On September 6, Realty Income (NYSE:O) announced an agreement to purchase American Realty Capital Trust (NASDAQ:ARCT). ARCT shareholders would receive 0.2874 O shares for each ARCT share they owned, valuing ARCT (based on September 5 prices) at about $12.21 per share, a premium of less than 3%. O's shares actually rallied slightly before drifting down over the last few days (typically, an acquirer in an all-stock deal will see significant downward pressure as a result of a large, dilutive transaction). And as of this writing, the implied purchase price is under $12 per share.
The core thesis here: invest based on the expectation that the price will be revised upward. But also invest because ARCT is a really good company, and even if O does not revise its bid and walks away, there is a lot of value here in today's low-yield environment.
First off, what is ARCT? ARCT is a real estate portfolio of 486 fully-occupied properties with an average life of 5.3 years covering 15.6 million square feet. The properties are leased out on a triple net basis with an average duration of 13.0 years. Virtually none of the rent roll comes up for renewal before 2018, and ~75% of the tenants are investment grade. The top ten tenants represent 54% of the portfolio and all but two (Payless Shoes and PetSmart) are investment-grade.
ARCT is conservatively capitalized with a $1.7 billion market cap and about $900 million of debt. And since ARCT was added to the Nasdaq in March, it has paid out $0.06 monthly dividends consistently, equating today to a yield of about 6% and about 7% next year based on today's projections. It should be noted that O, which is admittedly larger, trades to a dividend yield of about 4.4%, so one can see how attractive a no premium deal is to O - it is immediately accretive.
Second, why is / was ARCT trading so cheaply? ARCT began as a private REIT in 2009 tailored to dividend-oriented retail investors. ARCT raised equity over that past three years from in excess of 40,000 individuals through different retail advisory platforms. As part of the deal, ARCT was required to have a liquidity event for shareholders in late 2012. Through 2011 and early 2012 management explored various alternatives such as selling the entire portfolio in one transaction or in chunks.
Management instead decided to list ARCT shares on an exchange and allow for the price to settle out on its own. Without a traditional IPO marketing process, few investors know of ARCT's existence, while many of the original investors were looking for liquidity. The stock listed March 1st and has traded in a range between $10-$11/share for the last several months, until deal rumors started filtering out, which appears to have begun in August (although in fairness to ARCT, they did hire Goldman in 2011 to explore alternatives, but there really is a limited universe of potential single-transaction strategic buyers).
So given the trading history, why is $12.20 such a bad offer? Well, for one, it seems absurd in today's low-yield environment that one REIT can acquire another in a no-premium deal ; for that matter, it seems absurd that any deal should be compensated without a control premium. Second, many of the pieces seem like fodder for activist involvement: a no-premium deal, JANA Partners as a ~4% shareholder, a half dozen attorneys lining up to sue to block the merger, and perhaps most interestingly, a giant cash payout to the principals of ARCT.
The two principals, Nicholas Schorsch and Wiliam Kahane, collectively own about 1.25 million shares of common, which will result in a not insignificant $15 million or so stake in O. However, Schorsch and Kahane will have no active role in the surviving entity, so their payout comes in the form of a demand note that O has agreed to pay in the amount that can be between $58.6 million and $76 million.
You can read the recently filed 8-K, but suffice it to say that Schorsch and Kahane basically have a 15% carried interest ARCT's profits (which existed prior to the merger). O is agreeing to foot the bill and set a range for this payout. In addition, the principals will receive over $30 million from the accelerated vesting of incentive options.
This type of profit participation and incentive compensation is standard for private real estate partnerships, but it creates a huge misalignment between management and shareholder interests when management can effectively be bribed to give the shareholders a subpar deal.
So please buy some stock and join in opposing this merger. Vote the proxy, call your friends, call investor relations. Don't let O get by so easily on this one. Schorsch and Kahane will be laughing at us all the way to the bank.