In one month after the announcement of a merger creating a "world-class diversified real estate and investment management platform", shares of the three merger parties are all down sharply:
While the merger does not meet unrealistic expectations of some NorthStar Realty (NYSE:NRF) and NorthStar Asset Management (NYSE:NSAM) holders, the combination would resolve some issues that have held back valuation of the individual companies:
- NRF and NSAM valuations are depressed by costs, risks, and conflicts of interest from their management contract.
- Colony Capital's (NYSE:CLNY) valuation is depressed by perception of the company as a Commercial Mortgage REIT (like ARI and STWD) or Alternative Asset Manager (like BX and KKR), sectors that trade at low valuations due to unpredictability of earnings.
Completion of the merger followed by greater integration of managed funds with proprietary holdings would create a more appealing investment vehicle deserving a target Price/FFO of 10X. That would provide price appreciation over 60% from current levels, while the company also pays a pro-forma yield over 10%.
Key terms and expected benefits of the proposed merger
- Merger of equals at an exchange ratio in line with recent market prices. 1 future Colony NorthStar share will equal 1 NSAM, 0.68 CLNY, and 0.91 NRF.
- Diverse portfolio of owned assets (Healthcare and Hospitality properties from NRF, and Industrial properties, Distressed acquisitions and Credit from CLNY).
- Diverse asset management platform (institutional funds from CLNY and NSAM, and retail funds and private REITs from NSAM).
- Reduced leverage and lower cost of capital.
- New business model with the company serving as a 20% lead investor in each pool of assets while the 80% balance is managed on behalf of outside investors. Company ROE will increase from current 10%-15% on owned assets to a combined 14%-23% from co-invested assets. Management described third-party funds as providing "non-financial leverage and turbocharged economics."
- Internal management of the combined company would remove conflicts of interest that have harmed the market value of the NorthStar entities.
- Increased flexibility to sell assets and build value through share repurchase.
- Annual expense savings over $115M.
- Increased appeal to institutional investors (large market cap and market position will make it a core holding). Higher valuation comparable to Brookfield Asset Management and Kennedy Wilson.
- Initial post-merger dividend of $1.08, a current cash yield over 10% based on a conservative and sustainable payout ratio of 62-70%.
- Projected close in January 2017.
Reasons for investor disappointment
- NorthStar Realty holders hoped for a deal that would deliver value closer to the firm's published NAV estimate of $24.07 (page 12 of the Q1 2016 Financial Supplement).
- NorthStar Asset Management holders hoped for a deal that would recognize the full value of its management contract with NorthStar Realty. Activist investment firm Land and Buildings (L&B) claims the contract is worth about $2.4B ($12.32 per NSAM share) and with other income streams the business is worth $20/share (based on 1/22/16 L&B letter).
- Colony Capital holders are probably frustrated to be dragged down by the falling NorthStars. CLNY shares are trading at a slight premium to their NRF/NSAM exchange ratio, implying that some investors hope the merger will fail.
- NorthStar executives will share $106M in "change of control" payments.
The NorthStar management contract problem
The merger would resolve the dysfunctional financial relationship between NorthStar Realty and NorthStar Asset Management. Their 2014 agreement (Link to SEC filing) seemed to have been structured to maximize the short-term appeal of the NSAM spin-off. Unfortunately, it introduced conflicts of interest and may have damaged the Northstar brand in a way that has impaired the market valuations of both NRF and NSAM. Key provisions of the contract:
- Base management fee initially set at $100M/year and increasing by 1.5% of any NRF equity issuance. The base fee is now $186M/year or 4.9% of NRF shareholder equity at 3/31, a rate much higher than industry averages.
- An incentive fee when NRF per share Cash Available for Distribution exceeds a threshold.
- NSAM performs all day-to-day management functions for NRF, including property management, screening of acquisitions, accounting and investor relations.
- The agreement has a 20-year term that is automatically renewed every year.
- The agreement cannot be terminated except for cause (defined as fraud, bad faith, or gross negligence that has a material adverse impact on NRF).
The agreement incentivizes actions that maximize short-term management fees but add risk and undermine the long-term value of NRF:
- New share offerings increase annual management fees regardless of whether the use of funds is beneficial to NRF. And after signing the agreement, NRF made equity sales and exchanges that greatly increased the base management fee (LINK LINK LINK).
- Higher leverage increases returns past the incentive fee hurdle rate, but carries increased risk for NRF shareholders. NRF's assets/equity increased from 2.35 X at 12/31/13 to 3.23 X at 12/31/15.
- Riskier assets push NRF returns past the incentive fee hurdle rate, but carry increased danger of loss. NRF owned $1.1B of investments in 173 private equity funds managed by 98 general partners at 12/31/15.
- NRF paid excessive dividends (90% of FFO) and suggested that it could grow over time. The unsustainable yield kept NRF shares at a high level enabling large secondary offerings that dramatically boosted fees payable to NSAM.
The agreement disincentivizes or complicates corporate actions that might enhance the value of NRF:
- Share repurchases will decrease NRF's earning assets, but there is no provision under which the base management fee will ever be reduced. NRF has repurchased $186M of stock when it has been trading at low prices over the past year (LINK) and shareholders have benefited from NAV accretion, but suffered from a rising expense ratio.
- Sale of NRF or a majority of its assets is not permitted unless the buyer agrees to assume responsibility for continuing the contract with NSAM.
The value of the NRF contract with NSAM
The value of the management contract is crucial to estimating the fair value of NRF and NSAM and their relative value in a merger. L&B addressed a series of public letters to NSAM and its Board of Directors in which it pointed out provisions of the contract beneficial to NSAM and demanded measures to deliver that value to NSAM shareholders (LINK). The 1/22/16 letter explained:
Unfortunately, L&B has never published a more detailed analysis. Adjusting the numbers to exclude NRE:
L&B's analysis contains significant weaknesses:
- It assumes that all management obligations under the contract can be performed for just $20M (leaving a 90% profit margin) when the actual margin achieved by NSAM is in a range of 70%-75% (see NSAM Investor Presentation). Considering NSAM's heavy use of stock based compensation, the true economic profit margin it achieves from the NRF contract may be closer to 60%
- It assumes that the NRF management fee is an asset that could be sold to an independent third-party at a yield of 7% (equivalent to 14.3 X EBITDA), but this valuation fails to recognize the significant risks associated with future income from this contract:
- Future fee payments are effectively a junior obligation of a leveraged non-investment grade payor.
- If the current special relationship between NRF and NSAM were broken, then it would be highly desirable for NRF to seek every possible means of canceling the contract by discovering "cause". Alternatively, it would be very appealing for NRF to file for bankruptcy on the earliest possible pretext in order to reject the management contract. Considering these risks, the valuation that an independent third-party would pay to acquire the contract is likely well below L&B's suggested price.
- The terms of the contract have damaged the value of NRF and will continue to do so in the future. Prospects for growth in fee payments from NRF are low.
- The 7% yield and 14X multiple is far above comparable transactions (described below).
Colony Financial's 2014 acquisition of its external manager, Colony Capital, included a fairness opinion (LINK), which analyzed the multiples paid in 14 prior cases where REITs acquired their external management companies:
The most expensive transaction multiple of 10X (equivalent to a 10% yield) was well below the 14X suggested by L&B. Adjusting L&B's simplistic model:
At a valuation of $1.3B, the contract is an "asset" worth $6.61 per current NSAM share and a liability of $7.04 per current NRF share. At this level, the current relative pricing of NRF and NSAM shares appears rational. NRF shares are cheaper on Price/NAV and Price/FFO metrics, but carry higher risk because they are exposed to the volatility of real estate cash flows and asset values.
Small changes in assumptions can lead to significant changes in the estimated value of the contract. Valuation inputs such as the risk of contract cancellation and the potential for future growth are hard to estimate. This may explain why the NRF and NSAM exchange ratios in the proposed merger were based on market prices rather than a model.
The executive compensation problem
Preserving the value of existing management compensation agreements seemed to take a significant place in the deal negotiations. NorthStar executives David Hamamoto, Al Tylis, and Dan Gilbert will share $106M in "change of control" compensation even though Hamamoto and Gilbert will continue as senior executives of the merged company (not sure about Tylis). In anticipation of the merger, NSAM postponed its 2016 annual shareholders meeting and did not file a proxy statement that would have documented 2015 compensation. 2014 NorthStar Asset Management payments were (from NSAM 2015 proxy statement):
And the same executives also received exceptionally high 2014 compensation from NorthStar Realty as a reward for "unlocking significant shareholder value with the spin-off of our asset management business" (NRF 2015 proxy statement).
Amazingly, they now plan to accept huge payments for unwinding the spin-off.
Colony's 2015 compensation was comparatively modest and Colony executives will not receive any special compensation associated with the proposed merger:
What is the upside for successful execution?
The proposed future strategy would generate higher earnings (combining the return on investment of the company's own capital with management fees from outside co-investors) and trade at a higher valuation multiple (due to internal management and market presence as a real estate industry leader). The company cited Brookfield and Kennedy Wilson as examples where investors have awarded high valuations to similar business models.
Using a 10X FFO multiple generates a 2017 price target of $16.50 for a consolidated Colony NorthStar. Adding the 10% dividend yield leads to a total return over 70% with additional potential if the sector's recent Brexit losses are reversed.
Can the merger be approved?
The merger needs to be approved by shareholders of all three companies. L&B has stated its opposition in a 6/6/16 letter (LINK):
Despite its demands for meetings with NSAM Directors and for replacement of NSAM directors, L&B's ownership stake in NSAM is quite small, just 937,855 shares at 3/31/16 or 0.5% of outstanding. As noted above, L&B's estimate of NSAM's valuation is based only on a very brief explanation with aggressive assumptions. To influence the outcome of the merger, it will have to make a much more detailed public case.
Each of three companies has many sophisticated institutional investors. There is also significant overlap so that holders of 2 or 3 of the companies may not be very concerned about the relative valuations in the merger agreement if they believe the combination will unlock an increase in overall value.
Holdings at 3/31/16 in $mm
All three stocks are down so none of the companies is motivated to accept less from the merger. The one adjustment that would mildly enhance the value and assuage shareholder concerns would be waiver of all Northstar "change of control" payments that might be triggered by the merger. These make Hamamoto Tylis and Gilbert conflicted parties and undermine their credibility when they argue in favor of the transaction.
NRF and NSAM are under strong pressure to complete a deal. The participation of the well-regarded Colony Capital management team in a three-way transaction came as a surprise to the market. Tom Barrack and Richard Saltzman will not receive any special compensation if the deal goes through and their recommendation may have significant influence on the voting intentions of major shareholders.
Will this team end up like the Brooklyn Nets?
Like NorthStar, the Nets paid extraordinary salaries to build a leading organization in 2014 only see it flounder in 2015. But unlike the NBA, NorthStar is not operating under the pressure of a salary cap (although NSAM does limit maximum compensation for any individual employee to $100M/year) and the real estate business has room for more than one winner. With a new game plan for 2017, Colony NorthStar has potential to do well. The Nets will still be a distressed asset.
Investing in any of the three companies carries significant risks. Notably:
- the merger may not be completed due to shareholder opposition or a change in management intention;
- the merger terms may be revised to the detriment of one entity or another;
- the transition of the business model to integrate more third-party investors may take longer than expected;
- the market may not award the company a higher valuation model; and
- the value of the real estate assets owned by the companies may decline due to changes in the economic outlook, interest rates, or real estate supply/demand factors.
Disclosure: I am/we are long NSAM NRF.
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.