Wednesday, October 26, 2022

Acres Commercial Realty: Trading Well Below BV, Buybacks Over Dividends

This is a similar idea to WMC, Acres Commercial Realty (ACR) ($73MM market cap) is also a mortgage REIT trading at a similar discount to book value (38% of BV)  but without the near term catalyst of a potential sale.  ACR has gone through a few name and manager changes over the years, it was originally Resource Capital (RSO), then became Xantas Capital (XAN), and following a 2020 margin call of their CMBS portfolio, current management came in and once again rebranded.  This is my third bite at the apple and is less of a short term event driven idea and more a 2-3 year transformation path back to a normal commercial mREIT.  

While ACR doesn't have the near term catalyst of WMC, the assets and balance sheet are cleaner at ACR and a majority of the cheap price can be attributed to its small size, current market conditions and lack of a dividend, the latter being the main appeal of mREITs to retail investors.  The reason ACR doesn't pay a dividend is two fold, both of which should appeal to readers of this blog: 1) since shares trade at a significant discount, management have been buying back shares, approximately $30MM worth (significant for an entity this size) since November 2020, with $10MM remaining on their authorization; 2) following the 2020 margin call, ACR has a significant amount of both net capital losses and net operating losses ("NOLs").  To monetize the net capital losses, ACR has created a side pocket of opportunistic equity real estate investments with turnaround plans that if executed should generate taxable income or gains.  Those proceeds would then be reinvested in the core business of originating and holding transitional commercial real estate loans.  The tax asset is valued at $21.6MM (again, meaningful for an entity this size), but has a full valuation allowance against it on the balance sheet.  Once the tax assets are soaked up and the shares trade closer to book value, the REIT will turn the dividend back on and retail investors should return.

ACR lays out the tax monetization strategy in one of their slides, but this doesn't include the potential for more accretive buybacks.  Shares currently trade for $9.26 vs. $8.19 below and I wouldn't count on it trading for book ($24.48) anytime soon, but the math they layout is quite attractive.

ACR's core business is originating and holding "transitional" commercial real estate loans, this typically means ACR will help a developer or investor finance a value-add property, the equity owner will execute on their plan over a couple year period and then will refinance the property at stabilization, taking out ACR's loan in the process.  Over 3/4ths of ACR's loans are to multi-family properties, I remain reasonably bullish on this sector, at least from a lender's perspective.  With interest rates increasing, potential new homeowners will be stuck renting for a few more years and ACR's heavy concentration to FL and TX (44% between the two) should have continued demographic tailwinds as people/businesses migrate to sunny skies and lower cost of living geographies.  If multi-family properties do get hit, ACR does have a reasonable equity cushion below each loan with a weighted average loan-to-value of 72%.  ACR's loans are floating rate, thus should have minimal duration risk, although as rates continue to increase, that added interest expense borne by their borrowers will start to increase credit risk at a certain point.

To fund their loans, ACR predominately relies on the CRE CLO market.
Newly originated loans are placed in the "CRE - term warehouse financing facilities" and once of sufficient size, they'll raise longer term CRE CLO financing (also floating rate) and transfer the warehoused loans into the CRE CLO.  ACR retains the junior bonds and equity of the CLO.  CLOs are great because they're not mark-to-market vehicles and give the manager flexibility to repurchase problem loans inside the SPV to avoid any tests failing that would cause cash flows to be diverted from junior tranches.  During the height of covid, CRE CLOs continued paying all noteholders and no test failures occurred, unlike in the CMBS market where the collateral has an observable mark and was financed via repurchase agreements that were marked-to-market daily.  The CRE loans inside ACR's CLOs are whole loans that are not syndicated and don't have live marks available on them.  ACR is likely still being punished for 2020, but the manager is gone and the CMBS assets that cause the blow up are gone too.  The CLOs originated by the old manager all performed fine.

There is an external manager here, Acres Capital, with a fairly traditional mREIT fee agreement that includes a base fee of 1.5% of equity and 20% of earnings above a 7% hurdle, that's not great, but they otherwise seem to be doing the right thing even if it goes against their incentive in the near term (like buying back a significant amount of stock).  One thing I don't like about the fee agreement, the manager receives 25% of their incentive fee paid in stock, at this discount that's highly dilutive to minority shareholders.  But overall, they own 6+% of the company and seem to be reasonable corporate stewards.  There is also the presence of two sophisticated credit investors which is a plus, Oaktree remains a significant shareholder following the 2020 bailout with 9% and First Eagle Credit Management (large CLO equity investor, they manage ECC which owns CLO equity and bonds) with 12.5% of common, plus a good slug of the preferred stock (check those out if you like yield).

Most of the commercial mREITs are trading at a discount to book value in today's market, the best of breed like Starwood Property Trust (STWD) and Arbor Realty (ABR) trade right at book, but even the small cap external peers like NexPoint Real Estate Finance (NREF) and Lument Finance Trust (LFT) trade for about 2/3rds of book (both pay a low double digit dividend), putting the same multiple on ACR would be about 75% upside.

Disclosure: I own shares of ACR

Applied Genetic Technologies: No Deadline CVR

It has been a while since I've dipped a toe into the CVR ("contingent value rights") pond, full disclaimer, I've only had one payout in the last 7-8 years, these normally don't work out.  But Applied Genetic Technologies (AGTC) ($25MM market cap) is an interesting situation because it has two buckets of CVR payments with attractive twists: 1) the miscellaneous AGTC assets the acquirer doesn't want that have values you can point to on AGTC's balance sheet; 2) your traditional FDA approval and sales milestones style payment thresholds but without a clock or deadline that often have the appearance to be gameable by CVR counterparties.

AGTC is the typical clinical-stage biotechnology company that relies on open capital markets to fund its development program, with current tight market conditions and their liquidity quickly draining, AGTC announced Monday it is being acquired by Syncona (LON: SYNC) for $0.34/share plus a CVR.  The alternative was bankruptcy as the company has near term debt and only had a cash runway through the end of the year.  AGTC's area of focus is gene therapy treatments, primarily for a rare eye disease, X-Linked Retinitis Pigmentosa ("XLRP"), that approximately 20,000 people suffer from in the U.S. and Europe.  No approved treatments exist for this condition.  In May, the company reported positive clinical results for their AGTC-501 product (positive based on their press release, I have no expertise to be able to confirm), but they don't have the resources to continue development themselves.  This *might* be a non-zero value asset that is just caught up in a terrible biotech capital raising market, Syncona is at least making that bet.

The shares currently trade for $0.37/share, a $0.03 premium (8%) to the $0.34/share cash consideration.  There's no financing condition, the buyer is real, the deal is scheduled to be a quick close (via a tender that launched tonight), now its just time to look at the CVR (link to the agreement) which has 4 potential milestone payments:

Milestone 1. Parent will be obligated to pay up to $12.5 million, in the aggregate, upon the (a) sale, license, transfer, spin-off of, or the occurrence of any other monetizing event, whether in a single or multiple transactions, involving, all or any part of the Non-RPGR Assets (as defined in the CVR Agreement), (b) the sale or transfer of the Bionic Sight Equity (as defined in the CVR Agreement) and/or (c) the sale, lease or transfer of the Manufacturing Assets (as defined in the CVR Agreement), in each case, that closes on or prior to the date that is eighteen (18) months after the date of the closing of the Merger. The aggregate amount payable in connection with such milestone will be equal to the amount by which the sum of (i) 60% of the Gross Proceeds (as defined in the CVR Agreement) attributable to the Non-RPGR Assets and/or (ii) 100% of the Gross Proceeds attributable to the Bionic Sight Equity and/or (iii) 100% of the Gross Proceeds attributable to the Manufacturing Assets (reduced by the amount of certain taxes and expenses as more particularly described in the CVR Agreement), collectively, exceeds $5.0 million;

Milestone 2. Parent will be obligated to pay an aggregate amount equal to $12.5 million upon obtaining U.S. Food and Drug Administration (the “FDA”) approval of a Biologics License Application (BLA) for AGTC-501 to treat patients with XLRP caused by mutations in the RPGR gene, as evidenced by the written notice of such approval by the FDA, which approval (a) must be consistent with the patient population, at a minimum, as established by the inclusion/exclusion criteria of patients studied in the pivotal clinical trial, (b) may be subject to conditions of use, contraindications, or otherwise limited, and (c) may contain a commitment to conduct a post-approval study or clinical trial (the “Marketing Approval”);

 Milestone 3. Parent will be obligated to pay an aggregate amount equal to $12.5 million if, as of the date of the Marketing Approval, no other AAV gene therapy product expressing the RPGR protein (including any derivative or shortened version of the RPGR protein) has received a marketing approval from the FDA; and

Milestone 4. Parent will be obligated to pay an aggregate amount equal to $12.5 million the first time that Net Sales (as defined in the CVR Agreement) of AGTC-501 in any calendar year is equal to or exceeds $100.0 million.

For simplicity, putting these in my own words, the first one is if Syncona decides (unfortunately I don't see anything that forces them to try) to monetize the non eye disease assets of ATGC.  These non-core assets include a 15.2% stake in Bionic Sight (partner in their optogenetic program) which is on the balance sheet for $7.8MM, ATGC's Manufacturing Assets, which I read to mean their $4.7MM in PP&E, plus other early stage programs that AGTC has abandon/paused.  If the total is more than $5MM within 18 months of closing ("Milestone 1 Deadline Date"), the CVR holders receive 100% of the excess for Bionic Sight/Manufacturing Assets and 60% of the excess for the other pipeline assets.  Some big "ifs" ahead, but if Syncona sells the assets in Milestone 1, and if they go for their book value (attributing no value to the other pipeline assets), that equals $12.5MM, or $7.5MM ($0.11/share) in excess of the $5MM threshold to CVR holders.  That would more than cover the $0.03-$0.04 the market is valuing the CVR above the $0.34 cash consideration.

The other three milestones are typical FDA approval and sales related, interestingly, combing through the CVR Agreement, they don't appear to have a termination date other than:

7.8 Termination. This Agreement shall be terminated and of no force or effect, the parties hereto shall have no liability hereunder (other than with respect to monies due and owing by Parent to Rights Agent), and no payments shall be required to be made, upon the earlier to occur of (a) the payment of the full amount of each potential Milestone Payment required to be paid under the terms of this Agreement, (b) the termination of the Merger Agreement in accordance with its terms and (c) the final determination that no further Milestone Payments will ever be payable under of this Agreement. Notwithstanding the foregoing, no such termination shall affect any rights or obligations accrued prior to the effective date of such termination or Sections 2.4(e), 3.2, 7.4 to 7.8 and 7.11, which shall survive the termination of this Agreement, or the resignation, replacement or removal of the Rights Agent.

There is a "Milestone 1 Deadline Date" but no corresponding ones for milestones 2-4.  This leads me to believe there isn't one, that is it open ended intentionally and doesn't allow Syncona the option to slow roll the development of AGTC-501 to reduce their CVR liability.  The total payout if all milestones are met is $0.73/share, to be clear that's highly unlikely to happen, but it seems like a lottery ticket worth taking given the structure of the CVR and the quick close on the deal.

Disclosure: I own shares of AGTC

Thursday, October 20, 2022

Western Asset Mortgage Capital: Trading Well Below BV, Exploring a Sale

Western Asset Mortgage Capital (WMC) ($56MM market cap) was one of the mortgage REITs caught up in the margin call wave of 2020 when otherwise safe mortgage back securities ("MBS") suddenly went no-bid.  Mortgage REITs often financed their MBS with daily mark-to-market short term financing, when MBS prices suddenly dropped (they would later recover), financing counterparties forced liquidations and significant shareholder value evaporated in the process.  WMC did survive, but in a wounded and subscale form.  Around the end of last year, they started to transition their portfolio away from commercial mortgages to residential mortgages, primarily in Non-QM loans (financed via RMBS under the Arroyo branded shelf).  Non-QM is short for non qualifying mortgages, those that aren't eligible to be purchased by the GSEs, most of these are actually to prime borrowers (746 average FICO) but those borrowers don't have regular W-2 income to meet tighter post-GFC mortgage underwriting standards.

Getting straight to the point, WMC trades for $9.35/share despite having an economic book value of $24.58/share, or WMC is trading at just 38% of book.  Their book value will likely come down a fair amount when they release Q3 earnings due to rates rising and spreads widening since 6/30, but it should still be very cheap to its net asset value.  WMC is managed by large fixed income specialist Western Asset Management, they've already cut their fees 25% for 2022, have no chance of raising additional capital to regain scale, and are thus waving the white flag by announcing they've commenced a strategic alternatives review process.  It is likely just not worth Western Asset's time at this size (their management fee is based on equity, not assets).

Here is WMC CEO Bonnie Wongtrakool discussing the rationale in their Q2 earnings call:

The primary way to achieve scale as a mortgage REIT is to issue additional common equity, but our philosophy and practice has been to conduct equity offerings only at such times when they have not been materially dilutive to existing shareholders. The last time we issued any meaningful amount of equity was in the second quarter of 2019, when we raised nearly $50 million, which was done at a modest discount to our book value at that time.

Unfortunately, when COVID hit the following spring, our portfolio experienced a significant decline in value and our stock price experienced an even greater decline relative to book value. Since then, our overarching goal has been to improve and stabilize our future earnings power.

Over the last two years, we have made significant progress by taking actions to improve our liquidity and balance sheet and by shifting our investment focus towards residential real estate. Nonetheless, we do not see these positive actions being reflected in our stock price. Therefore, we believe that yesterday's announcement regarding our decision to review strategic alternatives is the best path forward towards unlocking shareholder value, and we are committed to analyzing alternatives that may involve a sale, merger or other transaction involving the company.

I'm always a little skeptical of externally managed mREITs looking to sell themselves, sometimes it means they're simply selling the management contract to another asset manager that will just rebrand and the discount to NAV won't close much.  But here the discount is so wide and the language sounds slightly more focused on shareholders.  There is likely some middle ground in between the share price and book value to get a deal done that pleases all three parties: 1) WMC shareholders get some premium to current prices; 2) Western Asset rids themselves of the distraction and receives some value for their management contracts; 3) one of the countless potential acquirers gets a publicly traded permanent capital vehicle or a current mREIT gets some additional scale and fees for their manager.

Similar to LMPX, this is a completely commodity/fungible type business or balance sheet that trades hands regularly, even in this currently strained M&A market, a willing seller (which sounds like they are) should find no problem finding plenty of willing buyers.  Most likely this will be a stock-for-stock deal or reverse merger with a non-traded REIT, so the upside won't be as big as a liquidation or cash deal, but still an attractive risk/reward.  My best guess is $12-14/share in value.

Other thoughts:

  • Their balance sheet is a mess and difficult to untangle.  For example, one of their legacy commercial investments is a mezz tranche of the Mall of America CMBS (CSMC Trust 2014-USA) and due to accounting rules, WMC actually consolidates the entire SPV.  WMC's economic exposure is $10.7MM, but they consolidate the $1.4B in liabilities on their balance sheet.  Mall of America's future is certainly cloudy, they did restructure the loan during the pandemic, but as an important tourist attraction for the Twin Cities MSA, I would expect it to get political support to survive as a destination/entertainment mall.  In 2020, alongside the restructuring, Trep did put a $1.9B value on the mall, for whatever that's worth.
  • They also have one big problem CRE loan, "CRE 3" in their disclosures which is described as an entertainment/retail property in New Jersey.  I couldn't find it in their disclosures, but it wouldn't surprise me if that was the troubled American Dream mall as it shares ownership with Mall of America.  CRE 3 has been in non-payment status for about a year, if WMC needs to write down the full value of the loan, that knocks about $4/share off the book value.
  • Their Non-QM loans are highly concentrated in California, about 2/3rds.  LTVs look good (originally 65% at the time of underwriting) at the current moment, but we're early in any housing correction and California typically exhibits higher price volatility than other markets.  WMC disclosed that about 15% of their Non-QM loans have near term rate resets (these are ARMs) that will slightly help offset the price pressure of higher rates.

Disclosure: I own shares of WMC

Friday, October 7, 2022

Mereo BioPharma: Activist Proxy Fight

Back in the March 2019, I wrote up the merger between U.K. based Mereo BioPharma (MREO) (~$100MM current market cap) and OncoMed Pharmaceuticals (formerly traded as OMED) as a way to play the contingent value rights that were issued to OMED shareholders.  The CVR part of the thesis hasn't worked out, at least yet, there are still potential milestones on Navicixizumab in play before the CVR expire on 4/23/24.  Since closing out that trade (I received MREO shares in the merger but sold immediately at $5.30, shares trade for $0.95 today), I've checked in on the company occasionally as the CVRs naturally have Mereo counterparty risk.  On the most recent of those check ins, I came across two Seeking Alpha write-ups (here and here) by Dalius Taurus of SSI that piqued my interest.

Mereo BioPharma has six product candidates, four purchased from larger biopharmaceutical companies (Novartis and AstraZenca) that previously received considerable investment in the pre-clinical stage but were no longer strategic priorities and two product candidates inherited from the OncoMed acquisition.  MREO's market cap is approximately $100MM (MREO trades as an ADR, each MREO share equals 5 ordinary shares) and last reported a cash balance of $105MM (current conversion rate, MREO reports in GBP) as of 2021 year end, after some cash burn, it likely has a small positive enterprise value.  

Similar to most pre-revenue biotechs these days, Mereo's investors have lost their patience funding development pipelines, Rubric Capital (~14% owner) has stepped up as an activist to stop the cash burn by attempting to reconstitute the board of directors.  Rubric has its eyes on gaining control of the board, then monetizing assets and returning cash to shareholders in what amounts to a liquidation.  Rubric is run by David Rosen, who was a portfolio manager at SAC Capital (now Point72) before going on his own in 2016.  It just so happens that the second largest MREO shareholder is Point72 with 8.6%, likely friendly to Rubric, further increasing the likelihood that Rubric gains board seats in the proxy campaign as the current board/management owns an insignificant amount.

Below is the back of the envelope valuation math provided by Rubric in their 6/9/22 letter:

I have little way of confirming or refuting their valuation, but even if they're wrong by half the stock is approximately a double from here.  Mereo's most valuable asset according to Rubric is their partnership with Ultragenyx (RARE) on Setrusumab (originally purchased from Novartis) which is a treatment for a rare bone disease, osteogenesis imperfecta ("OI"), that currently has no approved therapies.  Mereo retained the commercial rights for Setrusumab in the UK and Europe, otherwise Rubric is ascribing no value to Mereo's other product candidates, including Alvelestat which is a treatment for a rare lung disease undergoing clinical trials.

Alvelestat is the one product candidate that came from AstraZenenca (AZN). In June, which to be fair is a lifetime ago in this market, The Times of London reported that AZN was considering a bid for MREO:

Word is that it is considering a bid for Mereo Biopharma, a specialist in cancer and rare diseases.

Mereo, which has developed a portfolio of six clinical-stage product candidates, is based in London but listed on the Nasdaq exchange in New York and lists AstraZeneca among its partners alongside Novartis, OncXerna and Ultragenyx. There are suggestions that at least one other suitor, possibly another partner, may also be on the prowl.

Shares in Mereo have been a stinker, shedding almost 80 per cent of their value in the past year, although they jumped by 8.5 per cent to 69 cents on Wednesday, valuing the company at $81 million. Analysts have an average target price of $7 and the talk is that Mereo would accept $5, equating to $500 million including American depositary receipts or ADRs. Evercore and Citigroup are said to be involved as advisers.

This article came out around the same time as the Rubric letter, they might be related, or it might be coincidence.  Even if the Setrusumab valuation is overstated, there might be other assets worth something here.  Rubric and Mereo's management have been going back forth on Rubric's request for a special meeting, Mereo seemingly was citing every technicality why Rubric's request was ineligible but eventually relented and the special meeting is now set to happen sometime in November.  It appears that a new board will be put in place shortly, we'll see what happens from there.  I bought a small position.

Disclosure: I own shares of MREO and some non-tradable OMED CVRs