Thursday, March 23, 2023

Star Holdings: iStar Spin, Familiar Monetization Strategy

Star Holdings (STHO) (~$225MM implied market cap) is the upcoming spinoff of the merger of iStar (STAR) and Safehold (SAFE) targeted to be completed on 3/31/23.  Similar to other real estate spinoffs, STHO will be stuffed with legacy assets with a stated strategy to monetize the portfolio over time and return sale proceeds to shareholders.  

iStar was a commercial mREIT prior to the great recession, during '08-'09 many of their commercial mortgage loans went bad and the company ended up foreclosing on various property types across the country.  In the years since, they've run off much of that legacy portfolio (I previously owned it for the legacy assets) and then several years back launched a new ground lease strategy under the Safehold (SAFE) banner, a REIT that is externally managed by iStar.  As the SAFE strategy succeeded in the low rate environment (a ground lease is typically 99 years, about the longest duration asset you'll find) and iStar's legacy portfolio ran off, there was little need to maintain two separate public companies with related party arrangements.  iStar with its management contract and SAFE shares was basically an asset backed tracking stock of SAFE.  Last August, iStar and SAFE announced a merger transaction where SAFE would internalize management and iStar would spinoff its non-ground lease assets into STHO.  Similar to other real estate spins (SMTA, RVI, etc), the new combined SAFE will be the external manager of STHO.

As usual in spinoffs now, iStar will be receiving a dividend back from STHO, the use of funds is to pay down iStar's debt and leave primarily just SAFE shares to then swap for new SAFE.  In order to facilitate that dividend, STHO is receiving $400MM in SAFE shares that they will then take a $140MM margin loan out against and send that, plus a $115MM term loan collateralized by all of STHO's assets back to iStar.  The term loan will amortize down quickly as all cash above $50MM will sweep to pay down principal and the margin loan will be in place at least 9 months per a lockup agreement on STHO's SAFE shares.  The proforma STHO looks something like this (note, the STHO share count will be approximately 13.3 million, or 0.153 shares for every STAR share):

The legacy portfolio is a mix of assets, the two largest ones that account for roughly half of the book value are smaller master plan communities, one is Asbury Park Waterfront (a collection of developed and pre-development mixed use properties) on the Jersey Shore and Magnolia Green (a golf course centered 1900 acre single family home community) just outside of Richmond.  STHO will also have some legacy commercial real estate loans and a parcel of land in Coney Island NY, they anticipate it will take 3-4 years to monetize most of the legacy assets.

The trickier, and possibly scarier part of STHO is the SAFE shares, as mentioned, its basically a perpetual bond masquerading as an operating company.  But with the rate curve substantially inverted, the market is pricing in quite a few rate cuts that would be beneficial to SAFE shares.

On March 17th, iStar put out a press release estimating the consolidation ratio with SAFE (it will be finalized immediately prior to the merger using a VWAP calculation) at 0.15 shares of SAFE for each share of STAR.  Using that ratio we can back into the implied price of STHO:

At today's close, unless I made a dumb error (always possible), STHO shares are trading at roughly 40% of book value.  Shares could potentially get even cheaper after the spinoff occurs, STAR is a REIT and included in REIT indices, STHO will be a c-corp and will likely get sold by any REIT index funds (although the largest ones like VNQ now include non-REIT real estate companies as well) and it won't pay a dividend.  Owning real estate right now is a bit scary, but STHO's chunkier legacy assets are tied more to residential markets and we continue to have a shortage of housing in this country.

The management agreement is also worth calling out here, they've designed it to be a fixed fee versus a bps fee on assets, with the fixed amount going down each year to reflect the intention to liquidate over a 4ish year period.  Many externally managed entities will trade at a wide discount because the assets inside the holdco will never make it back to the shareholders, here the discount should narrow overtime as the assets are monetized and proceeds are used to either paydown debt or distribute back to shareholders.
Management Fees and Expense Reimbursements
We do not maintain an office or employ personnel. Instead, we rely on the facilities and resources of our manager to conduct our day-to-day operations.
We will pay our manager an annual management fee fixed at $25.0 million, $15.0 million, $10.0 million and $5.0 million in each of the first four annual terms of the agreement, and 2.0% of the gross book value of our assets thereafter, excluding the Safe Shares, as of the end of each fiscal quarter as reported in our SEC filings. The management fee is payable in cash quarterly, in arrears. If we do not have sufficient net cash proceeds on hand from sales of our assets or other available sources to pay the management fee in full by the original due date of the management fee, we will pay the maximum amount available to us by the original due date and the remaining shortfall will be carried forward and be paid within 10 days after sufficient net proceeds have been generated by subsequent asset sales to cover such shortfall in full; provided that in no event may such shortfall in respect of any fiscal quarter remain unpaid by the 12 month anniversary of the original due date.
I went synthetically long STHO this week by shorting out 0.15 shares of SAFE for each share of STAR.  You could also go one step further and short out the SAFE shares that STHO will own. 

Disclosure: I own shares of STAR and short shares of SAFE (synthetically long STHO)

Friday, March 17, 2023

PFSweb: Updated Thoughts After Sell Off

What a wild week in markets.  I'm finding plenty of new ideas, unfortunately don't have enough dry powder to throw at them all.  Instead, I'm going to re-highlight PFSweb (PFSW) ($87MM market cap) as a boring business that shouldn't be impacted by bank or market stress trading at an extremely low multiple while also pursuing a sale.  PFSW is a third-party logistics company primarily providing online order fulfillment services for 100+ retail brands.  In 2021, PFSW came on my radar when they sold a large business unit and were continuing to pursue strategic alternatives for the remaining 3PL business.  M&A markets have slowed since then but they're still guiding to wrap up the process sometime in 2023.  To be fair they could end up remaining public and pursuing a go-it-alone strategy but their posture has been a sale.  In PFSW's recently updated investor deck (whole thing is worth a look if you're interested in the idea), they lay out the following options:
#2 scares me a bit as it sounds like what ADES did, but PFSW already distributed most of their cash to shareholders in a special dividend last year, they don't have a huge cash balance burning a hole in their pocket.

Providing 3PL services to the retail industry, you'd expect PFSW to be in the midst of a covid hangover similar to UPS/FDX or Amazon, but the company has continued to grow on top of their covid gains and are similarly guiding to 5-10% revenue growth and 6-8% standalone EBITDA margin in 2023 (on their recent conference call, 2023 is off to an "very strong start" and later a "phenomenal start").  They also provide their estimate of public company costs of 2% of revenue that could be eliminated by either a strategic acquirer or if the company was taken private.  Following the 2021 asset sale and special dividend, PFSW has a clean balance sheet with $30MM in net cash.
The above is using the standalone EBITDA guidance (full corporate overhead), if we use the ex-public company cost guidance it naturally looks even cheaper.
A popular 3PL is GXO, a recent spin of XPO Logistics, GXO is a much larger, more scaled and diversified business, but it trades at 13x 2023 EBITDA guidance levels, well above PFSW that is under 4x EBITDA.
PFSW reported earnings on the 14th, its down about 30% since then despite no negative news coming out of the earnings report or the conference call.  My guess is either someone is getting liquidated, this is a relatively illiquid stock, or the revenue guidance is getting picked up by data aggregators as a significant decrease.  PFSW had a quirky contract where their GAAP revenue was distorted higher, but that ran off last year, their GAAP revenue will now match their previously reported "service fee revenue".  

The sale process has dragged on longer than anticipated, they wanted to dress up the company for sale and by the time the makeover was done, the markets have changed just a bit.  There should buyers for this business, dozens of private 3PL providers would make strategic sense and plenty of middle market PE shops that could also be interested.

Disclosure: I own shares of PFSW and calls

Friday, February 24, 2023

Sculptor Capital Management: Boardroom Fight, Cheap Stock

Sculptor Capital Management (SCU) (~$500MM market cap) is probably more familiar to most by their old name, Och-Ziff (OZM was the old ticker) or OZ Management, but the storied hedge fund manager (one of the first alternative managers to publicly list pre-GFC) has run into tough times in recent years.  There was a bribery scandal in the mid-2010s that saw the firm pay over $400MM in fines and in more recent years a public succession spat between founder Daniel Och and current CEO/CIO Jimmy Levin over Levin's pay package.

Sculptor today has approximately ~$36B in assets under management, roughly half of which is in CLOs that have lower management fees, with the rest in a mix of their flagship hedge fund, real estate and other strategies.  The publicly traded entity is a holding company that owns partnership units in the operating partnership (see the below diagram) which creates confusion around the share count and ownership percentages of the parties involved.

Och left the company in 2018, but continues to own a piece of the operating partnerships and controls ~12% of the vote (Levin has ~20% of the vote) through the B shares.  B shares don't have any economic interest in the publicly traded holding company, but are meant to match the economic interest in the operating partnership (if you squint, its one share one vote), if you see it reported that Och owns less than 1% of the company, that's just the publicly traded SCU shares.  He's presumably still a significant owner of the business, which makes the current situation awkward and certainly doesn't help capital raising efforts.  Och doesn't want Levin running what he views has his company, and Levin doesn't want Och owning a piece of what he views as his company.

In October, Och sent a letter to the board, the key excerpt:

I, as well as other founding partners, have been contacted by several third parties who have asked us whether the Company might be open to a strategic transaction that would not involve current senior management continuing to run the Company. It is not surprising that third parties would see the potential for such a transaction given that outside analysts have previously identified the Company’s management issues and concluded that, at its current trading price, the Company may be worth less than the sum of its parts.

Shortly after, Sculptor's board responded that they're always open to third party offers.  The back and forth went on from there, on 11/18 the board formed a special committee, presumably there's an effort being made to either sell the management company in whole to a third party or Levin taking it private and out of Och's hands, or possibly some combination where the CLO business gets sold to a third party and the remaining business is taken private.

What might it be worth?  The financials are pretty confusing here, there's a lot of operating leverage in the business, high fixed costs in the form of large minimum bonuses, the business isn't one you'd consider being run for the shareholders first.  Last year was a tough year, the flagship fund finished down mid-teens, but a few quarters back, Levin outlined the following "run-rate" expectations for the business:

Today, we have meaningful earnings power, and we generally think about this in 2 buckets. First bucket, management fees less fixed expenses or, said differently, earnings without the impact of incentive income and the variable bonus expense against that incentive income. And the second is inclusive of that incentive income and that variable bonus expense against it.

So in the first bucket, we look at it as management fees less fixed expense, and this went from a meaningfully negative number to what is now a meaningfully positive number, and that's the simple result of a couple of things. It's growing management fees while reducing or maintaining fixed expenses. And the growth in the management fees comes from the flow dynamic we discussed, and it comes from compounding capital within our evergreen funds. And so where that leaves us today is just shy of $1 of earnings per share from our management fees less fixed expenses.

Alternative managers are typically valued on base management fees, incentive fees are often lumpy and shared heavily with the investment team.  If we're trying to derive a private market value, $1/share of management fees is a nice round number to use.  Most alternative managers trade for a high-teens multiple of management fee earnings, but we'll discount SCU here to 10x to account for the hair and past reputation.  Also a third-party might be worried that assets would flee without Levin in the CEO/CIO seat.

Sculptor's balance sheet is in fairly good shape, with $250MM in cash and ~$150MM in investments in their funds, backing out the remaining $95MM term loan gets you to $306MM of net assets.  Putting it all together, I get something around $15/share for SCU versus a current price below $8.50.

I'm over simplifying things here, I could be making an obvious error, but the current structure doesn't seem to work for Och, Levin or the business.  Some corporate action needs to happen and there's plenty of candidates that would be interested in this business.  If the status quo prevails for some reason, the stock seems cheap anyway, the company seems to agree as well, they have spent $28.2MM of a $100MM stock repurchase authorization (significant compared to the Class A float) as of their Q3 earnings.

Disclosure: I own shares of SCU

Talaris Therapeutics: Trading Well Below Cash, Strategic Alternatives

Talaris Therapeutics (TALS) (~$79MM market cap) is another failed biotech that recently announced they are pursuing of strategic alternatives after discontinuing a phase 3 trial and a phase 2 trial for their cell therapy intended to help those with kidney transplants.  Talaris hasn't completely raised the white flag, but close, they are still enrolling patients in another phase 2 trial, this time for scleroderma, and only laid off one-third of their workforce (112 employees as of the last 10-K).  However, Talaris is trading well below cash even in a conservative 4 quarters of cash burn scenario, any hint of a liquidation or other corporate action could spur the shares higher.

Talaris disclosed in their recent 8-K that they had $181.3MM in cash and securities remaining.  Using the implied Q4 cash burn rate for the remainder of 2023, I get a proforma net cash amount of $129.3MM against a current market cap of $79MM.  One benefit here is the presence of Blackstone's Life Sciences arm (Clarus Ventures) which owns just under 20% of the shares, hopefully enough to look out for shareholder value during the process.

Disclosure: I own shares of TALS

Saturday, February 11, 2023

Oramed Pharmaceuticals: Trading Well Below Cash, Strategic Alternatives

Oramed Pharmaceuticals (ORMP) (~$85MM market cap) is a biotechnology company that has a platform designed to reformulate injections/vaccines into orally administered drugs.  Their furthest along asset is ORMD-0801, orally administered insulin for diabetes patients, it recently did not meet its primary or secondary end points in their Phase 3 trial.  Previously, Oramed had been guiding to a 2025 anticipated FDA approval for ORMD-0801, given this sudden failure, the stock naturally dropped considerably on the news.  Then on 2/9, the company announced they were "examining the Company's existing pipeline and conducting a comprehensive review of strategic alternatives focused on enhancing shareholder value."  In addition to the diabetes trial, Oramed does have an ongoing Phase 2 trial for ORMD-0801 in patients with NASH, a liver disease without an approved FDA treatment.  Lastly, Oramed owns 63% of Oravax, a joint venture that is pursuing an orally administered COVID-19 vaccine and other applications of an oral vaccine.

Doing the same math as MGTA, below I took the 9/30 cash and subtracted four quarters of their cash burn (including the $1MM/quarter in interest income) since they're earlier in their busted biotech lifecycle, i.e. they haven't let go of their workforce (couldn't find the employee count in their filings, but Oramed only has 16 employees on LinkedIn) and haven't shutdown their other trials.  On the plus side, they only have a minimal lease obligation here, making it a bit of a cleaner balance sheet.

The same risks apply to ORMP as the rest of the busted biotech bucket, the company may decide to double down on their remaining pipeline, do a poorly received reverse merger, etc.  But the discount is significant and there might be some salvage value to their intellectual property.  

Keep in mind, I own all these in all small sizes, they're low conviction individually but I think should do well as a group.

Disclosure: I own shares of ORMP

Friday, February 3, 2023

Magenta Therapeutics: Trading Well Below Cash, Strategic Alternatives

This will be a relatively quick one, thank you to Writser for pointing me in this direction.

Magenta Therapeutics (MGTA) (~$47MM market cap) is another addition to my growing basket of failed biotechnology companies that are pursuing strategic alternatives like a reverse merger or liquidation.  Magenta is a clinical stage biotech focused on improving stem cell transplantation.  Their primary product, MGTA-117, initially had positive data readouts in December for their ongoing Phase 1/2 trial, but shortly after, patients using higher doses started experiencing adverse effects, culminating with the death of one trial participant and the subsequent shutdown of the MGTA-117 clinical trial.  Then yesterday afternoon, Magenta announced they were going to explore strategic alternatives, the press release is rather vague and generic.  But similar to SESN and others, I anticipate Magenta first trying to explore a buzzy reverse merger with a more promising biotech, if that doesn't work, pursue a liquidation.

Magenta's balance sheet is fairly simple, they had $128.3MM in cash and treasuries as of 9/30, no debt other than subleased space in a Cambridge, MA office/lab complex.

Since we're getting close to half way through Q1, I annualized the Q3 burn rate for two quarters.  The company hasn't given any initial indication of eliminating their workforce (as of the last 10-K, they had 75 people), but I expect that to follow shortly, along with breaking their lease.  Cambridge is a biotech hot spot, Magenta or the primary lessee shouldn't have too much trouble finding a new tenant.  Feel free to make your own assumptions, but I come up with MGTA trading at about a 40% discount to proforma net cash even after spiking on the news today.  In terms of other assets, Magenta does have $247.2MM in NOLs and two other early stage product candidates (one has a Phase 2 trial ongoing), but as always, difficult to put a value on those.

The primary risk here could be the company deciding to double down on their two other early stage products, but the discount is wide enough here to warrant an add to the basket.

Disclosure: I own shares of MGTA

Wednesday, February 1, 2023

Advanced Emissions Solutions: Recut Deal w/ Arq, Torpedoes Shareholder Vote

Typically, I don't like to write about stocks that I don't own but I'm going to break that soft rule here, as mentioned in the Year End post, I sold my shares in Advanced Emissions Solutions (ADES) ($59MM market cap).  My original post outlining the thesis from November 2021 is here, as usual, the comment section is worth going through for a blow-by-blow of the events.

This afternoon, ADES published a press release announcing their merger with Arq Limited had been completed.  That required a double take and a quick click since the merger as originally constructed required a shareholder vote to complete, and no such vote was held.  

To take a step back, in May 2021, ADES announced it was pursuing strategic alternatives as the run off in one segment was generating a lot of cash, but that business was coming to an end due to the expiration of a tax credit, leaving just their Activated Carbon business (Red River plant) which is subscale for a public company.  According to the background section in the original deal's S-4 filing, ADES received several non-binding indications of interest from private equity firms shortly after publicly announcing a process for their remaining Activated Carbon business for between $30-$50MM.  However, ADES flipped to being a buyer and in August 2022, finally entered into an agreement with Arq Limited for a reverse merger where ADES would acquire Arq for cash and stock.  It was a very SPAC-like deal (here's the SPAC deck) with a pre-revenue startup and rosy revenue outlook several years out.  Shareholders who were expecting a liquidation type transaction revolted, sending the shares from $6.41 immediately prior to the deal announcement (to be fair, it had spiked over the previous week after ADES management indicated a deal was near on their Q2 earnings call) to a $3.86 on the close, then drifting all the way down to $2.20/share in December.  For context, as of 9/30 the company had $86MM of cash or $4.50/share, if they sold the Activated Carbon business to one of the PE firms, shareholders could have netted somewhere in the area of $6.50/share.  Much lower than I originally penciled out, but well ahead of where shares trade today.

With that value discrepancy, you'd expect an activist to come in and attempt to break the deal, force a quick sale of the Activated Carbon business, distribute all the cash and reap a nice tidy profit.  However, that was impossible because ADES has a rights agreement preventing anyone from crossing the 5% ownership threshold in order to maintain their NOLs and tax credits.  That 5% ownership limit in combination with the small market cap prevented most funds from owning shares (its individual investors who are getting screwed here).  In a strange twist, the original transaction with Arq Limited would qualify as an ownership change, therefore eliminating the NOLs and tax credits, but the rights agreement protecting those tax assets was still in place.  Despite that, there was some hope that shareholders would vote the deal down (like MTCR that was discussed in my SESN post comments) or it would be terminated before to save the embarrassment, forcing the company into a liquidation.

That brings us back to today, ADES recut the merger with Arq presumably to circumvent the shareholder vote by issuing a new series of preferred shares (this kind of rhymes with the shenanigans over at AMC with the APE preferred shares) to Arq shareholders as consideration.  

The preferred shares feature a 8% coupon and are convertible to common stock at a $4/share conversion price if approved by common stock holders.  Common stock holders have no reason not to approve the conversion, saves the 8% coupon the company can't afford (it will be cash flow negative for the next couple years, even under their rosy projections) and it would convert at an above market price.  The debt financing is also to a related party, a board member of Arq (will also be on the new ADS board) that pays 11% cash coupon, plus a 5% PIK.  

While the deal is optically better for ADES shareholders (not saying much, presumably does preserve the tax asset, but questionable whether the combined company ever generates significant taxable income), it likely would still get voted down, after hours trading reflects this as well, shares were down ~16% as of last check.  Hard to speculate on motivation, but management owns little stock and probably wants to keep their well paying jobs.  Apologies to anyone that followed me into this situation, I hope I'm missing something.  None of this smells right.

Disclosure: No position

Thursday, January 26, 2023

Sesen Bio: Plan A Reverse Merger w/ Carisma, CVR; Plan B Liquidation

Sesen Bio (SESN) (~$130MM market cap) is another failed biotech themed investment idea.  Sesen Bio has one late-stage product candidate, Vicineum, a treatment for a type of bladder cancer, where a biologics license application (BLA) was filed with the FDA, but Sesen was sent back to the drawing board when the FDA issued a CRL (not a denial, but a "needs work") in August 2021 citing deficiencies in the original application that would require Sesen to complete a new (and long/expensive) Phase 3 trial before refiling.  Sesen believes that Vicineum still has a path to approval, but the stock traded well below net current asset value on the news, limiting Sesen's capital raising ability to move forward alone with a revised Phase 3 trial.  The company then announced they were pursuing strategic alternatives, which in failed biotech language usually means a reverse merger, if that doesn't work out, a liquidation.

In September 2022, Sesen's board went with Plan A, by announcing a reverse merger with Carisma Therapeutics, another cancer focused biotech with a supposedly promising platform ("CAR-M") but very much early/clinical stage.  The original deal was for 34.4% net ownership of Carisma and a CVR that would pay $30MM or ~$0.15/CVR out if Roche initiates a Phase 3 trial on EBI-031 (Sesen was f/k/a Eleven Biotherapeutics); Roche currently has Phase 2 trials ongoing with an estimated completion date of September 2024.  Importantly, none of the cash was to be return to shareholders and the combined Carisma would receive any proceeds from other asset sales.  Later it was first adjusted to include a special dividend of up to $25MM, based on the excess cash over $125MM delivered to the new merger entity from Sesen.

Shareholders disliked the deal, the stock promptly dropped on the news.  As an heathcare/biotech outsider, it can be difficult to tell which reverse mergers will pop and which will fail, often it seems to be timing, where the market's risk appetite is at any given moment.  But here, going from a liquidation candidate (similar to the situation over at ADES) to the board approving investing shareholder cash into a clinical stage company was a poor read of the room.  An investor in Sesen could sell their shares and invest in countless other similar science experiments, didn't need Sesen's board to do that for them.  What makes things worse here, management and the board own very little stock themselves.

Two investors came forward (dubbed "Investor Group", they own 8.5% of SESN) against the deal, instead pushing for Plan B, a liquidation.  Some back and forth went on behind the scenes, thanks to the activists, Sesen and Carisma recut the deal but it still is insufficient according to the Investor Group, who are still planning on voting against the reverse merger on the upcoming 3/2 shareholder meeting (if approved, deal will close shortly after).

Here's the new recut deal, for context, shares trade for $0.62/share today:

  1. $75MM or $0.34/share special dividend
  2. CVR that would receive the sale proceeds from Vicineum and other pipeline assets (no good guess here, but possibly a meaningful amount), plus the $30MM ($0.14/share) milestone payment from Roche if Roche initiates a Phase 3 trial for EBI-031 prior to 12/31/26
  3. 25% ownership in Carisma Therapeutics (CARM will be the new ticker), at the stated deal value of $357MM, that's $0.41/share of value to SESN shareholders.  This is the value pre-closing financing partners (which includes a few blue chips names like AbbVie and Merck) are purchasing shares in Carisma ($30MM at $15.60 per share, 37.7924 exchange ratio into pre-reverse split SESN shares) which should have some haircut applied
Investor Group is still pursuing a liquidation, claiming that Sesen could return $140MM in the near term, or $0.70/share with the remaining legacy assets monetized over the three years it would take to wind up the entity in Delaware.  Sesen struck back, saying they could only make an initial distribution of $0.40-$0.60/share.  I'm sort of indifferent to the outcome, could make arguments for both sides, a liquidation would provide a low floor/low ceiling return and the reverse merger also seems pretty protected on the downside here (assuming Vicineum does indeed have some value) with the immediate $0.34/share cash return but with upside of the CARM stub as the market begins to heat back up.  Luckily for me, I don't have to make a voting decision as the record date has already been set as 1/17, before I purchased shares.  I bought some shares this week to follow along with the drama, welcome others thoughts on this situation.

Disclosure: I own shares of SESN 

Tuesday, January 17, 2023

Vertical Capital Income: Carlyle Deal, Transitioning to CLO Equity Fund

Last week, Vertical Capital Income Fund (VCIF) ($98MM market cap) announced a proposed manager and strategy change, if approved, Carlyle Group (CG) will assume management of the closed end fund and transition the portfolio from residential whole loans to CLO equity and debt.  To encourage the proposal passing, Carlyle will make a one-time payment to VCIF holders of $10MM or $0.96/share.  Then to ensure alignment, Carlyle will tender for $25MM at NAV and invest an additional $25MM in the fund through a private placement done at NAV.  Following these transactions, Carlyle will own ~40% of the fund.

CLO stands for collateralized loan obligation, these are securitized pools of below-investment grade senior secured bank loans made to corporations (largely PE sponsored).  CLO equity sits at the bottom of the securitization's capital structure and receives the residual cash flow after all expenses and interest is paid to senior noteholders in the transaction.  CLO notes feature term financing with no mark-to-market, meaning CLOs can withstand volatility in the underlying bank loan market and often the manager can "build par" to offset any losses in the portfolio by purchasing loans at a discount and holding them through repayment at par.  CLO equity is generally underwritten to a mid-teens IRR.  There are several publicly traded CLO equity funds today, two prominent ones are Eagle Point Credit Company (ECC) and Oxford Lane Capital (OXLC), both trade roughly inline with NAV or slightly ahead (NAV is lagging, loans are up 1.80% to date, CLO equity values are likely up a bit).

Carlyle is one of the largest CLO managers, by taking over this fund, the PE giant will have a permanent source of equity capital for future CLOs.  This is important for future fund formation and why Carlyle is willing to pay $10MM to holders directly.  Fees to fund holders are going up in the transition as well (but roughly on par with similar funds/BDCs), VCIF currently pays 1.25% of assets, now will pay 1.75% of assets plus a 17.5% incentive fee above an 8% hurdle rate.  Carlyle does get to double dip a bit, they'll likely purchase Carlyle Group managed CLOs where they also earn a management fee.

VCIF currently trades for $9.38/share against a 12/31 NAV of $10.25/share, or an 8.5% discount (without factoring in the $0.96/share payment).  The vote is mostly secured at this point, 36% of shareholders have signed a support agreement.  I quickly sketched out what the return stream might look like in the next six months (the deal is set to close in the first half of 2023):

The biggest assumptions I'm making:
  • NAV is constant, the portfolio is marked monthly, the current holdings are mortgages with interest rate sensitivity, it'll move inversely with rate expectations (mortgage rates are flat-to-slightly down YTD).  As part of the transaction, current management has committed liquidating to cash at least 95% of the gross assets in the portfolio, thus reducing the NAV risk.
  • Only the January distribution is made and it doesn't erode NAV.  Additional interest income we'll assume goes to pay for any deal expenses the fund is expected to pay.
  • All holders participate at 100% in the tender offer.  If less than 100% participate, it improves the realized IRR.
  • Following the transition, the shares trade at a 15% discount to NAV.  In the last 12 months, the fund's shares have traded at an average discount of 12% and as mentioned earlier, the prominent CLO equity funds trade roughly in line with NAV.

I come up with a ~18% IRR for the 5+ months it'll take to close this deal (feels like it should happen sooner pushing the IRR above 20%) and might hold after closing when it will be rebranded as Carlyle Credit Income since CLO equity is reasonably cheap today.

Disclosure: I own shares of VCIF 

Tuesday, January 10, 2023

MBIA Inc: Puerto Rico Exposure Cleaned Up, Sale Next?

MBIA Inc (MBI) ($680MM market cap) is now a shadow of its former self, prior to the 2007-2009 financial crisis, MBIA was the leading financial guarantee insurer in the U.S., where MBIA would lend out its AAA rating to borrowers for an upfront fee.  This business model probably never made sense, it assumed the market was consistently mispricing default risk, the fee MBIA charged had to make it economical to transform a lower rated bond to a higher rated one.

In the early-to-mid 2000s, MBIA was leveraged over 100 times, they guaranteed the timely payment of principal and interest on bonds that were 100+x that of their equity, only a small number of defaults would blow a hole into their balance sheet.  When the business was first founded, MBIA focused on municipal debt through their subsidiary National Public Finance Guarantee Corp ("National"), with the thesis being that even if some municipal bonds weren't formally backed by taxpayers, there was an implied guarantee or a government entity up the food chain that would bail out a municipal borrower.  That has largely proved true (minus the recent quasi-bankruptcy in Puerto Rico), however MBIA was greedy and grew into guaranteeing securitized vehicles (via subsidiary MBIA Corp) prior to the GFC.  MBIA and others (notably AIG Financial Products) got caught, finding themselves on the hook for previously AAA senior tranches of ABS CDOs and subprime-RMBS that went on to suffer material principal losses.  There was no one up the chain to bail out a Cayman Islands special purpose vehicle with a P.O. box as a corporate address.  A lot has happened in the 15 years since 2008, MBIA Corp stopped writing new business almost immediately, National continued to write new business on municipal issuance but stopped in 2017 after Puerto Rico went further into distress, National had significant exposure to island.  The business has been in full runoff since then.  

The distinction between National (municipal bonds) and MBIA Corp (asset backed securities) is important, MBIA Corp and National are legally separate entities that are non-recourse to the holding company, MBIA Inc.  MBIA Corp's equity is way out of the money, completely worthless to MBIA Inc, the entity is being run for the benefit of its former policyholders.  National on the other hand has positive equity value, but when consolidated with MBIA Corp on MBIA Inc's balance sheet, results in an overall negative book value.  But again, these are two separate insurance companies that are non-recourse to the parent.  The SEC slapped MBIA Inc's wrist for reporting an adjusted book value based on the assumption that MBIA Corp's negative book value was no longer relevant to the parent, as some compromise, MBIA Inc stopped providing the end result, but still provides the components of their adjusted book value (not sure how that's significantly different, but whatever).  Here are the adjustments for Q3:

By making these adjustments, MBI's adjusted book value is roughly $28.80/share, today it trades for $12.50/share.  The last two items in the adjusted book value bridge are more runoff-like concepts, these are the values that MBIA Inc would theoretically earn over time as the bonds mature in their investment portfolio and erase any mark-to-market losses (largely driven by rates last year) and then any unearned premiums assuming their expected losses assumptions are accurate.

I've kind of skipped over Puerto Rico, I've passively followed it over the years via Reorg's podcasts, it is too much to go into here, but MBIA Inc's (via National) exposure is largely remediated at this point (announcing in December that they settled with PREPA, Puerto Rico's electric utility that was destroyed in Hurricane Maria), clearing the way to sell itself.  From the Q3 earnings press release:

Bill Fallon, MBIA’s Chief Executive Officer noted, “Given the substantial restructuring of our Puerto Rico credits, we have retained Barclays as an advisor and have been working with them to explore strategic alternatives, including a possible sale of the company.”

Essentially all of the bond insurance companies have stopped writing new business, the only one of any real size remaining in the market is Assured Guaranty (AGO) ($3.7B market cap).  Assured has significant overlap with National that would drive realistic synergies.  Street Insider reported that AGO and another company are in advanced talks with MBIA.  They're the only true strategic buyer (maybe some of the insurers that bid on runoff operations might be interested too), AGO also trades cheap at roughly 0.75x GAAP book value.  AGO would need to justify a purchase to their shareholders that would at least be on par with repurchasing their own stock (which they do constantly).

In my back of the envelope math, I'm only pulling out the negative book value associated with MBIA Corp from the adjusted book value, then slapping a 0.75x adjusted book value multiple on it.  Again, the other two items in MBI's adjusted book bridge seem more like market risks a buyer would be assuming and should be compensated for bearing the risk of eventually achieving.  AGO should be able to justify paying the same multiple for MBIA Inc since it will include significant synergies.  I come up with a deal target price of approximately $16/share, or 28% upside from today's prices.

I bought some shares recently (I know, another speculative arb idea!).

Disclosure: I own shares of MBI