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