Wednesday, September 14, 2016

ZAIS Financial: Merger w/ Private REIT, Tender Offer, ZAIS Group

ZAIS Financial Corp (ZFC) is a $125MM market cap residential mortgage REIT that failed to gain size and operating leverage, ZFC's external manager ZAIS Group (ZAIS) is reeling from some poor performance at its main credit hedge fund and decided to refocus efforts away from the sub-size mortgage REIT.  In April 2016, ZAIS Financial announced it was merging with Sutherland Asset Management, a private commercial mortgage REIT, ZAIS Group's management agreement will be cancelled and Waterfall Asset Management, Sutherland's external manager, will take over the combined company with a typical base/incentive fee structure.

The merged company will take the Sutherland Asset Management name and trade under the symbol SLD.  Sutherland's strategy is to acquire and originate small commercial loans and SBA loans, they classify small commercial loans as those ranging from $500k to $10MM that often have a personal guarantee attached back to the business owner.  This is a bit of a niche non-bank lender sector made possible by the retreat in community and regional banks from making riskier loans that come with greater capital requirements.  Sutherland both originates their own loans and acquires portfolios of performing and non-performing loans from larger banks and the securitization market.  There might be an opportunity for alpha in this niche as these loans are too small for larger institutional investors but too risky for small banks, but it's not without risk as these are loans to franchisees and small time commercial real estate investors, basically borrowers without any scale or significant enough collateral for traditional lenders to touch.

Additionally, Sutherland is one of a few non-banks with an SBA license, borrowers that take out SBA loans are even shakier than their core small commercial loan business but with SBA loans the government guarantees a (senior) portion of the loan.  The guaranteed portion is then sold and securitized into the secondary market, there's usually a nice premium for the lender in the sale as these loans have a wide spread compared to traditional treasuries or other government sponsored enterprises.  The lender of an SBA loan keeps the servicing relationship whether they choose to keep the guaranteed portion on balance sheet or not, if the guaranteed portion is sold as the servicing relationship is kept, that effectively increases the interest and fees earned on the remaining portion held by the lender.  Originating SBA loans is a good business.

So that's Sutherland's business, lending to riskier small commercial lenders, it should do well during good times and not so good during bad times.  It's effectively a commercial mortgage REIT with elements of a residential mortgage REIT.

Why merge with ZAIS Financial?  
Sutherland attempted an IPO in January 2015 and ended up pulling the offering when it couldn't raise capital within the desired range.  Sutherland is about 3 times the size of ZAIS Financial, so merging with ZFC can effectively be thought of as a reverse merger and a way to backdoor list Sutherland.  Further to that point, ZAIS Financial has sold most of their liquid assets leaving their mortgage servicing operation, a business unit that a fund managed by Sutherland sold to ZAIS Financial a couple years earlier.

Why is this deal interesting?  
If shareholders approve the issuance of shares to complete the merger on 9/27, then ZAIS Financial is going to commence a tender offering for approximately 47% of their shares outstanding (cash from selling down their liquid RMBS assets) at $15.36 per share, the shares trade for a $14.07 per share, or a 9.2% premium that should happen fairly quickly.  Additionally, ZFC is paying a $0.40 dividend to shareholders on 10/17 with a record date of 9/30, for another 2.8% return.
Per the merger agreement, both sides adjusted their book values down to account for intangible assets, litigation costs, transaction fees, and ZAIS Group's termination payment.  If you follow the math, assuming everyone tenders their shares (the math gets better the fewer people tender), an investor can create shares in the new Sutherland (SLD) at 73% of tangible book value.  The deal should close in the 4th quarter assuming both sides approve the deal on 9/27.

I expect SLD shares to trade poorly after the deal happens as previously locked up (and mostly retail) shareholders now have liquidity and can sell their shares.  But most mortgage REITs trade somewhere between 0.9-1.1x BV, residential mortgage REITs on the low side, commercial mortgage REITs on the high side, Sutherland should trade somewhere in between the two sectors overtime as it has elements of both, but either way above 73% of book value.

Sizing a situation like this is important, you'll get about half your money back quickly and don't want to worry about the remaining stub if the new SLD gets sold off once the deal closes.

ZAIS Group
ZFC's soon to be former external manager, ZAIS Group (ZAIS), might be a situation worth digging into further.  After losing ZFC's management contract, ZAIS will have a little more than $3B in AUM primarily across two hedge funds that have good long term records but poor short term (far from their high water marks) and 4 CLOs, one of which they closed this year which is a feat for a small manager like ZAIS.  As a result of losing their incentive fees, their operating expenses are greater than their run rate management fees putting them in a tight spot.  The stock is down 80+% in the past year.  There are some corporate governance issues, its a former SPAC, and one of those structures where the public company owns 2/3rds of the operating LLC and insiders own the rest.  But at a $28MM market cap, its trading below book value (mostly cash) and other CLO managers have been sold recently at nice premiums (see CIFC), ZAIS could be another.

Disclosure: I own shares of ZFC, no position is ZAIS

Friday, September 2, 2016

Dell Technologies Class V: New VMWare Tracking Stock

I'm posting this on Friday afternoon before a long holiday weekend for a reason, smarter people than I have written on this topic so not much of the below is new but I wanted to memorialize some thoughts as part of my process.

Last October, Dell and Silver Lake (their PE backers) announced the acquisition of EMC in a cash and stock deal worth $67B.  Dell is a private company and wants to stay that way, so the stock part of the merger consideration is a bit tricky.  EMC owns 81% of VMWare, a software company that sells virtualization technology that helps large enterprise servers share resources and become more efficient, the remaining 19% stake is publicly traded under the VMW symbol.  But Dell is a recent leveraged buyout, and they didn't have the available financing to buy both EMC and their stake in VMWare simultaneously, so instead of paying cash for all of EMC and their 81% stake in VMWare, Dell is issuing a tracking stock that represents 65% of EMC's 81% interest in VMWare to former EMC shareholders to bridge the funding gap, but still get to control VMWare.

In Dell's own words (Denali is Dell's parent company):
Q:           Why is a tracking stock being used to finance the acquisition of EMC?
A:           The Class V Common Stock will afford EMC shareholders the opportunity to benefit from any value creation that may result from any revenue synergies of the Class V Group with Dell. Collectively, EMC shareholders indirectly own approximately 81% of VMware as of the date of this proxy statement/prospectus. Upon the completion of the merger, EMC shareholders will receive shares of Class V Common Stock that will be publicly traded and that are intended to track, in the aggregate, an approximately 53% economic interest in the VMware business (assuming no change to the percentage economic interest of EMC in the VMware business prior to the completion of the merger and that EMC shareholders either are not entitled to or do not properly exercise appraisal rights).
Owning EMC’s interest in the VMware business is a fundamental part of Denali’s strategic rationale for this transaction. VMware’s success is important to the business strategy of a merger combining Dell and EMC, and Denali believes it will be in the best interests of its common stockholders after the merger to retain a large economic interest in the VMware business. Additionally, given constraints on the amount of cash financing available for the transaction, the issuance of the Class V Common Stock enables Denali to pay a higher purchase price for EMC than it could in a transaction consisting entirely of 100% cash consideration.
Shares of the tracking stock, Dell Technologies Class V, started trading recently in the when-issued market under the symbol DVMTV and will start trading regular way as DVMT after the deal closes on 9/7/2016.  Each share of DVMT represents the same economic equivalent of each share of VMW, there will be 223MM shares of DVMT outstanding compared to just 80MM of the regular VMW common shares, meaning the tracker should be more liquid than the real thing, an odd situation.

While neither DVMT or VMW have any material voting rights, the two stocks are significantly different in that DVMT is exposed to Dell's highly leveraged balance sheet as DVMT is a share class of Dell Technologies (the merged Dell and EMC) not VMWare.  After the deal closes, Dell will be levered about 6 times and their debt is rated below investment grade, Dell's stated plan is to deleverage (as they did following their 2013 buyout) over the next 18-24 months in order to re-achieve an investment grade rating.  Their debt facilities do allow for some share repurchases but I would expect those to come second to the initial de-leveraging.

The big question is what discount should be applied to the DVMT tracker for taking on the additional balance sheet risk?  I think most scenarios where Dell ends up in serious financial trouble so does VMWare.  Several have speculated that Dell is really interested in VMWare over the rest of EMC, VMWare's software will be a key differentiating factor in Dell's enterprise business going forward.  If one falters the other will, Dell is in complete control of both.  The circumstance where Dell's balance sheet could be an issue for DVMT is a near term slowdown in their business that puts a wrench in the de-leveraging plan.  What discount is that risk worth?  I'd vote a 15-20% discount is fair for DVMT, it's currently trading at $43.90 and VMW at $72.88, or a 40% discount.  I don't have a strong opinion on VMW's valuation but its trading for a forward P/E of ~17x or fairly close to the market as a whole for a company that's generating mid-single digits topline growth.

How does this structure get fixed long term?  Dell has the option to swap VMW shares for the tracker, but likely won't do so for both tax reasons and they don't want to give up control.  The more likely scenario is after paying down debt from the EMC transaction, Dell might come back for the tracker and VMW shares in another deal.  Dell's initial management buyout was scrutinized for being unfair to minority shareholders, so the prospect of Dell doing it again to VMWare is another possible reason for a high discount rate.  Either way, 40% seems too high and is worthy of a small position.

Disclosure: I own shares of DVMT