Leucadia and its principles have shown uncanny ability over the years to make opportunistic investments and profit from it. Capmark appears to be a case in point, and although all is not said and done yet, Cummings and Steinberg have a terrific track record at finding value in the trash heap.
Commercial Real Estate company Capmark Financial filed for bankruptcy protection today. This is not a surprise to anyone watching the mortgage industry and was widely expected. Capmark entered into a pre-bankruptcy filing Asset Put Agreement with Berkadia III LLC, where Capmark can exercise its put rights to sell certain parts of the company to Berkadia III.
As you may know, Berkadia is a 50/50 partnership between Berkshire Hathaway (BRK.A) and Leucadia National. This is indeed not the first joint transaction that these two companies have done. Here are the basic facts about the deal:
The Asset Put Agreement with Capmark
Under this deal, Capmark bought the right to sell certain assets to Berkadia III and paid Berkadia $40 million for the right. The right has to be exercised within 60 days of filing for bankruptcy, so the clock starts ticking today. If Capmark chooses not to exercise the right, they just handed Berkadia a $40 million gift. This can potentially happen if Capmark finds a better price for these assets through the bankruptcy auction. On the other hand, if Berkadia decides to back out if certain closing conditions are not satisfied, than they have to pay back $20 million to Capmark (and keep $20 million for their troubles).
If the put is exercised, Berkadia will buy a) Capmark’s mortgage origination and servicing business for $490 million, and, b) Capmark’s owned mortgage loans outstanding, at par, for about $600 million.
Therefore, the total deal value is approximately $1,090 million.
Berkadia’s Capital Structure
It is instructive to look at Berkadia’s capital structure. Cash portion amounts to $188 m in cash contributions from both Leucadia and Berkshire each, and $40 million in the put consideration that Capmark paid for a total of $416 m. Berkshire will chip in another $650 m in debt financing. The remaining $24 million are likely to be in the form of Berkadia notes issued to Capmark.
So let’s recap what the Berkadia business will look like once the deal is completed:
- Any positive operating cash flows from the Capmark mortgage origination and servicing business and new mortgage loan originations.
- Interest and principal payments on the existing book of commercial mortgage loans (principal = $600m).
- Interest/principal payments to Berkshire on $650 m in debt.
- Interest/principal payments to Capmark on $24 m in Berkadia notes.
Therefore, as one can see, for Berkadia to make any money (and hence Leucadia and Berkshire Hathaway to profit) from the deal, profits from the new mortgage business + interest income from the existing book (adjusted for defaults) should exceed the interest paid to Berkshire Hathaway and the smaller note to Capmark. Given Berkshire’s credit, its cost of capital is likely to be low (much lower than Capmark’s) so it is not difficult to imagine that this is a simple debt swap replacing expensive debt with a much cheaper one.
The big questions here is whether the $490 m paid for the origination and servicing business is a good price to pay. Given the parties involved one can be fairly sure that they are not overpaying for the assets and with proper management of the mortgage origination and servicing business (Berkshire and Leucadia know a thing or two about this business), it can be turned into a profitable enterprise.
What is in it for Leucadia?
Leucadia is essentially making a $200 m investment (188 in cash plus 50% of 24m in Berkadia notes) to gain 50% of a business worth $1 B at a conservative estimate. Will this be a good investment? The margin of safety appears to be there as even if the business turns out to be worth only half of what they are valuing it at, Leucadia still comes out with a 25% ROI. If the business is indeed worth $1 B (or even more) and the cash flows work out in favor, than Leucadia’s potential gains are in excess of 150%.