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