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My Thoughts On The ARI – AMTG Merger

|Includes: AMTG, Apollo Commercial Real Estate Finance, Inc. (ARI)

This article is a brief summary of my thoughts on the merger; I will do my best avoid running through the same points that others have covered, either in other posts/articles or comments.

Quick Overview of the Merger Terms:

· ARI and AMTG merge

· ARI pays roughly $7.5 per AMTG share, and 0.417 shares of ARI per AMTG share

· The cash portion of the buy-out will be dependent on the market value of the non-agency securities at the time of the official purchase letter distributed to shareholders

· They have an insurance entity lined up to buy a significant chunk of the non-agency positions in AMTG

· That insurance entity has a warehouse set up to lift ARI shares post-merger if it were to fall below the share price at the time the AMTG buy-out occurs. This will extend for 30 trading days (~1 month and a week)

Current Share Prices Given the Merger Terms

Today ARI closed at 15.45 and AMTG closed at 12.90. Share prices remained relatively flat for today, the next trading day after the morning of the announcement. The numbers don't quite add up:

12.90 per AMTG - 7.53 cash refund = 5.37 net AMTG

5.37 net AMTG converted to ARI at 0.417 shares

0.417 * 15.45 ARI closing px = 6.4427 equiv val received for each AMTG share

So, buying AMTG now gives you an opportunity to add ARI shares at effectively ~12.88.

Granted, there are risks - the cash refund isn't a fixed value (could change from now until the formal exchange letter), or they could just decide to not do the merger at all. Given that it's practically an internal merger, I would imagine there aren't any break-up fees or other costs to back out.

So, assuming the cash refund stays static and the deal goes through, how would I profit? I sold half my holdings in ARI and bought AMTG (I also bought more AMTG). If I played around with options, I might have even written an ATM call on ARI (though that would open me up to additional risks in exchange of receiving that options premium).

What does this mean for the market?

I don't think this is a start of a consolidation trend in mREITs. Rather, I think this is a combination of:

· Apollo possibly exiting the non-agency market,

· Obtaining cheap(er) financing for ARI by effectively transferring the 8% AMTG pref to ARI,

· Profit off of the difference between the purchase price of AMTG and the market value of the underlying securities (which may differ from book value)

They mention facing "headwinds" in the non-agency market - this could mean a lot of things. The securitization market has been widening since the end of Q4 2015, but given the long investment horizon of mREITs, this should be a buying opportunity rather than a "headwind." Banks have been facing a lot of constraints with securities lending, and I have seen this in repo terms getting increasingly unfavorable for the investor.

Typically, legacy non-agency bonds will yield roughly 3 - 5% (the less hairy/cuspy bonds anyway), with middle of the stack SFR/CRT bonds yielding roughly 4 - 5%, and new issue prime jumbo 2.0's yielding about 3 - 4%. Compare this to the business of originating CRE loans - depending on the property and borrower, CRE loans could yield anywhere from 7 - 12% (though my expertise is not in CRE loans - this assumption is based on the small number of CRE loans I've seen). I suspect this is simply an exercise of applying the available leverage provided through the pref shares to investments that are expected to yield more.

I can't tell if Apollo is completely exiting the non-agency market (perhaps they will continue employing non-agency strategies through their funds), but the announcement clearly stated that ARI will not be incorporating any non-agency strategies for the mREIT. It would be interesting to see if they end up using their funds to buy out (perhaps cherry-pick) the remaining non-agency securities that were not included in the Athene sale agreement.

That being said, AINV has 3 tiers of prefs paying divs of 6.625, 6.875, and 8. I believe the reason they chose to roll up AMTG as opposed to AINV is due to the agreement with Athene. In the insurance world, there is an entity called NAIC that publishes prices on non-agency securities for insurance companies to use in reporting the market values of their non-agency positions in their funds. In the BWICs I've seen that had NAIC prices for comparison, I would see the bonds trade a few to many points behind the NAIC price. In the non-agency world you can't really say whether a price is "right" or "wrong" but NAIC prices seemed to consistently be higher than the last trade/cover.

My guess is that ARI has an agreement with Athene to sell them some of the more senior/better protected non-agency securities at levels closer to NAIC prices than they could get on the open market, with the remaining bonds not NAIC eligible. They wouldn't be able to do the same (I believe) for corporate credits (i.e. AINV). However, perhaps they can roll AINV up into ARI and distribute the investments in AINV into a non-public entity (this would be fairly expensive, as it would require an independent third party to assess reasonable levels for transfer pricing of AINV's assets).

Both AINV and APO creeped higher. It will be interesting to see how this plays out.

Disclosure: I am/we are long ARI, AINV.

Additional disclosure: I am not a registered investment advisor in any sense and this article is meant to be an opinion piece, not investment advice.