Corporate culture is filled with conflicts of interest. One of the challenges in analyzing a REIT is trying to project future performance. Sadly, some people may simply look up the annualized dividend yield and buy the companies with large dividends. They might even think they are being diligent if they skim one research report on it.
No research report can be perfect. Every reader is different and will have different interests, but one of the most overlooked areas is ethics. Why doesn't anyone care about ethics anymore? Right, it is boring. However, it is only boring because it is always viewed in the abstract. It is only natural to see a long list of disclosures and have the eyes gloss over. Why can't we all just leave it for someone else to do? In efficient markets, wouldn't these problems remove themselves? Drop a comment if you believe you found an efficient market. Since the market is already efficient, telling other people about it should have no impact. The market works pretty well, but mistakes happen. Things get missed. That's why we do research. That's the whole point of due diligence.
Regulations are in place requiring companies to disclose the conflicts, but few investors read them. While scanning through the documents for several REITs, we came across a batch of five that scored high on the conflicts of interest that are most prevalent in their industry. We are not accusing any of the people involved in these corporations. We are not stating that they are not working in the employee best interest. We are merely observing what conflicts of interest that have permitted, or caused, to exist.
Below, you will see a chart showing several of the most common conflicts of interest, in shorthand, on the Y axis. Above the X-axis will be the ticker symbol for several REITs. This list is far from exhaustive.
The following description has been reproduced from an earlier article we published here on Seeking Alpha:
Green squares represent a conflict of interest that is not present.
Yellow squares fill the places where it could not be determined if the conflict of interest was present.
Red squares represent a conflict of interest that is present.
Numbers/Letters: These tell you where to go in the financial statements to find out more about a conflict, lack of a conflict, or see what inconclusive evidence has been discovered.
An empty cell means nothing was found on the topic. Only Yellow squares can be blank. If a conflict is clearly present, or not present, there will be a source.
How to read the numbers: The most common thing to find in a cell is #-K. The number represents the page number. The K is indicating that the appropriate document is the 10-K for the company. F-#-K is not an expletive, though it might feel that way after hours of reading statements. F-27-K would refer to page "F-27" of the most recent 10-K for that REIT.
The categories work like this:
External manager structure: The REIT has "externalized" management and reduced their reporting requirements.
Not arm's length: The negotiations may have had the same person on both sides of the table. If that's hard to imagine, pretend you married an attorney. Now imagine yourself going through a divorce and hiring her to represent you.
Golden Parachutes: Certain people or entities have a structure in place where they are paid for not providing value.
Equity-based compensation: The manager gets paid regardless of performance.
Adjusted "Equity" definition: The REIT uses the word equity, but has a meaning for it that is different from the one we all learned from GAAP (Generally Accepted Accounting Principles). They use this other definition when they are calculating how much money to pay themselves.
Indemnification: This basically says, "If management screws up, we can't hold them accountable."
Other employment is permitted: Seeing as you're already paying regardless of performance, why not let the manager get another job and spend his time on that?
No meaningful restrictions on employment: This takes it a step farther. Restrictions are completely gone. The employees may spend zero minutes working for you in the year, and they could even work for a direct competitor.
Competing employment is currently happening: Not only is other employment allowed, but we know that it is happening. The financial statements include a clear disclosure.
Discussion of the companies
MITT is swamped with conflicts of interest. The good news is that they do have a "lead independent director" on the board to mitigate some of the damage from the CEO/Chairman conflict. Perhaps he can stop them from having an agreement that may be impossible to terminate at times. No, that agreement already exists.
The manager can purchase the same (or substantially similar) securities for themselves and for other clients. The manager can sell those shares simultaneously. In short, there is not an established "priority of transactions" that would require the manager to put the best interest of MITT first.
STWD can create great quotes. Their proxy statement was the one containing the phrase: "In our opinion, a board of directors is less like to provide rigorous independent oversight of management if the Chairman is the CEO, as is the case with our company. CEO Barry S. Sternlicht has served as both Chairman and CEO since 2009." They know it is a problem for the shareholders, but it has only been five years… maybe they will get around to fixing it.
To prevent competition with other firms managed by the same manager, the firms are restricted on which securities they can invest in. Nothing creates alpha for shareholders quite like arbitrary guidelines. Is it an upside if the wording in the limitations is less than airtight? The controls appear to be poorly designed and the wording leaves more than a little wiggle room. This is a bad situation for shareholders.
CLNY has two things going for it in the ethics section. The first is the CEO and Chairman being different people. The second is that they have ONE executive assigned exclusively to them. The downside is the rest of the manager's employees are not so contractually obligated, they have to pay the base fee of 1.50% (industry standard) plus an incentive, and they can hide their definition of equity all the way on page F-32 of the 10-K. That's more effort than most companies make.
No incentive fee was paid out in 2013. That's great for cost control, but any projections about the company performing better in the future will need to build in that incentive fee instead of keeping management costs constant.
NCT is a special case. The Chairman and CEO are separate, but the board won't make a policy on it because they believe it is best to let them decide. Conflicts of Interest generally don't have a positive expected value for shareholders. I wouldn't want the board to make that determination if I was a shareholder. Previously, one person held both roles.
Edit: It initially appeared to the analyst that these portfolio companies of private equity funds included a significant position in NRZ. Upon further inspection, prompted by comments, it was found that NCT did effectively spin off substantially all of their interest in NRZ through a distribution of shares in NRZ to the holders of NCT on record as of May 6th, 2013. While the investments in portfolio companies do create some potential for conflicts, they are managed by affiliates of the manager rather than the manager directly. As such, there is a lack of evidence that these deals disadvantaged shareholders. There appears to be a potential for multiple layers of fees, but not in a way that would directly benefit the managers at the expense of shareholders. Based on this information, it does not appear that these positions are creating a conflict of interest.
The analyst still has concerns about the management agreement. Specifically page 26 of the 10-K states: "The management agreement, as amended, does not limit or restrict our manager or its affiliates from engaging in any business or managing other pooled investment vehicles that make investments that meet our investment objectives." However, the nature of these agreements is to create the potential for conflict. These conflicts are not unique to NCT, and many of them occur frequently throughout the industry.
End of edit
BXMT is brilliant. They managed to prepare the financial statements only using the words "arm's-length" once in the 10-K and never in the proxy. That's impressive when ALL executives are employees of the manager. It might seem like intentionally avoiding the easiest key words to search for is not in the best interest of shareholders. Don't worry too much about that though. The relationship is contractual, rather than fiduciary. That's indemnification at its finest. The contract is designed to remove the obligation to give a…. (fill in the blank).
These are five stocks I wouldn't feel comfortable holding. It isn't like the managers are incompetent. They are thoroughly intelligent, sometimes brilliant, and some even have a sense of humor. That would be great if this were OKCupid. This isn't dating, it is investing. Brilliance is only a positive trait to shareholders when it is used on their behalf. You might even refer to the ideal relationship as fiduciary.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.