CIM Commercial Trust: Proxy Fight, Possible Liquidation or Sale

CIM Commercial Trust (CMCT) is another small illiquid idea (~$240MM market cap), CMCT owns about ten office properties in LA, Oakland and Austin, plus the Sheraton Grand Hotel in Sacramento.  When thinking about asset types and locations where covid has been the most impactful -- office, CBD hotel, Bay Area migration, LA lockdown -- CMCT checks a lot of those problem boxes.  CMCT is an externally managed REIT, the manager is CIM Group, a fairly large and well respected real estate firm based out of Los Angeles.  The shares trade at a discount to the company's own estimated NAV (which is very stale, pre-covid), two different activists have put forward a slate of new directors  (here and here) with the intention to liquidate the portfolio.  I believe there's a decent chance management caves here and either commences a liquidation on their own or kicks off a strategic alternatives process aimed at selling the company to one of the other west coast focused office REITs.  The upside is a bit unclear to me (open to hearing from people with a stronger view), so possibly this is more of a watchlist idea, but I opened up a starter position at just under $14/share.  It popped unexpectedly today, apologies that this is not as timely or actionable, it could give it all back, but just for context purposes my cost basis is a bit lower than where it is trading today.

CMCT has a strange origin story for a public REIT, it began life in 2005 as a private equity real estate fund diversified across office, multi-family and hotel.  In 2014, as the fund's maturity was coming up, it was reverse merged into a small mREIT ("PMC Commercial Trust") that made SBA loans (CMCT oddly still makes SBA loans in this legacy segment), with the PE fund owning well over 90% of the proforma entity, but only the non-PE investor shares traded publicly creating this odd stub.  Cynically, CIM took a limited life fee stream and turned it into a permanent one at the detriment of their investors as the shares have failed to trade close to NAV since the reverse merger.  In the meantime, CIM has sold the majority of assets within CMCT in a few different slugs and then returned capital to investors either through a buyback or a big special dividend that was issued in 2019.  Notably, those asset sales were done near their published NAVs at the time.  So here we are now, a subscale externally managed REIT with long suffering shareholders that has limited options to raise capital to grow, sort of stuck in no man's land heading into a post-covid world.

Here are the real estate assets today:

Again, the portfolio is heavy on Oakland and LA.  In Oakland, they own the Ordway Building (1 Kaiser Plaza) which is primarily leased by Kaiser (30% of CMCT's overall rent roll).  Kaiser previously announced they would build a new headquarters in Oakland and consolidate their real estate foot print (presumably exiting CMCT's asset) but recently they cancelled those plans in light of the pandemic, so potentially Kaiser could extend their lease.  If not, market rents pre-pandemic were a decent bit higher than in place rents, we'll see how things shake out in the Bay Area, but Oakland could cool off significantly as San Francisco office becomes cheaper and reduces the spill over into the more affordable Oakland market.  Additionally, they do own a parking lot next door, which they've been marketing as a build-to-suit, but presumably new office development is off the table for several years, my guess is it remains a surface lot for the foreseeable future.

The other chunky asset of concern is the Sheraton Grand Hotel in downtown Sacramento.  CIM acquired the hotel in 2009, it sits next to the convention center in Sacramento which is finishing up a renovation and expansion project, the convention center is scheduled to open in February.  Pre-covid, CMCT was planning to invest $26MM to renovate the hotel, but those plans have been put on hold.  CMCT also owns another parking lot across the street that they suggest is an additional development site for either a hotel or multi-family tower.  Located in a state capital and positioned next to the convention center, I can see a path where this hotel fully recovers.  Downtown Sacramento has seen a considerable amount of development recently and there are a number of hotels that are in the pipeline, one is even considering breaking ground soon, signaling demand or at least the expectation of a recovery in the market.  The hotel is still cash flow negative, in October (last data point) it only averaged a 29% occupancy rate, and isn't expected to cross the break even line during the first half of 2021.

In LA they own several clusters of assets, LA is CIM Group's backyard.  I don't have much to add here, the one asset that is only 21% occupied was previously earmarked for a significant repositioning, but that's been put on hold as well.  The below slide management puts out also shows all of the properties CIM has exited over the years, clearly you can see that they're one of the major players in the LA market providing some comfort around this piece of the portfolio.

The other assets include an office complex in Austin that was just leased up and a small loft style office property in San Francisco.  And as mentioned earlier, they oddly still operate the SBA lender business which is a legacy from the reverse merger.  Making SBA 7(a) loans is a fairly good business, a portion of the loan is guaranteed by the government, SBA loan originators are able to sell that guaranteed portion into the secondary market and since it is guaranteed by the U.S. government, originators are able to sell those portions at a premium.  They're then left with servicing rights and the unguaranteed portion of the loan, which most lenders retain.  The one red flag with CMCT's SBA business, the portfolio is basically a pure player lender to franchisees of economy and midscale franchised hotels (think brands under the WH or CHH flags).  They also have PPP loans they've extended to their borrowers that will likely be fully forgiven and paid by the SBA to CMCT.  I tend to think the economy hotels make it through covid, but its worth flagging that there is risk in this asset. 

So those are the assets, the capital structure is a bit odd here, it's heavy on preferred shares, which about half of which are continuously offered through their RIA channel and are not publicly traded.  I took the 2019 proforma NOI from the Lionbridge letter and backed into what cap rate the market is putting on their assets, approximately 6.7% which feels high to me.

CIM Group does put out an annual NAV estimate, the current one is stale from pre-covid, year-end 2019.  The NAV is a little disingenuous as it also uses the old capital structure, the company has issued additional preferred stock since YE 2019.

We'll probably find out in the next month or two what the new NAV estimate is, it will certainly be lower, my back of the envelope guess is somewhere in the $20-22 range, which would be a 6.0-6.2% cap rate on 2019 NOI.

Will CIM Group cave to activist pressure? 

CIM Group was co-founded by Richard Ressler (Chairman of CMCT, also Chairman and former CEO of JCOM), Avi Shemesh and Shaul Kuba in 1994.  Today they manage just under $30B in assets, about $1B of which is CMCT (at their stale valuation) and they also have a significant non-publicly traded REIT business after their purchase of Cole Capital in 2018.  I bring that up because they recently merged a few of their private REITs, potentially in preparation to list them publicly, might be stretch but that vehicle is much larger than CMCT and they wouldn't want to damage their reputation and limit that REIT's growth in future (assuming CIM agrees that CMCT failed in becoming a growth platform).

The management agreement at CMCT is a bit non-standard for an external REIT, it was rolled over from the original PE fund and wasn't revised in the merger:

• The management fee is tiered with breaks as CMCT gets larger, but instead of getting bigger, it has only gotten smaller as a public entity, and more problematically the fee is based off of the asset value in the NAV calculation.  The stock has never traded anywhere near NAV and clearly NAV is subjective and manipulatable in their favor.  Additionally they have typical expense reimbursement provisions, read through the activist letters for more detail. 
• It is a perpetual term contract, "and shall remain in full force and effect until the Partnership is dissolved, this Agreement is required to be (or is automatically) terminated pursuant to the terms of the Partnership Agreement or the Partnership and the Adviser otherwise mutually agree" -- I'm guessing this is the angle of the activists, take over the board and then "dissolve" the partnership entity through a liquidation. But not entirely sure a proxy win for the activists is needed here.
• One benefit of rolling over the original management contract, it doesn't appear to have a termination fee which most externally managed REITs include, making it more attractive for activists to get in here and attempt to remove the manager.

CMCT is a Maryland corporation which does make it difficult to unseat an external manager, CIM insiders own roughly 20% of the company, so it's an uphill battle.  But again, this is a small piece of CIM, why ruin your reputation over a relatively small management fee stream?  And most importantly, CIM has relented to shareholder pressure before, here Lionbridge describes the events leading up to previous asset sales:

What transpired over the next few years bore little resemblance to CIM’s originally stated growth objectives for CMCT. In 2017, CMCT sold over $1 billion in assets and repurchased a similar amount of CMCT stock owned by the private fund. In its public communications, CMCT depicted these corporate actions as the result of a regular evaluation of its business and prudent management. Based on our firsthand discussions with CIM Urban REIT investors, however, we believe these sales were the result of extreme pressure from its fund investors, who were voicing displeasure for the public vehicle. In other words, only when it was clear that the REIT strategy had flopped, and under intense pressure from its pension-fund clients, did CMCT begin selling property and returning capital to investors.

 

Rather than rightfully completing the sale of its portfolio once and for all and returning the remaining value to its investors in cash dividends, CIM dug in its heels. In 2018, the company announced a "Program to Unlock Embedded Value in Our Portfolio and Improve Trading Liquidity in our Common Stock.” At the time, CMCT was trading at a nearly 40% discount to NAV. This program contemplated another $1 billion in asset sales, or roughly half of the remaining portfolio at the time. The net proceeds were distributed to shareholders, but again, instead of completing a cash liquidation, the private comingled fund was dissolved via a distribution of CMCT shares to its partners. The result was a more structurally flawed company with even less scale. Upon the distribution of CMCT shares, the partners would own over 95% of this deeply flawed and obscure REIT’s shares.

In its public messaging CMCT portrays its asset-sale programs as discretionary capital allocation moves made in response to strong markets and emblematic of CIM’s willingness to return capital to shareholders. Again, based on firsthand accounts from CIM’s partners, we believe that assertion is misleading. We understand the asset sales and return of capital were being demanded by the partners, according to some accounts, under threat of litigation and were not what CIM Group was otherwise inclined to do.

Contrary to what CIM representatives portrayed to prospective investors, what awaited the market after executing the plan to “unlock value” and “increase liquidity” was an ownership base comprising almost entirely legacy fund investors whose moods we understand generally ranged from frustrated to incensed at CIM’s refusal to completely liquidate the company for cash. In the aftermath of the distribution, the shares were soon trading at a nearly 50% discount to published NAV, wider than when the “Program to Unlock Embedded Value” was announced. They would remain in that vicinity for months before they further collapsed in the COVID-related market sell-off.

CIM Group has caved twice to CMCT investors, starkly clear this isn't a growth vehicle for them, my thesis is they'll do the right thing and either liquidate or sell the company, keep their public reputation in place for where there is actual growth (like their private net lease REIT) and brush this entity under the rug.

Another interesting way to play this idea is the Series L preferred shares (CMCTP), I tried for a couple weeks to buy shares but didn't have any luck, it is very illiquid but strangely the class has a liquidation preference of $28.37 versus the usual $25, and its redeemable next year at shareholders option, the company has the option to play stock or cash, but either way it seems like a pretty attractive high teens, low twenties IRR if you're able to get shares at $22-$23.

Disclosure: I own shares of CMCT

Year End 2020 Portfolio Review

What a traumatic and unpredictable year, certainly it has been tragic for those directly impacted by the virus or who have suffered the death of a loved one.  From a pure financial standpoint, I am in a lucky position where I'm able to work from home and didn't need to tap into savings or my brokerage account to make it through the year.  Being in that fortunate position, and also not managing outside capital, allowed me to hold through difficult times and not capitulate.  However, especially after November and December there are now signs of excess everywhere and I'm having a hard time squaring overheated speculation in certain areas with the never ending list of bargains I'm finding.  Confusing times in the market.

I finished the year up 24.34%, which is well shy of some others investors performance this year but still above the S&P's 18.40% -- fully acknowledging that the large cap index is not a good benchmark for my portfolio, on the surface I take more risk, but it's more of an opportunity cost bogey and widely quoted.  My lifetime-to-date IRR of this portfolio is 24.52%.  Positive attribution winners this year included Green Brick Partners (GBRK), Colony Capital (CLNY), Five Star Senior Living (FVE) and Franchise Group (FRG); negative attribution losers were MMA Capital Holdings (MMAC), Liberty Latin America (LILA/K) and some undisclosed special situations (MCK/CHNG splitoff, MGM tender) that went haywire in the spring meltdown.

Thoughts on a few Current Positions

• While not a high conviction idea, I still do like Accel Entertainment (ACEL), the largest distributed gaming provider in Illinois.  The thought here is that slot players are going to go hyper local post-covid, why drive an hour or two to a depressing rundown regional casino when you can drive five minutes to a depressing rundown strip mall?  These VGT locations are essentially mini-casinos first and a bar or restaurant second, the bar/restaurant piece is often regulatory arbitrage to allow for the VGTs and not the other way around.  Regional casinos make the vast majority of their money from slot machines, ACEL is the slot machine revenue without the capex and overhead of actually running a casino.  Currently there are no VGTs in the city of Chicago, but with covid destroying the budget even further, wide spread tax increases seemingly difficult to push through in the current economy, legalizing VGTs within the city limits could be on the table providing an easy growth opportunity for ACEL.
• Despite a good run in 2020, Five Star Senior Living (FVE) is still a cheap stock, with an enterprise value of just $150MM ($96MM of cash, $7MM of debt, and I'm capitalizing an RMR termination payment of 2.875x annual fees) and another $96MM of owned real estate on the balance sheet, against $30-35MM of EBITDA, trading under 4.5x EBITDA for a company that is now mostly an asset-lite management company.  Tucked away inside of FVE is a high growth rehabilitation concept, Ageility, that is growing quickly and only requires $20-30k of upfront start up costs per new location, it could be quick to scale.  What happens to all the cash?  Management clearly has their hands full operating the business this year, but once covid passes, what will be the capital allocation plan?  It hasn't been well articulated at this point.
• My obligatory bullish comments on Howard Hughes Corporation (HHC) -- Their diversified model should help them versus pure play REITs, in the coming years I picture HHC being more focused on residential land development than on office/multi-family new construction they were pre-covid, their big land banks are in Las Vegas and Houston, maybe not as hot as Austin and Miami but they're both low cost-of-living and no state income tax markets that should have the wind at their backs.  While not in the same markets, Green Brick Partners (GBRK) should continue to benefit from similar migration trends to Texas as well as their shift in focus to entry level homes which are benefiting from incredibly low mortgage rates.  Rounding out a real estate discussion, "new" BBX Capital (BBXIA) should still have some upside despite the obvious problems, their assets are primarily cash, a note to a timeshare operator (good reopening/stimulus trade) and Florida real estate which should have continued tailwinds.  It's trading at just 35% of book value, even if the right number is 50% of book value, that represents an additional 42% upside.
• MMA Capital Holdings (MMAC) has been a frustrating hold since they went to an external structure, I won't pretend that I've spent more than a few minutes on Hannon Armstrong Sustainable Infrastructure Capital (HASI), it appears to be a better and more diversified business, but it trades at over 4.75x book value and MMAC trades at 0.65x.  Just reading through the HASI 10-K and investor presentations you get all the good ESG vibes that MMAC should be putting out, but still aren't, maybe with the recent CEO we'll see a change, with all the money flowing into ESG products, MMAC has to take full advantage.  Even from a skeptical external manager point of view, you'd assume Hunt wants a piece of what could be a decade long theme.
• Colony Capital (CLNY) was a significant winner for me this year, thank you to those that encouraged me to take a closer look at the common after my post on the preferred stock near the bottom of the crisis.  I doubt I'll have much to add on CLNY going forward, the business is a bit above my head, but willing to give Ganzi some room and will continue to hold.  I found this write-up well done and helpful in modeling the path forward from here.  Even if you're not sold on CLNY, I think it is worth of monitoring because of the number of transactions that revolve around it (hopefully CLNC), there will opportunities that arise in the next few years.

Previously Unmentioned Positions

• Back in the spring, I puked out of my position in Perspecta (PRSP), a 2018 spinoff of DXC that provides IT services to the government, but since then activist fund JANA Partners has taken a liking to it after PRSP passed its 2 year safe harbor post-spin making it able to be acquired without jeopardizing the tax free spinoff.  In November, Bloomberg reported that PRSP had hired advisors to pursue a sale.  The original thesis was that PRSP could be a replay of CRSA (also a DXC government services spinoff) which was sold for 12x EBITDA to General Dynamics, that thesis might still hold, 12x PRSP's ~$600MM EBITDA would be approximately $30 per share. 
• ECA Marcellus Trust I (ECTM) is a 2010 vintage oil and gas trust that were a popular structure a decade ago, an E&P company would sell producing wells to the trust and the trust in turn sold shares to retail investors promising high dividend payments.  Unsurprisingly, these didn't go quite as promised, ECTM is now a tiny nano-cap that is pushing closer to tripping a clause in its trust indenture that would force a liquidation of the trust, returning any proceeds to unit holders.  ECTM shut off the dividend and if the royalty payments fall below $1.5MM for the trailing twelve months the trust will liquidate, royalty payments were $1.12MM through 9/30 putting it very close to tripping for the year.  Greylock (successor to the original sponsor ECA) projects the royalty to exceed the threshold this upcoming quarter (however that was before natural gas prices started to fall on fears of a warm winter), even if it does, it appears this trust will trip it sometime next year forcing the liquidation.  The trust has 17,605,000 units outstanding, trading at a price of $0.17, for a total market cap of just ~$3MM against a book value of $17MM.  Most of that book value is the estimated fair value of the royalty interests which can be pretty squishy, Greylock has the right of first refusal buying the royalty interests back and there's a bit of uncertainty around if ECTM is entitled to get 100% of that payment or 50% (I read it as the 50% clause applies only on the formal trust termination date of 3/31/30 but I could be wrong).  Either way, pretty attractive upside that should be non-correlated with much of the market, but again, only a small PA type trade.
• I did jump into the SPAC arb trade with Pershing Square Tontine Holdings (PSTH) thanks to a great post by Andrew Walker.  Instead of selling puts, I did a buy-write trade, just fits my eye a little better.  I see the downside as pretty minimal, Bill Ackman is an incredible marketer (I'm generally a fan of him despite his flaws) and if a deal is announced in the next few months that would close before 6/18/21, I have a hard time imaging it would trade significantly below the trust value after it de-SPACs.  Ackman will get on TV, etc., and he'll also be investing a significant sum alongside PSTH in a pre-committed PIPE at $20 further providing support to the transaction value.  Selling pre-deal SPAC call options might be a theme for me next year.

Closed Positions

• On 10/19, Front Yard Residential (RESI) announced that it would be acquired by a consortium of private equity (Ares and Pretium) for $13.50 per share, I sold that day, and then several weeks later on 11/23, the offer was bumped up to $16.25 after a better offer came to light.  This could be the start of similar deals where post-covid the entity will be too subscale (MCC and CLNC are two potential examples) and there is plenty of private equity money out there willing to buy cheap real assets.
• I've mostly reduced my exposure to hospitality plays, Extended Stay America (STAY) has weathered the storm nicely as their rooms feature kitchens (limiting interaction between guests) and acts as temporary residences rather than true leisure travel.  It also drummed up some rumors of PE interest, I sold to put money to work in other places, but it could be worth monitoring as it still is the only remaining major hotel chain that is both the brand manager and the owner of its hotels (plus the weird paired share structure), eventually that will change.  Similar idea with Hilton Grand Vacations (HGV), it probably still gets sold at some point to Apollo (who will pair it with DRII before coming back to the public markets), but I sold to put money to work elsewhere, HGV might be interesting as a re-opening trade.  I could see stimulus checks going towards downpayments on timeshares, people will want to "live a little", prioritize vacations again, plus timeshares are similar to extended stay, often feature a kitchen and more space that might be desireable in a post-covid environment.  Lastly, I have been selling calls over and over on Wyndham Hotels & Resorts (WH), the implied volatility (not that I really know what that means) seems to be too high to me and so I've been rolling covered calls until the day when the shares get called away from me.  WH is almost a pure franchising play on economy and midscale hotels, which have held up better than the upscale business or destination focused hotels, but its trading at a fairly full 12x 2019 EBITDA and who knows when it'll get back to 2019 EBITDA levels?  I like the business, but feels like its been bid up as a reopening play alongside MAR/HLT when it shouldn't necessarily as its business model is significantly different enough.  These three all skew away from the traditional business traveler which will likely be the last to return in full, so all three could be attractive depending on your view of the reopening trade.
• Another one where there is probably a little more upside but I've needed cash for other ideas is Gaming & Leisure Properties (GLPI), their primary tenant is Penn National Gaming (PENN), PENN's stock as 20x since the bottom and presumably has unlimited access to capital right now thanks to Barstool Sports and the online sports gambling theme.  PENN starts to pay cash rent again here next month which should allow GLPI to reinstate a cash dividend (dividends have been a combination of cash and stock this year) and should fully recover to the mid-to-high $40s. 
• I finally let go of Liberty Latin America (LILA/K) this month (at least temporarily), I did fully participate in the recent rights offering and the stock responded well after that, but had a sizeable tax loss that just became too valuable for me this year.
• I sold about 2/3rds of my Avenue Therapeutics (ATXI) position after getting long term capital gains treatment, unfortunately, I should have sold it all as I ended up taking a loss on the remaining 1/3rd when ATXI failed to secured FDA approval for IV tramadol.  Their merger partner has moved to terminate the deal while ATXI is trying to fix their FDA submission, I'm far out of my comfort zone in trying to handicap the situation but could be an interesting idea for others more inclined.
• The Marchex (MCHX) tender offer was bumped up and I exited, haven't followed it much since then but did have several people reach out to me saying their call analytics software is best-in-class so there might be something there to those interested in small cap software businesses.
• Maybe it was a bit of "quarantine brain", but I did a lot of small merger arb or other quirky special situations throughout the year that I didn't get to writing about or didn't have anything more to add to the discussion -- more than I normally would -- these included CETV, SKYS, BREW, DLMV, SPAC warrant exchange offers for BIOX and ATCX.  One positive to the SPAC mania this year is its likely to result in a lot of interesting special situation opportunities in the coming years.  Screw ups included the MCK/CHNG exchange offer where I was unhedged and loss a fair amount of money and to a lesser extent miscues with the MGM and AMCX tender offers.
• Two old CVRs came up empty, INNL and GNVC, BMYRT appears to be the same way, I still want to like these but it is important to be selective, think through the structure of each CVR and the counterparty.  On the positive side I did receive interim distributions from IDSA and MRLB -- although curiously MRLB hasn't paid its final milestone payment despite the sales threshold being met several months ago, if you know the story there, please reach out.

Performance Attribution

Current Portfolio

My leverage is a bit higher than I'm comfortable with right now, but given personal circumstances, didn't want to realize gains in 2020 versus 2021, so I might be trimming early in 2021 (anecdotally I'm not the only one) some winners to make room for new ideas.  As always, thank you for reading and especially to those that I've interacted with either via the comment section or via email/DM, I'm not always quick to respond but I do appreciate the networking and the sharing of ideas has made me a better investor.  Happy New Year and stay safe, there's light at the end of the tunnel.

Disclosure: Table above is my blog/hobby portfolio, I don't manage outside money, its a taxable account and only a portion of my overall assets.  The use of margin debt, options, concentration doesn't fully represent my risk tolerance.

Colony Credit Real Estate: CLNY Moving Quickly, CLNC Sale Next?

Colony Credit Real Estate (CLNC) is a commercial mortgage REIT that is trading at 52% of undepreciated book value (their owned real estate is triple-net), Colony Capital (CLNY) owns 37% of the shares and is the external manager of CLNC.  CLNY is in the midst of a transition to a PE manager focused on digital infrastructures assets (they've hinted that they'll likely convert to a c-corp next year) and is quickly selling off their legacy traditional REIT assets, in recent months announcing the sale of their hospitality portfolio (a bit of a surprise versus handing over the keys) and more recently their remaining industrial assets.  CLNY CEO Marc Ganzi is everywhere, blitzing the virtual conference circuit, multiple TV appearances and selling assets left and right, the CLNY stock price has responded by roughly doubling in the last 5-6 months.  

CLNY has two large assets remaining (lots of smaller ones too), their healthcare real estate portfolio and CLNC, prior to covid they announced intentions to pursue an internalization transaction with CLNC where CLNY would presumably have gotten additional shares in CLNC as compensation for their management contract.  Post-covid, that internalization concept no longer makes sense as the bid-ask spread is too wide since CLNC trades at such a significant discount of book value, it makes it difficult for both sides to come to an agreement, CLNY would have to take a discount or CLNC shareholders would face dilution for an internalization transaction to work at current prices.

What do I think might happen?  Somewhat similar theme to MCC, most commercial REITs are externally managed and thus incentivized to grow/acquire --  I think we could see Ganzi push a sale of CLNC and CLNY's external management agreement to another commercial mREIT.  This would create a win-win for all sides, CLNY would get full immediate value for their external management contract, the buyer would acquire CLNC at a discount which benefits both its shareholders and adds AUM to the buyer's external manager, and CLNC shareholders would get a premium to current price and relieve the overhang of what might happen to CLNY's non-strategic 37% ownership position.  There is some transaction on the horizon, just a matter of the structure, here is Ganzi on the Q3 CLNY earnings call (courtesy of tikr.com):

Jade Rahmani (KBW)

Okay. Well, I applaud the swift actions the management team had taken. Definitely refreshing and very good to see the progress. I wanted to ask you about a particular -- as Tom Barrack might call it a Rubik's Cube, which is CLNC. There's an overhang in the mortgage REIT space because people are looking at commercial real estate as a long cycle to recover and potential impairments, loan losses on the credit front. So that's one thing that they have to address. Secondly, there's the liquidity that go into managing that. And finally, there is some access investment capacity. But when you look at stocks like CLNC and there's many others TRTX, LADR, to name a couple trading at 40% to 50% of book value. It means that investors are also potentially assuming an eventual dilutive capital raise.

So CLNY owns 37% of CLNC. And to me, that bodes for an opportunity, you can have CLNC buyback some of those shares at a premium to where it's trading, yet it still would be wildly accretive to its book value, wildly accretive to its earnings. It would reduce the overhang of CLNY's 37% stake because people do wonder when those shares will be liquidated, and yet it would provide CLNY with fresh capital to accelerate the digital transformation. How do you think about that as a potential option for both CLNY and CLNC to explore?

Marc Ganzi

Well, Jade, it's almost like you bugged our investment committee. So look, seriously, first and foremost, I want to applaud Mike Mazzei, Andy Witt, David Palamé. For those of you that had the chance to hear that earnings presentation, it's also another great story of transformation and execution.

When we brought Mike Mazzei on board to run that business unit, we couldn't have been more clear about what the objectives were: first and foremost, to make sure that we shored up our loans that had any issues with them, hit repo lines on 2 loans, gravitating to liquidity, and Mike's done an amazing job stabilizing that portfolio, returning cash to the balance sheet. And now that business is poised, as you heard yesterday, to play offense and be selective. And they'll play offense inside of their sandbox. And I don't get too involved in what Mike and his team does. I think they're doing a great job of executing and as one of their largest shareholders, we couldn't be happier with the progress that's happening at CLNC.

When you look at its peer group, CLNC got ahead of its issues quickly. Mike addressed those issues. He stabilized the story, he rotated the cash and now we have an enviable position where we can play offense, and we'll continue to recover book value.

You saw the shares perform well after market last night. They performed well today. We have a lot of confidence around that management team's capability. And in the meantime, we keep our options open, Jade. No option is off the table for CLNC. We've made that clear 2 quarters ago. We made it clear a quarter ago. I'll make it clear today. As we rotate to digital, if there's a good opportunity to harvest, the hard work that's been done at CLNC, we have an open ear, and we'll listen to whatever proposal comes across the table.

Seems pretty clear to me that a transaction will happen soon, given the pace of divestitures at CLNY, I would bet on Ganzi surfacing value here.  I doubt that CLNC would buy back CLNY's shares as suggested by the analyst question as it doesn't divest the external management contract, an outright sale of both CLNC and the management contract seems more likely, swift and bold, more in the Ganzi deal mold.

But let's take a look a CLNC a bit closer, I think its reasonably attractive as a standalone entity.  CLNC was created out of the threeway merger of old CLNY/NSAM/NRF, it was previously a non-traded product that was brought public in early 2018 and has since had a rough existence.  As expected with a non-traded REIT, their portfolio resembled an asset gatherer mentality without much of a cohesive strategy.  Here's what the portfolio looks like today, predictably they have a legacy segment ("LNS" = legacy non-strategic) where they house all the iffy stuff like their retail exposure.

The portfolio is a little bit of a grab bag, but back in March, Colony brought Michael Mazzei in to be the CEO of CLNC, Mazzei is an alumni of Ladder Capital (LDR, disclosure: long) where he served as the president until June 2017.  Ladder has a reputation has being a conservative credit shop, I personally like their style, so when Mazzei joined CLNC it was worth monitoring.

I've been surprised along with others, but commercial real estate loans have generally held up better than expected during the pandemic, whether the reason is modifications, interest reserve accounts, or the equity injecting additional cash into the deal -- their CLO for example hasn't experienced any credit events in the portfolio -- with a vaccine on the way, I tend to think all parties involved will continue to work together to salvage value and get to the other side.  Now is the time to get long some of these asset plays with a catalyst, the market exuberance hasn't quite made its way down to publicly traded private credit vehicles with actual real assets, but I think it eventually will.

CLNC has confidence in the future, I like when management at least acknowledges what the market is thinking, this is an external vehicle, so their options aren't ideal, but they've already hinted they'll reinstate their dividend in Q1 2021 and are making new loans today (tikr.com), you don't do that if you're on the ropes:

We also recognize that our current share price is a deep discount to our book value. This discount is also greater than that of our peer group. The current market valuation effectively implies that there are approximately $1.2 billion of future potential losses. We feel the best way to address this disconnect is by shifting the focus and momentum of the CLNC team beyond the challenges of COVID-19 and toward playing offense.

In our effort to close this gap, we are committed to continuing to protect the balance sheet while redeploying capital into new investments, building earnings and reinstituting a quarterly dividend.

In summary, while not fully out of the woods, we have accomplished many of our goals during this challenging time. We are now focused on executing our business plan to grow earnings. We have already begun to originate new loans while continuing to remain vigilant on asset, liability and cash management. The continued risks of COVID-19 can, by no means, be dismissed. However, through the efforts of the CLNC team and the support of our counterparties, CLNC is now in a position to lean forward.

CLNC does have a mix of financing, a CLO, repurchase agreements, they should have decent amount of flexibility to handle any problem loans.  Leaving out a lot here, but at 50-55% of book value, I think the setup is more important than the actual assets -- I trust Ganzi to make something positive happen here both for CLNY and CLNC.

Disclosure: I own shares of CLNC and CLNY

Medley Capital: Internalizing Management, Sale Seems Likely

Apologies for the recent string of relatively small and/or illiquid ideas, here is another one from the trash bin: Medley Capital (MCC) is an orphaned BDC that will likely be sold in the next several months.  The story begins in August 2018, when MCC's external manager, Medley Management (MDLY), orchestrated a three way merger that would combine the manager with its two BDCs, publicly traded MCC and non-traded Sierra Income.  That deal met a lot of resistance from shareholders as it appeared to be a non-arms length way to bailout the overleveraged MDLY at the expense of the BDC shareholders while ensuring underperforming management continued on top.  The deal was in limbo until May of this year, almost a full 2 years after the merger announcement, when the deal was finally put out of its misery and terminated.  I'm skipping a lot of drama in those two years including a proxy fight with the team from NexPoint, but following the termination, MCC continues to retained advisers to pursue strategic alternatives and recently announced that MDLY's management agreement would be allowed to expire at year-end and that MCC will internalize management.

After a 1-for-20 reverse split earlier this year, MCC is trading for ~$26.50 ($71MM market cap) with a 6/30 NAV of $54.83 (MCC's fiscal year end is 9/30, the 10-K should be coming out shortly), meaning MCC is trading at roughly a 50% discount to NAV.  For reference, despite the pandemic, the average BDC trades for 86% of NAV today.

For the uninitiated, BDC is an acronym for business development companies, which typical function as non-bank lenders to leveraged middle market (sub $50MM in EBITDA) companies, often providing financing for private equity buyouts or M&A transactions.  Following the financial crisis, banks can no longer provide these loans on reasonable terms, so non-bank lenders like BDCs of CLOs have filled much of the void.  These loans are all below investment grade and the leverage ratios of the underlying companies is typically 5-7x EBITDA, they can be a bit scummy and certainly shouldn't be pitched as safe dividend payers to retail investors.  There are some 45+ publicly traded BDCs (like REITs, there are also non-traded ones like Sierra Income that are sold through the investment advisor channel), most of them are externally managed, often by household names (at least to anyone reading this) like Ares, KKR, Oaktree, Apollo, BlackRock and others that can essentially use the BDC as a lender for their own PE activity.  If that wasn't enough, they charge hedge fund style fees to the BDC.  These management fee streams are highly valuable as a BDC is technically a closed end fund and the capital inside it is essentially permanent.  So the average BDC trades for 86% of NAV, roughly 10 of the 45 trade above NAV which allows the BDC to issue additional equity, anyone below NAV is generally restricted from issuing shares but they can still grow assets through M&A which has been fairly active in the bottom of the sector.

Given this dynamic of external managers wanting to grow fees and now that MDLY will be out of the way (MCC no longer has to serve two masters in a transaction), the orphaned BDC should make for an easy M&A target, especially considering the wide discount to NAV.  The buyer and MCC can essentially split the discount somehow and both come away happy.  Following the sale of their broadly syndicated loan (larger borrowers, more liquid loans) JV to Golub and paying off one of their two baby bonds, MCC is clearly too subscale (maybe the 40th largest BDC of the 45 by assets) to be internally managed and if the plan was a true go-it-alone strategy, they likely would have refinanced the baby bond versus pay it with cash on the balance sheet.  The new CEO is an activist in MCC, David Lorber of FrontFour Capital, he's also headed up the Special Committee, from the internalization press release they've hired a credit person on what seems like a temporary basis to oversee the remaining portfolio, all sort of signals to me that this is once again for sale.

Of course, everyone has seen the deal, it was shopped previously and the conflicted board (MDLY management on the MCC board) turned down other offers during the go-shop period in order to continue to push the MDLY-MCC-Sierra deal that would have preserved MDLY's management team.  However, now that MDLY is largely out of the way, debt markets are flush with capital (low rates is great for private debt, everyone will be reaching for yield), we're looking at a potential reopening and economic recovery, I'm guessing at least one of those suitors will come back and make a deal for MCC.

Other Thoughts:

• I haven't discussed the portfolio, obviously given the turmoil this company has been through in the last two years as you'd expect, the portfolio is a bit of an unclear mess of assets.  It is more heavy on equities than most peer BDCs, including 764,040 shares of AVTR which is up ~66% since 6/30 or $8MM in NAV ($3ish per share).  On the downside, the JV they did sell to Golub is about -$7MM in the other direction.  The S&P/LSTA Leveraged Loan Index is now trading about 95 cents on the dollar, up significantly from the lows in March and April, and for reference, on 6/30 it was trading at 89.  Even the junkiest of loans, rated CCC, are today trading at 86.  We'll see in a few days where the 9/30 NAV is struck, but I don't think it should be materially below where it was on 6/30, but I'm not a credit analyst and only spent a little time thumbing through their holdings.
• This situation reminds me a little bit of RESI, a broken deal, external management being pushed aside and no reasonable path to becoming an internally managed company for the long term.  That one ended very successfully with a quick deal that was then revised upwards after a competing offer came to light (I unfortunately was out by the time of the revised deal).
• BDCs are no longer included in most indices, MCC doesn't pay a dividend, there really isn't a natural investor base for this and I think that partially explains how its languished here and really doesn't have a future outside of a deal.

Disclosure: I own shares of MCC

NexPoint Strategic Opportunities: Exchange Offer

Back in August, I wrote up a quick post on NexPoint Strategic Opportunities ("NHF"), it is a closed end fund that is transitioning into a REIT over the next 18-24 months (they'll technically be a REIT in 2021, but won't fully transition the assets until later, quite a bit of wood to chop here before its a clean story).  To summarize the thesis, NHF is trading at 57% of NAV and they'll be selling much of those assets presumably somewhere near NAV to invest opportunistically in real estate -- there should be no shortage of attractive opportunities coming out of the pandemic -- add in some leverage and it could have quite the multiplier effect (see what the same team has done with NXRT).  And to get the negatives out of the way, NHF hasn't articulated a clear strategy at this point other than saying it will be a diversified REIT and there's the potential for double dipping on fees, much of what NHF owns today are investments that were at one time or are now managed by NexPoint/Highland, it has sort of acted as a dumping ground for them.

The stock's reaction to the conversion news has been muted and it hasn't rallied much recently in comparison to the market or other real estate assets.  The company came out with an exchange offer structured as a Dutch tender that expires 12/10, shareholders can exchange common shares for a combination of 80% in a newly created preferred stock and 20% in cash, the range is set at $10-12 and the stock currently trades at $9.50.  The $10-12 number is highly dependent on the value the market prescribes to the newly issued preferred shares, the company is trying for a 5.5% dividend rate on the prefs, that feels a bit aggressive, but more on that later.

I love the idea of the exchange, the maximum amount is $150MM on a $433MM market cap company, the exchange will essentially force a portion of the shares to be valued at NAV accruing that closed discount value to the remaining shareholders.  It also further tightens the spring when they do fully transition to a REIT, this is already going to be a levered vehicle.  But again, the 5.5% dividend yield feels a bit aggressive on the preferred shares, so thinking through the possibilities of where the preferred could trade after the exchange, I came up with a little table:

The x-axis is where the Dutch tender prices at and the y-axis is where you think the preferred shares should trade on a yield basis incorporating the 20% cash component.

I've also played around with different scenarios based on how many shares are actually tendered and what it would do to the NAV ($16.70/share as of the latest proxy) of the remaining shares, just based on the share price and my uneducated view, seems like the market is skeptical of the exchange.  The minimum amount is $75MM.

Then my last table is using the NAV in the table above, what the price/NAV ratio would be (using a $9.50 share price, or a 57% starting point):

I've spent a lot of time in the last few months on the commercial mREITs (maybe more posts to come), most of them have preferred shares that have yields well above the targeted 5.5% NHF management is shooting for and that might be skewing my view of where the prefs will trade following the conversion.  NHF is likely to be focused on either self storage or single family homes, maybe both, equity REIT preferreds in those sectors do trade below 6%.  I took a look at the holdings of PFFR, a REIT preferred index fund, and here are the names that trade sub-6.0%, some of these didn't surprise me as they're seasoned and/or loved REITs, but others were a bit surprising.  

For example, Office Properties Income Trust's (OPI) 5.875% pref trades just above par, this is an externally managed REIT of RMR Group (RMR) that has a history of abusing minority shareholders and is in the office sector.  Is 5.5% too aggressive?  Possibly, but not by that much in a zero interest rate world.

I've added to my NHF position.  I'm currently thinking about the exchange like this: I'm planning on tendering a portion of my shares somewhere in the middle of the range (could change as we get closer to the expiration date), but still leaving behind a relatively full position.  If there is enough interest where I don't get filled on the tender and it goes closer to the lower-end of the range, common shareholders should benefit as the NAV increases even more and they've obtained cheap financing.  If I get filled, I still feel comfortable that the trading price of the prefs following the conversion should result in a good short term IRR.  Either way feels like a win to me.  NHF could also bump up the yield on the preferred shares if there isn't enough investor interest (they got a rating agency to put a BBB- rating on the prefs, presumably to head off investor skepticism on the proposed dividend yield), even paying 0.5-1.0% more in yield to entice shareholders to exchange would be very accretive to the remaining common.

Disclosure: I own shares of NHF

LGL Group: Warrant Dividend, SPAC Sponsor

LGL Group is an illiquid small (~$55MM market cap) aerospace and defense parts maker I covered once before in 2017 when they did a rights offering while at the same time an acquisition offer was outstanding for their operating business.  That thesis didn't quite work out as planned, the acquisition offer never materialized into a deal, but maybe for the best, the operating business has performed quite well over the last three years, growing revenue 50% (total, not annualized) and EBITDA has jumped by 300%.

The company is effectively controlled by the Gabelli family, they own/manage the top three spots on the shareholder register:

source: tikr.com

Mario's son, Marc, is the chairman of the board and steering the ship here, although his father hasn't been shy about expressing his views in the past.  The Gabelli's have done a number of corporate actions in the last decade to increase their investment in LGL, the stock is illiquid, so in order to meaningfully increase their exposure to the business, they do things like rights offerings and backstop them.  Back in 2013, the company issued a warrant dividend with a 5 year term and a $7.50 exercise price, despite the stock trading below the exercise price on expiration, Mario exercised the warrant and added to his position.  So clearly they want more of it and are up to a similar transaction announcing a new warrant dividend to shareholders.  Here are the details from the press release, the stock trades at ~$10 as I type this:

The LGL Group, Inc. Declares a Warrant Dividend

 

ORLANDO, FL, October 29, 2020 – The LGL Group, Inc. (NYSE American: LGL) (the "Company") today announced that on October 27, 2020 the Board of Directors declared a dividend of warrants to purchase shares of its common stock to holders of record of its common stock as of November 9, 2020, the record date set by the Board of Directors for the dividend. Each holder of the Company’s common stock as of the record date will receive one warrant for each share of common stock owned. Five warrants will entitle their holder to purchase one share of the Company's common stock at an exercise price of $12.50. The warrants will be "European style warrants" and will be exercisable on the earlier of (i) their expiration date, which will be the fifth anniversary of their issuance, and (ii) such date that the 30-day volume weighted average price per share, or VWAP, of the Company's common stock is greater than or equal to $17.50. The warrants are expected to be issued on or around November 16, 2020, and the Company intends for the warrants to be listed and traded on the NYSE American on or around such date, subject to NYSE American approval.

Part of LGL's stated strategy is to be an acquisition vehicle, but since that 2017 rights offering the company hasn't made a significant deal and has mostly let cash pile up on the balance sheet, currently at $22MM (including marketable securities which is in a Gabelli fund and can swing net income around a bit).  Thus another rights offering probably doesn't make sense, but a warrant dividend could as a way to get more exposure to the company, either through adding in the secondary market if the warrant trades poorly or just in another five years, exercise the warrant again.

LGL has two main operating businesses, MtronPTI and Precise Time and Frequency, both sell highly engineered products into the aerospace and defense sectors.  The operations did about $4MM in EBITDA in 2019, with a market cap of $55MM and $22MM in net cash, you're paying about 8.25x EBITDA for the business today.  They do other things to signal the operating businesses might be undervalued, like break out the accumulated depreciation of their PPE which is multiples of the carrying value of the assets on the balance sheet.  But the most interesting asset inside LGL is an ownership stake in a SPAC sponsor, its 2020 after all, the SPAC is LGL Systems Acquisition Holdings (DFNS) which is targeting a defense business, thus the ticker.  

Being the SPAC sponsor is a great deal, depending on the final details of the deal, but often the sponsor ends up with ownership in the proforma company worth 20% of the SPAC trust fund.  If DFNS does an attractive deal and doesn't negotiate a discount of the sponsor shares, the result could be a material asset for LGL.  DFNS raised $172.5 million and trades at a 1.7% discount to the net asset value of the trust.   DFNS has about another year to find a merger, the deadline is 11/12/21, otherwise they'll send the money back to the SPAC shareholders and the sponsor is out of luck.  Here are the details on the SPAC investment:

In November 2019, we invested $3.35 million into LGL Systems Acquisition Holdings Company, LLC, a subsidiary that serves as the Sponsor of LGL Systems Acquisition Corp (NYSE: DFNS), a special purpose acquisition company, commonly referred to as a “SPAC” or a blank check company, formed for the purpose of effecting a business combination in the aerospace, defense and communications industries. Prior to a business combination, the Sponsor holds 100% of the shares of Class B convertible common stock outstanding of DFNS (the “B shares”) along with 5,200,000 private warrants at a strike price of $11.50. The B shares equal 20% of the outstanding common stock of the SPAC. Upon the successful completion of an acquisition the proforma ownership of the new company will vary depending on the business combination terms.

The Company is expected to own approximately a 43.57% interest in the Sponsor through its direct investment. Assuming the terms of the business combination are identical in capital structure as that of DFNS, the Company anticipates its economic interest will include approximately 8.7% of the SPAC’s pro-forma equity immediately following a successful business combination. There can be no assurances that this scenario and the resulting ownership will occur, as changes may be made depending upon business combination terms.

If DFNS is able to come to a deal, the value of the shares attributable to LGL could be worth ~$15MM, certainly material for a company of this size.  A couple of the DFNS executives joined the LGL board in August, possibly signaling that being a SPAC sponsor isn't a one-time affair (the mania is showing signs of cooling, so maybe that's a bit of a stretch).  Either way, it is some built in optionality inside of LGL, and could have a bit of double leverage, the SPAC shares and warrants inside of LGL and then the LGL shares and warrants.

Even though I play around with options quite a bit, not an expert at valuing the warrant itself, but if you plug in terms of the warrant into a calculator and use a 50% implied volatility, spits out about a $0.75 per warrant (need 5 of them for one share of stock).  Could trade a bit like a spinoff and certain shareholders might be inclined to sell it immediately.

Disclosure: I own shares of LGL

Catabasis Pharmaceuticals: Selling at 50% of Cash, Reverse Merger Candidate

Here's another entry in my sporadic biotech reverse merger candidate investment theme, Catabasis Pharmaceuticals (CATB) is a clinical stage biopharmaceutical company that recently announced their lead product candidate, edasalonexent -- a potential treatment for a form of muscular dystrophy, did not meet its primary or secondary end points of their Phase 3 trial.  I'll keep this pretty brief, from the sounds of the press release it sounds like this is game over for Catabasis:

BOSTON, MA, OCTOBER 26, 2020 – Catabasis Pharmaceuticals, Inc. (NASDAQ:CATB), a clinical-stage biopharmaceutical company, today announced that the Phase 3 PolarisDMD trial of edasalonexent in Duchenne muscular dystrophy (DMD) did not meet the primary endpoint, which was a change from baseline in the North Star Ambulatory Assessment (NSAA) over one year of edasalonexent compared to placebo. The secondary endpoint timed function tests (time to stand, 10-meter walk/run and 4-stair climb) also did not show statistically significant improvements. Edasalonexent was observed to be generally safe and well-tolerated in this trial. Catabasis is stopping activities related to the development of edasalonexent including the ongoing GalaxyDMD open-label extension trial. The Company plans to work with external advisors to explore and evaluate strategic options going forward.

 

“We are deeply saddened and disappointed by the results of our Phase 3 PolarisDMD trial,” said Jill C. Milne, Ph.D., Chief Executive Officer of Catabasis. “I want to sincerely thank all of the boys, their families and caregivers, investigators and the trial sites that participated in and enabled this program. The entire Catabasis team has worked tirelessly to find a treatment for this progressive disease. We hope that our data and work to date can be used to benefit ongoing and future research in DMD.”

 

The Phase 3 trial was a one-year placebo-controlled trial designed to evaluate the safety and efficacy of edasalonexent in boys ages 4-7 (up to 8th birthday) with DMD. The global trial enrolled 131 boys across eight countries, with any mutation type, who were not on steroids. Edasalonexent was well-tolerated, consistent with the safety profile seen to date. The majority of adverse events were mild in nature and the most common treatment-related adverse events were diarrhea, vomiting, abdominal pain and rash. There were no treatment-related serious adverse events and no dose reductions. The global COVID-19 pandemic had no meaningful impact on the trial or its results. Data from the PolarisDMD trial will be further analyzed and are expected to be presented at an upcoming scientific conference and published.

 

“These results are disheartening for the Duchenne community, and specifically for the boys who participated in this trial and their families. However, the results contribute to the natural history data of Duchenne and add to the knowledge base that will one day produce a foundational, long-term therapy for this disease,” said Pat Furlong, Founding President and Chief Executive Officer of Parent Project Muscular Dystrophy (PPMD). “The continued advancement of research and the development of possible treatment options will remain of critical importance to our community. We appreciate Catabasis’ efforts and commitment to every family that is or has ever been affected by Duchenne.” 

 

The Company expects to report Q3 2020 financials in November of 2020. As of September 30, 2020, Catabasis had cash and cash equivalents of approximately $52.9 million.

The company is pre-revenue, R&D is likely at a full stop now, general and administrative expenses have run a little under $3MM:

Now that the company is a cash shell, the burn rate should be lower, but let's just call it $1MM a month going forward.  Cash and marketable securities were ~$54MM as of 6/30, Catabasis does have an ATM program they have been hitting for incremental cash, so to square the cash burn against the $52.9MM they reported in their press release, let's assume they've issued another 1 million shares, bringing their total to approximately 20 million shares outstanding.  At a price of $1.36, that gives us a market cap of $27MM versus a cash balance of ~$50MM, almost a 50 cent dollar.  And since CATB never generated revenue, we have a large NOL here as well of approximately $200MM. 

The most likely outcome is in the next few months a privately held biotech will merge into and come public through a reverse merger with CATB.  Effectively using CATB as a capital raising transaction with a deSPAC like transaction except here a target has more certainty in the actual amount of cash raised.

Disclosure: I own shares of CATB