Altisource Asset Management (NYSEMKT:AAMC), a recent spinoff from Bill Erbey's empire of distressed real estate and mortgage interests, is the asset manager for Altisource Residential (NYSE:RESI), which owns a portfolio of non-performing mortgages ((NPLs)) and foreclosed single-family homes. In exchange for these services, AAMC receives a quarterly incentive fee, which in Q4 2013 was equal to 32% of RESI's dividends paid to shareholders (the "Incentive Fee").
We believe that AAMC's Incentive Fee is at least four to seven times higher than the compensation received by similarly situated asset managers, and as such, is a sweetheart deal that will unjustly enrich insiders with a beneficial stake in AAMC at the expense of RESI's shareholders.
As shareholders of RESI, we believe that RESI's independent directors have a fiduciary duty to either terminate or substantially renegotiate its asset management agreement with AAMC. To terminate the Asset Management Agreement between AAMC and RESI at the earliest date permitted under the contract (December 21, 2014), RESI's independent directors must give notice of their intent to do so by June 24, 2014 (97 days from today). We expect to sue RESI's independent directors for violating their fiduciary duty of loyalty to RESI's shareholders unless they address the lopsided compensation deal given to AAMC. RESI's independent directors are as follows:
- Michael A. Eruzione (former captain of 'miracle on ice' 1980 U.S. Olympic Hockey team)
- Robert J. Fitzpatrick (CFO of Institutional Mortgage Capital Canada, Inc.)
- James H. Mullen, Jr. (President of Allegheny College in Meadville, PA)
- David B. Reiner (Managing Director of Regional Real Estate Investment Corporation)
1. A Clear Conflict of Interest. RESI does not have its own executives. Rather, AAMC's management team serves in a dual role as both asset managers and executives of RESI, even though they owe no fiduciary duty to RESI's shareholders. Furthermore, AAMC's Incentive Fee is calculated by an opaque methodology and is therefore difficult to model (evidenced by the fact that Wall St. consensus estimates underestimated it by 454% in Q4 2013), giving AAMC significant discretion in calculating its own paycheck. Because AAMC's executive team today owns far more equity in AAMC than RESI, AAMC's management team is financially incentivized to generate large asset management fees at the expense of RESI's shareholders.
2. RESI Massively Overpays AAMC. Wall St. analysts estimate that AAMC's Incentive Fee will be 45% of RESI dividends in 2015, rising steadily from 32% for Q4 2013. We believe this compensation is significantly higher than the market compensation paid to similarly situated asset managers.
a. AAMC's Incentive Fee is Worth $2.7 billion. AAMC's market capitalization reflects the net present value that the market places on AAMC's rights under the Asset Management Agreement. By firing or internalizing its asset manager (or substantially renegotiating AAMC's fees), RESI's independent directors could capture much of the value of AAMC's management fees for RESI's shareholders, which we estimate would increase RESI's share price by 114% and boost its 2015 dividends by at least $0.15 per quarter per share.
b. Internally Managed REITs. Analysts expect RESI to pay 40%-45% of its dividends to rent a small management team (AAMC has seven employees and no material assets). By comparison, four internally managed mortgage REITs (NYSE: MFA, CMO, CYS and NLY) recently paid an average of 6.2% of their distributable dividends as compensation to their respective internal asset managers, suggesting that RESI pays AAMC over 7x what similarly situated mortgage REITs are paying for internal asset management.
c. Externally Managed REITs. Widening the comp set to include twelve externally managed mortgage REITS shows that RESI pays AAMC around 4x more than the amount paid by other REITs to external asset managers.
d. AAMC's Straw Man. RESI's management presentation includes a misleading comparison of its asset management fees with SWAY, a REIT with virtually the same strategy and an almost identical portfolio of NPLs and single-family homes. This comparison is blatantly misleading, as SWAY's asset manager has 545 employees and performs both asset management and property management functions. RESI is paying more for less: at an 8% ROE, SWAY's manager receives roughly $50,000 in fees per employee whereas AAMC receives $3.4 million per employee!
3. RESI has the Contractual Right to Revisit the Asset Management Agreement. A termination provision in the Asset Management Agreement gives RESI's independent directors the right to cancel or renegotiate the contract in the event that two-thirds of RESI's independent directors believe that AAMC's Incentive Fee is unreasonable, which in our opinion, is self-evident given that AAMC is paid four to seven times more than comparable (not to mention larger and more experienced) asset managers.
4. Independent Directors Have A Fiduciary Duty to Fire AAMC or Lower the Incentive Fee. We believe that RESI's independent directors face the material risk of a shareholder derivative suit over the Asset Management Agreement with AAMC. A potential plaintiff could easily argue that the independent directors violated their duty of loyalty to the corporation by giving AAMC a sweetheart deal on terms that are 4-7x above the market price for an asset manager.
a. Limited Disruption. RESI shareholders need not fear disrupting its relationships with Ocwen Financial (NYSE: OCN) (its mortgage servicer) or Altisource Portfolio Solutions (NASDAQ: ASPS) (its property manager), both related parties under the Erbey empire. RESI barely needs ASPS right now because it has few rental properties (RESI paid ASPS $2.8 million for property management and other expenses in 2013), making switching costs to another property manager painless. As for Ocwen (RESI paid OCN $9.3 million in 2013), mortgage servicers are a dime a dozen (Ocwen is fourth in the US residential space with 5% market share), making it highly likely that RESI can quickly and easily find a replacement.
5. Valuation. We believe that RESI's independent directors have a fiduciary duty to terminate the Asset Management Agreement or, at the very least, significantly renegotiate AAMC's Incentive Fees. The market believes that the NPV of AAMC's Incentive Fee is a staggering $2.7 billion. We project that RESI's share price will increase by up to 114% and its dividends will increase by $0.15 per quarter per share if it captures ¾ of these expected cash flows. We also estimate that AAMC's share price will fall by up to 87% as its compensation is brought in line with market rates.
RESI's independent directors must act quickly: with each passing quarter, AAMC's Termination Fee will only get larger. We estimate that if RESI terminates the contract in December 2014, the Termination Fee under the contract will be ~$55 million. By December 2015, we estimate that the Termination Fee will rise to a whopping ~$120 million. Winter is coming
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Disclosure: We are short AAMC and long RESI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This research article expresses our opinions. Use Glaucus Research Group California, LLC’s research opinions at your own risk. You should do your own research and due diligence before making any investment decision with respect to the securities covered herein. This is not investment advice nor should it be construed as such. We are short AAMC and therefore stand to realize significant gains in the event that the price of the stock declines. We are long RESI and therefore stand to realize significant gains in the event that the price of the stock increases. Please refer to our full disclaimer, which we hereby incorporate fully by reference, in our report at glaucusresearch.com.