.20 in cash - presumably for the non-mortgage REIT related asset manager businesses (CLOs, PE Funds, and the orphaned ACSF).

There is some conflicting information on when the deal will close, the presentation and corresponding call mentioned end of 2016 (or six months was referenced a couple times on the call), while the press release stated 12 months.

American Capital's non-diluted NAV was $20.14 on 3/31, so despite the recent ~$600MM in announced asset sales at or above book value, plus the huge share repurchases below book value, most of that activity only semi-masked the management incentive compensation dilution, losing the deferred tax asset (change of control) and a cool $200MM in estimated deal related costs (unsure if this includes management's golden parachutes - see page 35).  The dangers of investing in BDCs.

The merger arbitrage spread is fairly wide for a deal that's almost certain to close as it has clear benefits for the acquirer and has been fully shopped by ACAS.  If the deal does close by year end as mentioned in the presentation/call that creates a very attractive annualized return.  I'll probably hold onto my shares a while longer and wait for that spread to close a bit.

Additional Thoughts:

• The ACAS portfolio is a jumbled mess (middle market loans, private equity deals, and the asset manager), a small reason in comparison to overpaid management for the discount to NAV, but ARCC by contrast is much cleaner with a portfolio consisting mostly of leveraged loans that enable them to pay a high dividend, more of a BDC 2.0 that followed the original BDCs of the 1990s that ARCC has now swallowed up (ACAS, Allied).  Ares Capital is going to recycle the acquired portfolio and reinvest in more straight forward assets, the market places a higher value on simplicity (similar to what Gramercy Property Trust is doing with the Chambers Street merger), so I can see this being a slight win to ARCC shareholders.  Acquire a messy portfolio at a discount, hopefully sell most of the portfolio for the marked value, and then reinvest in something investors will pay up for like leveraged loans that enable dividends.
• After the externalizing management trend of 2012-2014, it seems to be reversing into an internalizing management trend, similar to how conglomerates go in and out of style.  We saw Colony Financial acquire their manager Colony Capital and now the merged Colony Capital (CLNY) is buying Northstar Realty Finance (NRF) and its manager Northstar Asset Management (NSAM) only a short time after NSAM was spunoff from NRF.  Ashford Inc (AINC) and Fifth Street Asset Management (FSAM) are facing similar activist pressure regarding the inherent conflicts of interest between fat asset management fees and a captive permanent capital entity.  The ACAS news is positive for AGNC shareholders now that they will be internalizing their manager, and even better news for the smaller ACAS managed mortgage REIT, American Capital Mortgage Investment Corp (MTGE), as it seems likely MTGE (which will now be externally managed by AGNC) will be folded into AGNC.  Maybe they could sell the cute ticker to an ETF company for additional consideration.
• The smallest of the ACAS captive entities is American Capital Senior Floating (ACSF), a BDC with just a $100MM market cap and trading at 85% of NAV, hard to imagine that Ares will keep this as a standalone entity, it could easily be folded into ARCC at something short of NAV and be a win for both sides.
• Ares Management (ARES), the asset manager, is also making out nicely in the deal, they'll add about $4B in assets to their externally managed ARCC.  It's a backdoor way of justifying a capital raise for a BDC that's trading below NAV.  At a 1.5% base management fee that's additional $61.5MM annually (they are waiving $10MM in fees for the first 10 quarters post close), plus they get a 20% incentive fee on income as long as they meet their 7% hurdle rate, it's good to be the manager of a BDC.

Disclosure: I own shares of ACAS

Pinnacle Entertainment: GLPI Deal Complete, OpCo Spinoff

In the fall of 2013, regional casino operator Penn National Gaming spunoff Gaming & Leisure Property Inc (GLPI) to hold their real estate assets and lease them back to Penn on a triple-net lease basis where the tenant is responsible for all the maintenance, taxes, and insurance.  The idea behind the move was a simple one, the market places a higher multiple on net lease REITs than it does gaming companies, so by separating the two, value is unlocked.  More recently, MGM did a similar move with MGM Growth Properties, and Caesars is contemplating the same within bankruptcy, it's becoming the industry standard operating model.  However, the IRS is starting to take a harder stance on REIT spinoffs which may lead to more scrutiny and give an advantage to those like GLPI who are already operating as REITs.

Following the Penn transaction, many investors looked to Penn's closest rival in the regional gaming sector, Pinnacle Entertainment (PNK), and pressured them to do a similar real estate spinoff transaction.  Concurrently, GLPI investors had been pressuring the REIT to diversify their tenant base as nearly all their casinos were leased back to Penn, a more diversified tenant base would lead to a higher valuation.  In July 2015, Pinnacle and GLPI came together in a deal that closed last month where GLPI acquired all of Pinnacle Entertainment and then simultaneously spunout the operating business under the same PNK ticker, creating "new" Pinnacle.

In the transaction, Pinnacle shareholders received 0.85 shares of GLPI and 1 share of new PNK for every share of old PNK they owned.  In effect, its a special dividend that recapitalized the company, much of the old debt moved to GLPI with the real estate and was replaced by a big capitalized lease payment.  The master lease has an initial term of 10 years, plus 5 options periods at Pinnacle's option for 5 years each.  The lease payment functions as an interest payment, except Pinnacle doesn't have to repay or refinance the debt, making it less risky in the event capital markets shutdown for a period of time.  While the lease is essentially debt, and I would treat it that way, it's not quite the same and when looking at the implied leverage ratio including the lease.

New Pinnacle Entertainment

The company now operates 15 properties (casinos, racetracks, hotel combinations) across 7 states but is relatively concentrated in Missouri (both Kansas City and St. Louis) and Louisiana with no exposure to Las Vegas or Macau as its larger peers.

Their biggest revenue generating casino is the L'Auberge Lake Charles in Louisiana that opened in 2005, in 2014 the Golden Nugget Lake Charles opened up next door creating competition, but in a "frenemy" sort of way as it's expanded the market, creating more of a regional weekend destination.  Visitors from nearby Houston (and it's energy economy problems) like the ability to easily go from one venue to the next, both have golf courses, spas, complementary restaurants and shuttles between the two properties.  In listening to recent earnings calls across the sector, gaming appears to finally be picking up around the country as consumers have more money to spend and have been moving away from retail to more experienced based spending.

One benefit of having casino REITs is their ability to acquire gaming assets at accretive prices given their low cost of capital, turn around and sell the operations to someone like Pinnacle and make the deal a win-win for both, essentially doing the REIT spinoff in reverse with the same benefits.  GLPI is doing just that with a racetrack and casino property, The Meadows, in Pennsylvania where it paid $440MM in December and sold the operations to Pinnacle for $138MM, which will close in the third quarter.  Ideally, the casino REITs aren't going to want to run the casino operations (GLPI has two they operate for spinoff tax reasons), but they'll be the most flush acquirers of properties that come up for sale giving operators like Pinnacle a source of new deals.  For The Meadows specifically, Pinnacle purchased the property for 6.4x TTM EBITDA and believes they can get an additional $10MM in synergies as it has been run as standalone business dropping the multiple below 5x EBITDA.

Proforma for The Meadows acquisition, Pinnacle did $645MM of TTM EBITDAR (R is rent to account for the capitalized lease expense), they have $130MM in cash, $968MM of conventional debt, and the lease obligation is $2.78B for a total enterprise value of $4.33B or an EBITDA multiple of 6.7x.  Penn National Gaming, it's closest peer in both markets and structure, trades for 7.4x EBITDA, which doesn't sound like a big difference, but when they're both as levered as they are PNK's market cap has some catching up to do.  Without the lease obligation and subtracting out the related rent payments, Pinnacle trades just under 6x EBITDA.

If the market valued Pinnacle at the same EBITDA multiple as Penn, it would be $18-19 versus ~$11.50 today.

Management in their roadshow presentation also laid out the case that Pinnacle was undervalued based on FCF (although a highly levered free cash flow).  On a free cash flow basis bumping it up to PENN gets closer to a $13-14 share price, still a fairly significant disconnect, it's probably worth somewhere in between the two metrics at $14-18 per share.

Overall, we have a slowly improving economy that's bring back some discretionary spending, a quality management team that has consistently driven margin improvements across their properties paired with some spinoff and odd accounting dynamics that are creating a temporary (hopefully) discount in Pinnacle's share price.

Risks:

• Leverage - Management will point to their conventional debt leverage in most discussions, which isn't entirely the wrong way to look at it since it's how their covenants are structured, but it's important to view the GLPI lease as debt when considering the entire picture.  With the GLPI lease, Pinnacle is about 5.6x levered, high for a cyclical consumer company and that leverage can cut both ways in a recession.  On just the convention debt, it's 3.6x levered.
• Lake Charles - Their Lake Charles casino is facing new competition at the same time as the downturn in energy is taking its toll on the Houston and Louisiana economies.
• Competition - Regional casinos were overbuilt in the last two decades, new supply is slowing outside of the northeast, Pinnacle doesn't anticipate any significant new competition coming online in their markets soon.  But local and state governments are always looking for new tax sources and as the economy picks up and casinos do well, its probably only a matter of time before additional gaming licenses are issued.

Disclosure: I own shares of PNK

Par Pacific Holdings: Update, Distressed Energy M&A Thesis

I received the Par Pacific Holdings (PARR) annual report in the mail this week and thought it made sense to revisit my initial thesis in an updated post now that I've spent more time on the company in the past 20 months I've owned it.  Last fall Par Pacific changed the holding company's name from Par Petroleum, and renamed their Hawaiian operations Par Petroleum, which coincided with Bill Pate being appointed CEO and signaling the future direction of the company.  Par Pacific traces its roots back to 2012 when it was known as Delta Petroleum, a failed natural gas producer that went through bankruptcy and ended up in the hands of creditors, the largest of which was Sam Zell's organization through the Zell Credit Opportunities Fund.  In the reorg, $265MM in debt was converted to equity and the $1.4B in net operating losses were preserved giving Par a significant tax shield as they pursue an acquisition strategy.

Sam Zell built his reputation and wealth as a distressed investor, and with much of the energy industry in distress, Par Pacific Holdings is a way to invest alongside him and his management team in an environment that should see plenty of attractive deal opportunities.  The bulk of Par Pacific today was created through two acquisitions of refining and retail assets in Hawaii.  In 2013, they bought Tesoro's Hawaiian operations for $75MM plus a $40MM earn out and in 2015 they paid $120MM for Mid Pac Petroleum (primarily retail locations).  Last year alone these assets generated $110MM in EBITDA.  Distress in the upstream oil and gas sector is migrating down to pipeline and retail players, Par Pacific's main focus going forward.

In current form, the company has three primary assets: Par Petroleum (Hawaiian downstream business), Laramie Energy (Colorado based natural gas E&P), and the tax assets.

Par Petroleum: Refinery, retail distribution network and related logistics assets located in Hawaii.

• Tesoro had mothballed their Hawaiian refinery and related assets, running them as an import, storage and distribution terminal while running an asset sale.  Most everyone passed, Tesoro wrote down the refinery to nothing, and then eventually Par came along and scooped it up for $75MM plus working capital/inventory.  Why did Par get a deal?  Tesoro made the strategic decision to exit Hawaii and focus on a new large acquisition it made with BP's old refinery in Southern California that could be operationally leveraged with Tesoro's in the same vicinity.  The Hawaiian business provided limited operational synergies and was a small piece of Tesoro's overall refinery business.  With no other buyers, Tesoro was able to effectively reallocate $325MM of net working capital to a more productive project for them with Par as the beneficiary.
• Being isolated in the Pacific Ocean, in order to drive profitability Par needed to increase it's on island sales otherwise it's expensive to ship refined product to either the west coast or Asia ($6 per barrel).  In 2014/2015 Par announced and closed on the acquisition of Mid-Pac Petroleum - 80 retail sites throughout the Hawaiian Islands.  The Mid Pac deal helps Par sell their refined product locally and internalizes consumption allowing Par to get both retail and refinery margins.  On a standalone basis the price wasn't outstanding, but the operational synergies Par will be able to squeeze out of their refinery makes it a transformational one.  They also own the land under 20 of the retail locations, so they have the ability to do a sale leaseback in the future.  With the Mid Pac retail locations, Par currently has 91 locations under the Tesoro and 76 brands, about 20% of the overall Hawaiian market.
• Management still believes there are acquisition opportunities in Hawaii, most likely additional retail to further drive the on island sales to match the output at the refinery, limiting the need to export.
• Later this year they will need to spend $30-35MM in maintenance capex at the refinery.  I assume/hope they will do their best to run at peak capacity around the scheduled down time in order to minimize impact.  Management has guided that the refinery will run at 1/2-2/3 capacity in the 3rd and 4th quarters.
• The refinery competes with one other in Hawaii, also located on Oahu, it was previously owned by Chevron and had shopped extensively until it was recently acquired by a private equity firm this month.  It's about half the size and Par was optimistically thought to potentially be a buyer of some Chevron assets, but regulators probably wouldn't have it.  The sale is likely just neutral for Par until we know more about the new owner's intentions.
• Par recently started breaking out their logistics assets as a separate reporting segment even though all sales are inter-company transactions and consolidated for reporting purposes.  But this change potentially signals further midstream acquisitions and in a distant future where MLPs make sense again they could sponsor their own and drop assets down.
• The combined Par Petroleum segment did about $110MM in 2015 EBITDA, which will probably come down some in 2016 with crack spreads coming in and the planned downtime at the refinery.

Laramie Energy: A minority interest in a privately own natural gas exploration and production company located in the Piceance Basin in Colorado.  This started as a legacy asset of Par's predecessor Delta Petroleum.

• In March, Laramie Energy completed a bolt on acquisition of nearby acreage for $157.5MM with Par contributing $55MM.  As a result of the deal, Par Pacific now owns 42% of the common equity and accounts for the position using the equity method.  Par's additional investment essentially created their own balance sheet write-down as of 12/31/15, the better the deal for Par the larger the write-down they needed to take.  But proforma for the acquisition, Laramie has a book value of $131MM.
• The timing of when the new acreage came up for sale wasn't ideal, management had been out in the investor community discussing mid and downstream acquisition targets but since this was adjacent to their existing JV the deal had a lot of strategic/operational value similar to what Mid Pac accomplished in Hawaii.  They know the area, and can spread their overhead costs over a larger asset base giving them additional leverage if the natural gas market recovers.
• Bob Boswell runs Laramie Energy, he's an industry veteran, currently serves on the board of Cabot Oil & Gas and has a history of starting and selling oil and gas producers.  In 2007, the first iteration of Laramie Energy was sold to Plains Exploration and Production for $1B, three years after the company was setup for $200MM (plus bank loan debt).
• Management seems realistic about this asset and has limited drilling planned for the near future.  They've also hedged much of Laramie's production through 2018, giving it the ability to wait out the cycle for a few more years.  It's mostly an upside option on natural gas prices.

NOL Tax Asset: $1.4B in net operating losses that can be used to offset future taxable income.

• Why do I like NOLs?  They attract long term investors that understand the importance of capital allocation and generally create an incentive to purchase cheap free cash flow businesses in order to monetize the NOL quickly.  The sooner the NOL is used up, the more valuable it becomes.
• Having the NOL reduces Par Pacific's cost of capital allowing them to be more competitive (pay a higher price) for acquisitions.  It also gives them additional flexibility in an asset sale (Laramie Energy for instance) where they could be more agreeable to a deal well above their cost basis knowing they have an NOL in place to shield capital gains.
• It is slightly tough having energy assets in an NOL heavy corporate structure, many energy businesses have built in tax shields to their business.  Par hasn't made much, if any, progress yet in monetizing the NOL, they're going to need a couple sizable acquisitions in coming years to start making a dent.

Valuation:

Below is a quick and dirty valuation for Par Pacific, refiners trade for 4-6x EBITDA, midstream trades 12-15x EBITDA, and retail seems to trade around 8x EBITDA.  For Laramie Energy, it's probably simplest to use the equity method book value; I'm thoroughly ignorant to how oil and gas companies are valued.  If anyone has any specific thoughts on Laramie's value, I'd love to hear them. 

At current prices, you're paying a cheap to fair price for the current assets and you get the acquisition runway/management as an upside option.  But I understand if non-shareholders would want to wait to see the next acquisition, it could create a better buying opportunity especially if it's paired with a rights offering.

Additionally, it seems like once a year the stock tanks for no apparent reason, in the summer of 2015 the company filed a shelf registration per the Shareholder Rights Agreement with Zell and other large shareholders which gave them the option to sell, but didn't actually mean they were going to, the stock sold off as if everyone was exiting and it went on to recover fairly quickly.  Shareholder Rights Agreements are one of those filing events to look for as some people sell first and ask questions later.

Risks:

• Hawaii - The state is a difficult place to do business, its heavily regulated and communal, they don't like outsiders running critical businesses in their state as can be seen with the Hawaiian Electric - NextEra merger drama.  Politically the state has a long term plan to move away from fossil fuels and have their energy needs provided 100% by renewable energy sources by 2045.  I would assume its safe to say that the military, tourism and other industries will still require refined products but there might not be room for two refineries long term if Hawaii meets its renewable energy mandate.
• Roll-up/Acquisition Strategy - Par Pacific describes itself as a growth company and most of that growth will come from repeated acquisitions funded through repeated capital raises.  The serial acquisition platform companies of the recent cycle have made roll-ups a dirty word as cheap debt and giddy equity markets led to some questionable deals and following meltdowns.  With Par Pacific you must believe in management's ability to identify attractive deals and not overpay for them.
• Equity Raises - Par Pacific will be a serial issuer of private placements or stapled rights offerings to fund its larger acquisitions in order to maintain the NOL asset.  Rights offerings are usually done at a discount, so shareholders will need to participate in them or be diluted.  I don't have any evidence to back this up, but it also seems to create a ceiling on the share price as investors become concerned that as the share price rises that management will use it as an opportunity to issue more equity.
• Natural Gas - After the recent bolt on acquisition, Laramie Energy is now a larger part of the company at a time when natural gas is as cheap and abundant as it has been in a long time.  Many oil and gas companies are going bankrupt, others have pulled way back on production, maybe at some point in the distant future natural gas prices will rise again, but they're likely to stay low for the foreseeable future.

Disclosure: I own shares of PARR

Interval Leisure Group: Reverse Morris Trust with Starwood

The bidding war for Starwood Hotels (HOT) between Marriott International (MAR) and Chinese insurance company Anbang grabbed a lot of headlines in the past month as Marriott eventually won after Anbang mysteriously dropped out. Caught up in the bidding war and subsequent merger arb trading are shares of timeshare vacation company Interval Leisure Group ("ILG" shares trade under IILG).  ILG struck a separate deal on October 28, 2015 for Starwood's timeshare subsidiary named Vistana Signature Experiences (previously set to be spunoff by Starwood) in a reverse morris trust transaction where Starwood would spinoff Vistana and immediately merge it with ILG.  The transaction will be tax free to Starwood shareholders, and after the merger, Starwood shareholders will own 55% of the new ILG with pre-deal ILG shareholders owning the remaining 45% of the shares.

The two Starwood deals happening parallel creates two technical, maybe non-economic, reasons why ILG's share price has fallen 35% since the deal announcement (there are other reasons discussed below as well): 1) if a Starwood shareholder was going to sell the Vistana spinoff anyway, well now they have a currency in ILG stock to do so before the spin date, essentially pulling forward some of the typical spinoff selling dynamics, 2) merger arbitrage investors are shorting ILG along with Marriott shares to capture the Starwood/Marriott spread.  While in both cases, the ILG shares sold short will be covered with new shares issued at the end of April when the deal closes, thus not creating a short squeeze, but after the deal is completed investors will begin to look forward and see a cheap company trading at ~7x EBITDA while its closest peers trade 9-10x EBITDA.

Any timeshare related bull thesis has to first acknowledge this is an industry with a questionable end value to its customers.  Most timeshares are sold, not bought, via free seminars where high pressure salespeople pitch people while they're on vacation to drop tens of thousands of dollars on a timeshare so they can relive their vacation year after year in perpetuity.  For most travelers this transaction is dubious, but maybe for a small subset who want to return to a resort year after year and stay in a suite larger than your typical two queen hotel room, a timeshare might make some sense.  But for many I suspect that they fall for the romanticism of owning a tiny piece of paradise without fully considering the annual maintenance fees and quickly depreciating (in many cases to $0) initial investment, it's a vacation home for people who can't afford vacation homes.  Even so, billions worth of timeshares are sold annually and the business of servicing and managing those timeshare units can be a good profitable one.

Interval Leisure Group was a 2008 spinoff of Barry Dillar's IAC which at the time was 30% owned by John Malone's Liberty Media, that ILG ownership has since been transferred to Liberty Ventures (LVNTA, a tracking stock of Liberty Interactive).  Historically, ILG has operated in the asset lite timeshare exchange business where they run Interval International, the second largest exchange behind Wyndham's RCI, allowing timeshare owners who pay a $89-129 annual subscription fee to trade their weeks/points with other timeshare owners.  Developers sign up with Interval International and often pay the initial year or two subscription in order to sweeten the pot and make timeshare ownership a bit more appealing to buyers by giving them flexibility to visit other locations/resorts.  This is a sticky business with a 90% annual renewal rate.

Over the past several years, ILG has also gotten into the vacation rental business (primarily in Hawaii) and other attractive management fee revenue businesses around the timeshare ecosystem.  In 2014, they purchased the timeshare development and management business from Hyatt where they have a licensing agreement to use the Hyatt name to develop and manage more timeshares, they build resorts and sell off the timeshare units while collecting an ongoing management fee.  As the timeshare industry has continued to consolidate, ILG's exchange business has faced competitive pressures as larger developers create their own internal/closed exchange network and don't sign up with ILG.  In order to feed the exchange and management contract businesses, ILG needed to increase their development/sales arm as more timeshare companies become vertically integrated.

Vistana -  Starwood's timeshare resorts under the Sheraton, Westin, St. Regis brands - will give ILG exactly that, it dramatically increases the timeshare (vacation ownership) sales piece of ILG.  Timeshare sales is a capital intensive and cyclical business, much more so than the legacy ILG business, so this feels like a defensive merger to quickly vertically integrate and protect the fee revenue businesses going forward.

The less enticing reason why ILG has fallen significantly since the merger announcement is the market believes they overpaid, at least when looking at near term multiples.  It's a stock for stock deal, but at the time of the press release the deal was valuing Vistana at $1.5B on only $125MM of EBITDA, at least two turns above where peers were trading and it looked to dilute ILG shareholders.  But in order to get comfortable with the multiple paid you have look a little longer term, Vistana includes over $500MM in timeshare mortgages that could be securitized and turned into cash, 5 standard hotel resorts that will be refashioned into timeshare properties, and additional development opportunities at Vistana's 22 current resorts.  All in, they estimate that Vistana comes with $5.5B in future timeshare inventory that can be sold, and then added to ILG's recurring fee ecosystem.

Tucked away in the merger documents (page 98) Vistana breaks out their long term projections all the way out to 2024, likely in response to the market's reaction to the sticker price, but also to show the value in the inventory pipeline:

Be a little skeptical but it provides some perspective on the headline price tag.

Valuation
To keep things relatively simple, ILG is expected to do $185MM in EBITDA in 2016, Vistana is expected to do $148MM (both from the most recent prospectus), assuming no deal synergies (guided to $26MM annually after 5 years) and subtracting out $18MM of stock based compensation gets a proforma 2016 EBITDA run rate of $315MM.  The new share count will be just under a 130 million, at $13.35 per share, that's a market cap of $1.733 billion, the new ILG will have $464MM in net debt (ignoring non-recourse securitizations).

Proforma EV/EBITDA = ~7x

Marriott's timeshare business, Marriott Vacations Worldwide (VAC), is a good comparable for ILG, both will be a mixture of recurring management/exchange fees and development sales, both operate on the higher end of timeshare brands, and they're both pure play vertically integrated companies.  Marriott Vacations trades for ~9x 2015 EBITDA, at the same valuation using my EBITDA estimates gets you to a $18.35 share price for Interval shares, or 36% higher than today which would just about make up the difference in performance between Marriott Vacations and ILG shares since the 10/28 Vistana deal announcement.

Risks

• Regulatory - The Consumer Financial Protection Bureau (CFPB) is investigating timeshare operator Westgate, shining a light on the industry's sales practices.  Diamond Resorts is in a similar situation and was recently profiled in a long New York Times piece.
• AirBnB/HomeAway - Condo/homeowners in vacation towns can compete more effectively with timeshare developers thanks to AirBnB and HomeAway, provides a similar room option without the upfront and ongoing expense.
• Secondary Market - Most timeshares can be purchased at significant discounts to developer pricing in the secondary market which puts a lid on new unit pricing and/or really shows unsavory nature of the sales process.
• ILG shareholders still need to approve the deal, there's a shareholder meeting set for 4/20/16, Liberty and management have already agreed to vote for the deal.

Disclosure: I own shares of IILG

KCAP Financial: Another Busted BDC, Potential M&A Candidate

We've seen a pretty incredible rally the last 5-6 weeks in the market, especially in junk debt and lower quality equities which basically describe business development companies perfectly.  I currently own too much American Capital (ACAS) for my own good, but they've been selling assets above their book value and plowing that money into buying back stock below book value as they stage the house for a sale.  I might have gotten the path to closing the NAV discount wrong in the case of ACAS, but value will still be unlocked as the assets are worth more in someone else's hands than they are with Malon Wilkus and team.

A similar situation is likely to play out in what I'm calling a mini-ACAS in KCAP Financial (KCAP).  KCAP is a small ($130MM market cap) internally managed BDC that invests about 70% of their assets in vanilla middle market leveraged loans and the other 30% in a CLO asset manager and their manager's related CLO equity book.  Similarly to ACAS, it also trades at a significant discount to NAV and its doubtful it will return to NAV in its current form.

Collateral Loan Obligations (CLOs) are securitization vehicles that own diversified pools of bank loans, many of which are made to leveraged buyouts or as a result of other M&A activity.  The equity portion of a CLO is typically levered 8-10x and captures the excess spread between what their bank loan assets pay and the interest due on their rated notes/liabilities.  During good times, CLO equity IRRs can be in the high teens to low twenties and were a favorite among BDCs as a way to pay the high dividends that investors demanded in a low interest rate world.  Now that the market as stumbled a bit in the past year, many of the companies whose debt is included in CLOs are facing financial trouble (such as Valeant which is about ~1% of CLO assets across the industry), and as the first loss tranche, CLO equity values have taken a significant haircut.  Fewer investors are currently willing to step in to buy the equity of new deals and as a result CLO issuance has slowed (additional reasons are contributing as well).

KCAP Financial's CLO asset manager, Trimaran Advisors (technically they also own Katonah Debt Advisors, but since the financial crisis they've only issued deals under the Trimaran banner) manages $2.7B in assets across their CLO platform.  But with current economic concerns and soon to be implemented risk retention rules taking effect later this year, many smaller CLO managers are having difficulty issuing new deals (to grow and replace ones that are running off) and have put themselves up for sale.  In KCAP's 2015 10-K, they slipped in language suggesting they're shopping their CLO manager platform that wasn't present in the 2014 10-K:

Asset Manager Affiliates.   We expect to receive recurring cash distributions and seek to generate capital appreciation from our investment in our Asset Manager Affiliates. We may also seek to monetize our investment the Asset Manager Affiliates if and when business conditions warrant. As a manager of the CLO Funds, our Asset Manager Affiliates receive contractual and recurring management fees from the CLO Funds for their management and advisory services. In addition, our Asset Manager Affiliates may also earn income related to net interest on assets accumulated for future CLO issuances on which they have provided a first loss guaranty in connection with loan warehouse arrangements for their CLO Funds.

Asset-Backed Alert, a weekly securitization industry publication, also reported in their March 4th edition (sorry, I only have a physical copy) that KCAP is actively selling Trimaran Advisors and presumably their retained CLO equity holdings in Trimaran's CLOs to potential buyers.

KCAP Financial's CLOs have been a headache for the company, its financial statements (they had to restate their financials recently due to incorrect CLO equity accounting), and as a result the stock price as investors have shunned BDCs with any significant exposure to CLO equity.  Removing that business and the related securities would leave a diversified portfolio of fairly straight forward middle market loans with minimal oil & gas, or mining exposure.

The net asset value at 12/31/2015 was $5.82 per share, given the rally in leveraged loans (bank loan returns are generally positive YTD) that NAV should be fairly steady if recast today.  KCAP is internally managed with a cost structure a little over 2% of assets - above the typical base management fee for an externally managed BDC of 1.5 to 2.0% - there's no incentive fee and management owns 12% of the shares, incentives should be fairly aligned.  The stock currently trades for $3.40, or 60% of NAV, if they're able to sell the CLO manager and equity for something close to their marked values, any number of strategic or financial buyers should be knocking down the door to buy the rest of the company as it would be incredibly accretive for any BDC trading above NAV.  Said another way, an investor today is essentially paying a small discount for the bank loan portfolio and getting a cheap option on the CLO manager and CLO equity.  With KCAP's leverage and distressed stock price, they can't increase assets to reach a size where it makes sense to be internally managed, selling to a larger BDC is best option for them and removing the CLO overhang will allow that.

Risks:

• Leverage - KCAP is just about maxed out on the BDC asset coverage ratio of 200%, selling the CLO platform would obviously solve that issue completely, but in the meantime mark to market losses in their portfolio will force them to sell assets in order to cure the asset coverage ratio failure.  In the current environment they should be able to sell their more liquid loans to reduce leverage, but during the financial crisis, many BDCs ran into trouble as they created a forced selling environment when they liquidated assets at lower and lower prices to meet their asset coverage ratio.  Their leverage has also limited their ability to repurchase shares which has irked analysts on recent conference calls.
• CLO Equity - The market has comeback for bank loans in recent weeks, but at certain points, and maybe still today on certain deals, if the CLOs were liquidated using current market prices it would leave nothing for the CLO equity.  But CLOs are cash flow deals, only when a loan gets downgraded near default territory do market prices get applied.  All of KCAP's CLOs are currently passing their coverage tests meaning funds won't get diverted from the equity to pay down senior notes. The accounting treatment for CLO equity is also murky and requires many assumptions that are subject to management's discretion.
• CLO Warehouse - Trimaran is in the process of raising funds for a new CLO, traction has been slow on it, but they do risk the CLO never coming to fruition and being stuck with the loans already purchased and any resulting losses associated with liquidating the partial portfolio.

Disclosure: I own shares of KCAP

NexPoint Residential Trust: Update, Substantial Discount to NAV

On February 22 at 5:30 pm, I'll be hosting the CFA Society Chicago's Special Situation Research Forum in the loop, the topic chosen was NexPoint Residential Trust (NXRT) which I've held since its spinoff from NexPoint Credit Strategies last April.  Some of this is a repeat from my previous post with some updated thoughts and numbers.  If you like/dislike this idea and want to join the discussion, or just enjoy talking stocks, please feel free to email me I'll add you to the attendee list.

NexPoint Residential Trust is a small orphaned Class B multi-family REIT that is externally managed by an affiliate of Highland Capital.  The REIT was started opportunistically in late 2013 inside of a Highland managed closed end fund, NexPoint Credit Strategies (NHF), as the management team saw an opportunity to buy neglected, under-invested suburban workforce apartment buildings, do some light renovations and re-lease rehabbed units at higher rates.  Highland spun-off the REIT last spring and it's since dropped ~20-30% which presumably takes raising equity off the table, and given its small market capitalization (~$235MM), once the initial rehabbing is completed management will likely look to sell the company as the private market is valuing multi-family units at a premium to the public markets.

Portfolio Overview

• NexPoint Residential owns 42 properties, consisting of 13,155 garden/suburban units spread primarily across the sunbelt (Dallas and Atlanta make up 50% of the market exposure).
• Average Monthly Rent: $796
• Occupancy: 93.1%
• 2015 NOI (run rate): $64.0-66.5 million - but ramping as they deploy excess cash to rehab
• All but one of the apartment complexes in a JV with their property manager, BH Management, where NexPoint owns 90% and BH owns 10%.  NexPoint maintains control and final say in any disposition scenario but also aligns the property manager as they're the boots on the ground in the turnaround process.
• The portfolio has significant debt (60-70% leverage ratio), more than other publicly traded peers, but still a reasonable amount and a structure most smaller/local real estate investors would employ.  Most of the debt is floating rate and on the property level, non-recourse to the parent, as management believes interest rates will stay lower for longer (appears the market agrees with them) and it allows for a simpler property-by-property sales as the mortgages can be assumed by the buyer.  The average interest rate as of 9/30 was 2.50%, most of these mortgages are pegged off of 1 month LIBOR which has gone up with the Fed Funds hike, so the current rate is likely somewhere between 2.50-2.75%.

Unlike Class A multi-family which has seen a building boom, especially in urban markets, Class B multi-family has seen little-to-no new construction in recent years.  It's just difficult to buy land and build apartments given current construction costs and make an acceptable return renting them out for $800 a month.  NexPoint Residential's properties are located in growing sunbelt markets that are seeing significant growth in population and jobs.  Lower energy and gas prices should act like a tax break for NexPoint's blue-collar commuter residents making them more attractive credits and able to endure rent increases.

A key part of NexPoint's strategy is to rehab communities by adding or improving lifestyle amenities (fitness centers, pools, clubhouses) and doing cosmetic upgrades to individual units (~$4k a piece) as they come off lease.  As of 9/30, they've rehabbed 13% of their units for $7.3 million resulting in an average rental increase of 11%, which has generated a 24.4% return on the rehab cost.  Since NexPoint is a small REIT, these incremental improvements can still move the needle fairly significantly and generate NOI growth versus new build development that exposes them to the market turning on them as they're leasing up (see HHC).

Funds From Operations

GAAP uses historical cost accounting convention for real estate assets and requires depreciation (except on land) which implies that real estate values diminish in a straight line over time.  We know that's typically the opposite, real estate values generally appreciate loosely following wage growth and inflation trends.  So the REIT industry created Funds From Operations (FFO) as a proxy for earnings that adds back depreciation expense and excludes gains from sales (since they'd be held at depreciated values) from net income.  Instead of P/E, P/FFO is commonly used in the REIT industry, but suffers from the same issues as different capital structures (like NXRT) can skew the ratio significantly one way or another.

NexPoint Residential looks really cheap on an FFO basis do their leveraged balance sheet.

* Acquired in 2015 (AEC was acquired at a 5.9% cap rate, HME at 5.6-6.2% cap rates)

If you normalize for the debt, NXRT is less of an outsider but still undervalued compared to other multi-family REITs and to where Home Properties and Associated Estates Realty Corp were bought out at in 2015.  But at under 7x forward FFO and a 7.40% dividend yield, I could see NexPoint generating some interest from retail investors looking for yield again now that rates don't appear to moving up soon.

NAV

To normalize for NexPoint Residential's capital structure, and to value the company based on a private market sale basis since any acquirer would have their own management team, capital structure, etc., an NAV calculation makes the most sense.

Below I'm assuming the company's new run rate net operating income including their November acquisition (333 unit - The Place at Vanderbilt) and historical rent increases will be just under $70 million.  Using a 6.5% cap rate, NexPoint's NAV would be approximately $18 per share, using the 6.1% cap rate that Milestone Apartments REIT recently paid for a similar Class B multi-family Landmark Apartment Trust portfolio would yield a $21 share price.  Given NexPoint's debt any small change either way in cap rates has a magnified impact on the resulting NAV.

To further that idea, I backed out what cap rate the market is currently valuing the company's assets at using the current share price and market capitalization.  Assuming my NOI projections are correct, the market is implying a 7.66% cap rate for NexPoint's assets, or a 20+% discount to what Milestone paid for Landmark in October.

Management

The market doesn't like external management structures, and for good reason, there's typically an agency problem as management's incentives are not aligned with their captive shareholders.  NexPoint's management contract is good, not great:

• Management Fee of 1.00% of Average Real Estate Assets, Administrative Fee of 0.20% of Average Real Estate Assets, and reimbursement of operating expenses but there's a total 1.50% cap on expenses paid to Highland.  The manager also has waived about $5.5 million in fees on the initial spinoff portfolio capping the fees at the same level they would have made if the spinoff didn't happen (not clear if this is a one time waiver or annual).
• Property Management Fee of 3% of monthly gross income to BH Management which works out to be another 0.50% on assets.

However, unlike many externally managed vehicles, Highland Capital and management itself purchased roughly 16% of the shares outstanding and their management contract doesn't have a termination fee.  Additionally, there are no dilutive incentive options or other forms of management compensation gravy trains that would dry up in the event of a sale.  On their conference calls management has been open about the idea of a sale if the valuation doesn't move up to peers to allow for a more sustainable, equity raise model of a typical REIT.  

Risks

• Highly leveraged (compared to peers) balance sheet with predominately floating rate debt - if short term interest rates were to rise quickly their interest expense would rise in kind.  Rising rates may at the same time lead to a fall in real estate prices which given the leverage would disproportionately impact the common stock.  Double whammy.
• External management structure - the market dislikes these to begin with and Highland Capital (via NexPoint, the adviser) recently made a play to manage the TICC Capital, a BDC that's seen activists swarming around for the management contract.  Is Highland interested in creating a platform of permanent capital vehicles?  Would they dilute shareholders and issue additional equity well below NAV to grow their management fee?
• Texas concentration - 35% of their units are located in Texas, primarily in the Dallas-Fort Worth area (2% in Houston).  Does the energy collapse hit the rest of the state and how hard?

NexPoint is too small to internalize management, the stock price is too low to issue equity, the balance sheet is too leverage for more debt, and management is incentived to sell.  I think a sale to a private equity firm or another apartment REIT is the likely end game.

Disclosure: I own shares of NXRT

Crossroads Capital: Busted BDC, Bulldog Pushes Toward Liquidation

The tide has just about fully washed out of the business development company sector (more on the manager/fund raiser side), most BDCs are really just leveraged loan vehicles and not "private equity for main street" as they were originally intended.  One of the few private equity like BDCs is tiny Crossroads Capital (XRDC), which has changed its name twice in the past two years (f/k/a BDCA Venture and before that Keating Capital) as it's original asset manager was purchased by an affiliate of the toxic Nick Schorsch and then recently famed closed end fund activist Bulldog Investors won board seats and took control of the company in the second half of 2015.

The grand plan was to invest in companies approaching an IPO, from the 2013 10-K:

"Our strategy is to evaluate and invest in companies prior to the valuation accretion that we believe occurs once private companies complete an initial public offering.  We seek to capture this value accretion, or what we refer to as a private-public valuation arbitrage, by investing primarily in private, micro-cap and small-cap companies that meet our core investment criteria.  Our investment strategy can be summarized as buy privately, sell publicly, capture the difference."

With the benefit of hindsight this strategy looks a bit silly, especially in the "unicorn" Silicon Valley valuation environment that's been going on for a while and is arguably the opposite of what's described above, private companies are being valued at a premium over public ones.  But in the middle of a bull market this is an easy high fee product to sell to main street retail investors looking for a way to profit from hot technology IPOs.  The slowing IPO market and high fees began to take their toll and this BDC started trading at a significant discount to net asset value before long.

Bulldog Investors, led by Phil Goldstein, is famous in the value investing community for their activism in closed end funds and other investment companies.  These vehicles often trade for a discount to NAV due to their high fees and closed end nature, there's no mechanism for investors to redeem their shares at NAV like opened end funds.  Bulldog often accumulates a large stake and then pushes for the manager to take steps to force the price back to NAV, typically first through share buybacks, if that's unsuccessful, a liquidation of the fund.

Bulldog went active on Crossroads Capital (then BDCA Venture) in March of 2015, here's the letter, calling for a sale or an orderly liquidation.  They've since bought more in the mid-$4s, now owning 11.65% of the shares.  Events didn't move quickly enough, Bulldog launched a proxy fight and gained board representation, Andrew Dakos of Bulldog was named Chairman of the Board, and the company parted ways with its external manager in October 2015.  They've since slashed operating expenses and outsourced most of the day to day administrative tasks to a third party provider.

On 1/25/16, the company announced their new strategy:

“The Company's new investment objective is to preserve capital and maximize shareholder value. The Company seeks to achieve its investment objective by pursuing the sale of its portfolio investments, limiting expenses and deploying surplus cash as appropriate, including into yielding investments to offset operating expenses.”

In the same press release they stated the current cash is approximately $1.46 per share.  So at today's $2.46 stock price, what is an investor getting for the additional $1.00 per share?  Below are their portfolio investments as of 9/30/15, its worth noting that they took the overall value down 12% from the 6/30/15 marks and will likely take something similar off for the 12/31 net asset value.

Using the 9/30 marks (additional writedowns likely), after cash you're only paying 25 cents on the dollar for the remaining portfolio ($4.02/share).  Most of their investments are in green energy and social media type private companies, not something I'm able to value but I did some light Googling and most of them seem reasonable and potentially worth something.  January was the first month in a long time where no IPO was completed in the United States, a quick liquidation of the assets might be difficult.  In the latest 10-Q:

"We further believe there may limited opportunities to sell our interests in existing private portfolio companies to third parties in privately negotiated transactions.  Accordingly, it is possible that an orderly monetization of our current holdings may take three to five years or more."

So that's base case, but I don't think it's as simple as a big discount to NAV being closed over three to five years (don't forget - outside chance their portfolio appreciates), that wouldn't be quite as interesting.  Now that Bulldog Investors is in control of the company, and armed with a $2MM buyback authorization (if fully utilized at current prices it would increase NAV by ~5%), additional buybacks could be in the cards, liquidation distributions, and other levers pulled here to generate returns for those that stick around.  I also wouldn't write off the possibility of a quick portfolio sale of the investments at a discount to another entity.  Crossroads Capital is a jockey play on Bulldog Investors being able to unlock the value backstopped by paying a cheap price for the asset base.

Why is it cheap?

• IPO window is potentially shut for these small cap speculative technology companies, uncertain time frame for value realization.
• The company is stopping regular distributions, the last of the retail BDC dumb money has probably sold out in the last two months.
• Liquidations in general tend to scare off investors: there's a lot of red tape holding up dissolution, they take longer than people would think, and can have principal/agent problems (even the bare bones administrative staff at a company liquidating isn't running to lose their job).  But with the largest shareholder in control, there's some confidence that the process will be expedited as much as possible.

I'm finding quite a few of these busted small/micro cap financials with a lot of cash recently and started to develop a small tracking position bucket, I added this one to it.

Disclosure: I own shares of XRDC