Front Yard Residential: Attractive IRR With Merger Expected To Close By Q2

Summary

• RESI's shareholder approved the transaction but the company has gone radio silence since the vote on 4/27.
• There are still a few obstacles before the consummation of the Merger including Freddie Mac Loan Consent.
• The Merger Agreement reads strong in favor of the Target (e.g. Material Adverse Effect).
• I still think it's more likely than not the deal closes shortly, providing a quick ~10% return.

Company Overview

Front Yard Residential (NYSE:RESI-OLD) is an externally-managed single-family (SFR) rental REIT. As of Q3-2019, RESI owns 14,403 SFR units across various states in the U.S. It's managed by Altisource Portfolio Solutions, a publicly-traded real estate management and mortgage services provider. As of FY2019, RESI has an accounting total assets of $2.05 billion vs. ~$1.65 billion of debt.

RESI's portfolio grew primarily through acquisition, which includes:

• 3,200 rental homes from Pacific Investment Management Co. for $485 million in 2018.
• 3,465 SFR units from Amherst Holdings for $534.9 million in 2017.
• 4,262 SFR units from Amherst Holdings for $652.3 million in 2016.

Source: Company Presentation

Merger

In May 2019, Snow Park Capital Partners started a proxy fight against Front Yard's board (presentation). The proxy fight ended in May 2019 with two new independent board members appointed and RESI formally launching a strategic view, with Deutsche Bank hired as the financial advisor.

Since then, a long marketing process went on for more than 6 months and finally on Feb 18, 2020, RESI announced that it's being taken private by Amherst Residential for $12.5/share. The transaction is valued at ~$2.3 billion, ~$690 million equity value, plus debt to be assumed or refinanced.

Goldman Sachs will be providing the debt financing, while Amherst has delivered an equity commitment letter for ~$270.1 million.

Lenders' Consent

Below is my understanding of the treatment of RESI's debt capital:

• To be refinanced:
  • CS Repurchase Agreement
  • Nomura Loan Agreement
• To be assumed (lenders):
  • Term Loan Agreement (Great American Life Insurance)
  • FYR SFR Loan Agreement (Freddie Mac)
  • MS Loan Agreement (Morgan Stanley)
  • Home II, III and IV Loans (Metropolitan Life Insurance)

Source: Company 10-K

Use/Source of Funds

To be clear, this is a levered transaction with the acquirer writing an equity cheque ~12% of the total transaction value, and pro forma ~8.2% equity-financed. I believe this is why the merger spread is so rich.

Source: Author based on company filings

Pro Forma Financials

So how would Amherst make the number work post-transaction? Pro forma debt level is around $2.1 billion, assuming 5% weighted-average cost of debt, the annual interest expense is ~$106 million. This is around $21 million more than what RESI is currently paying. So what can Amherst do to make up the difference?

• $14.3 million in management fee to Altisource in FY2019 can be eliminated, and...
• the $25.8 million in SG&A in FY2019 which can be largely reduced as Amherst already runs a sizable SRF portfolio - let's assume 50%.
• Combined, you get $27.2 million cost synergies, which is enough to cover the additional interest expense.

Remaining Conditions

In addition to the customary conditions, one of the most important things is to obtain lender's consent. MetLife, Morgan Stanley, and Great American Life Insurance all gave consent to the transaction. There's a possibility that the consents were rescinded given COVID-19 (and that's why the company went silent as they are scrambling to negotiate with the existing lenders and/or finding a replacement lender). Freddie Mac is the only consent that the parties are waiting on. Note that Freddie Mac gave a positive "early indication" already.

Above all, the "No Defaults" condition is the most important but looks the most impossible to meet at this point, because there are covenants attached to the Great American Life Insurance Loan and Freddie Mac Loan in the form of Rent to Debt Service Ratio (i.e. debt service coverage ratio). To make it worse, the covenant test is on a one month annualized basis (as opposed to on a LTM basis where you get the smoothing from the prior periods).

However, the saving grace is that there's a carve out in the merger agreement that says although the transaction is subject to a covenant test however...

any adverse change in the financial condition, results of operations or value of the assets of the Company and its Subsidiaries resulting from or otherwise attributable to any Specified Adverse Event shall be disregarded.

Elsewhere in the merger agreement, Specified Adverse Events are defined as:

• any acts of war, pandemic, sabotage, civil disobedience or terrorism or natural disasters (including hurricanes, tornadoes, floods or earthquakes),
• (7) changes in applicable Law,
• (8) changes in U.S. generally accepted accounting principles (“GAAP”) (or authoritative interpretation thereof).

By definition, pandemic is carved out of the Material Adverse Effect, and the above also indicates that failing covenants tests due to pandemic (i.e. lower rent collection) is disregarded.

Other Factors To Consider

There are a few other factors that supports my thesis. First, this merger is not conditioned on financing. In other words, Amherst can't walk away simply because it can't obtain debt financing. Second, Amherst needs to pay $48 million to RESI if the merger doesn't close. Third, shareholders already approved the transaction. Finally, according to the proxy statement, back in May 2018 (a year before the activist proxy fight), Amherst approached RESI and offered $12 per share to take RESI private, which means this is a strategic transaction for Amherst and it's been planning this for a while.

Conclusion

There's no way to hide that this is a levered transaction with the most unfortunate timing. However, I think this merger is more likely to close than the market is pricing in. While the world has changed dramatically over the past two months, I believe the merger agreement is solid and Amherst can't walk away from the deal without consequences (nor does it want to, given the strategic nature of the transaction).

The upside is the deal price $12.50. I also believe the deal will close within Q2-2020. The downside is $9.0, simply because the stock seems to bounce off that level repeatedly over the past five years. $9.0 also implies a ~6.0% cap rate.

Source: Author based on company filings

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RESI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.