Colony Northstar: Merger Pros and Cons for NSAM

Shares of the Colony Northstar merger parties have rebounded from their initial collapse after the announcement creating “A world-class diversified real estate and investment management platform”:

The background of the merger and the potential benefits were described in my earlier article (Colony Northstar: Will this team of overpaid former all-stars end up like the Brooklyn Nets?).  Since that time:

• The S-4 proxy filing on 7/29 provided details about the merger negotiations and fairness opinions
• Two NSAM shareholders (Abrams Capital and Land & Buildings) have expressed opposition to the merger.  see Abrams 13D filing and L&B Press Release and L&B Presentation: Shareholders Deserve a Better Deal
• The companies released 2Q16 earnings (Colony press release, Northstar Realty press release, Northstar AM press release)
• The companies promised a $1Bn commitment to build post-merger shareholder value through share repurchase  or further deleveraging (slide released 07/29)

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 35% from current levels while the company also pays a pro-forma yield of about 9%.

Merger opponent Land and Buildings (L&B) wants to reject the Colony Northstar combination, replace the NSAM Board of Directors, and then commence a new review of NSAM’s strategic alternatives.   An 80% return potential is suggested.

Based on information currently available, the merger seems better for NSAM shareholders than both the dysfunctional status quo and what has up to this point been only a very brief description of alternatives suggested by opponents.

Timeline for completion

The merger parties currently anticipate closing the transaction in January 2017.  This implies a shareholder vote is likely in December.  Merger opponents probably want the vote to proceed because rejection by shareholders would enable NSAM to terminate the merger agreement without paying a $92mm fee.

L&B has nominated directors for election at the next NSAM annual meeting of shareholders.  NSAM’s failure to hold a meeting in the 13 months following its last meeting (May 27, 2015) may entitle any shareholder to petition Delaware Chancery Court to order an annual meeting to be held (see Delaware General Corporation Law).  Convening a meeting prior to the merger vote could put the L&B nominees in an awkward position because under the merger agreement NSAM covenanted that its Board of Directors would not “change, withhold, withdraw, qualify or modify the recommendation of the board of directors of such Company to its stockholders to vote in favor of the merger agreement and the applicable transactions contemplated by the merger agreement“.   If a new NSAM Board changed the current recommendation in favor of the merger then a termination fee of $92mm would be payable.

If the merger is rejected then opponents will probably push for an Annual Meeting and election of directors as soon as possible.  If opponents elect new directors then NSAM would begin a new review of strategic alternatives.  L&B suggested that NRF could acquire NSAM for $8/share in cash and $8/share in stock, but NRF’s willingness to enter into a two-party merger on those terms is unknown.  5 of NRF’s Directors would have just been ousted from the board of NSAM and negotiation of a win-win combination might be difficult.  At that point NRF might seek any possible “cause” for voiding NSAM’s management contract.

Excessive Management Compensation

L&B’s presentation documented the extraordinary compensation paid to Northstar executives over the past three years even as NSAM and NRF shares fell sharply.  The Colony Northstar merger would result in additional payments of $223mm  in lieu of even larger amounts payable under “change of control” clauses in management employment contracts.  L&B notes that Northstar Chairman David Hamamoto and Chief Investment Officer Dan Gilbert would be paid these amounts even as they continue to serve as senior executives of the combined company.

Drawing less attention has been the agreement by Hamamoto and Gilbert to accept 2017 compensation of just $1 and to waive any future severance pay.  It does not seem that NSAM CEO Al Tylis will have any role at the post-merger company and would not receive any additional compensation.  Effectively, the “change of control” payments may be  severance and the Northstar execs will depart after facilitating a smooth 2017 transition.

The merger resolves the problem of the existing compensation contracts at a discounted cost to shareholders.  The same discount may not be available to merger opponents and they have not indicated any alternative plan for disposal of these management liabilities.

Valuation of the NSAM contract with NRF

The fair value of NSAM and its relative value in a merger depends on the unusual aspects of its agreement to manage NRF:

• Base management fee initially set at $100mm/year and increasing by 1.5% of any NRF equity issuance.  The base fee is now $186mm/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 four fairness opinions delivered to the three merger parties took many approaches to NSAM’s value:

Evercore:

• Discounted Cash Flow Analysis using a discount rate of 10-11%
• Peer Group Analysis (20 companies)

Goldman Sachs:

• Discounted Cash Flow Analysis using a discount rate of 11.9-13.9%

BofAML

• Peer Group Analysis (CG, BX, APO, ARES)
• Sum of the parts analysis (NRF contract valued at 8.6-9.5 times EBITDA)
• Discounted Cash Flow Analysis using a discount rate of 10.6-13.1%

UBS

• Peer Group Analysis (BX CG APO KKR OAK, ARES, FIG)
• Peer Group Analysis (19 “Traditional Asset Managers”)
• Sum of the Parts Analysis (detail not provided)

Despite all of these expert analyses, the terms of the merger agreement depended most heavily on the “volume weighted average prices of the three companies”.

The 4 fairness opinions did not treat the NRF contract as a unique asset.  Doing so would have required a similar analysis of the extent to which every peer might also have cash flows from special captive assets such as closed-end funds.

Opponents of the Colony Northstar merger point to the nearly perpetual nature of the NRF contract as deserving a high valuation.  L&B suggests using the 6% average yield of REIT preferred shares as a benchmark for valuing the net cash flow from the contract.  Like preferred shares, the contract payments are effectively a perpetual junior obligation of a non-investment grade payor.  But note that NRF’s preferred shares trade at yields over 8%.  And preferred shares provide greater security under some circumstances: they cannot be terminated, they have a liquidation preference, and they have rights under bankruptcy while the management contract could be voided.

If opponents of the Colony Northstar merger want a higher value attributed to the NRF contract then they will have to make that argument in much more public detail.

Considering L&B’s 80% Potential Return for a NRF/NSAM Combination

Page 29 of L&B’s Presentation included a brief valuation thesis derived from these Standalone Projections for NRF and NSAM in the S-4 filing:

“The NRF Standalone Projections were based on numerous variables and assumptions, including the following material assumptions: (i) completion of the pending assets sales of the manufactured housing, multifamily, medical office building and healthcare joint venture portfolios; (ii) redeployment of these proceeds throughout the projection period at leverage levels of approximately 30% loan-to-value and investment yields of approximately 9% return on equity; (iii) no future capital raising; (iv) repayment of existing $425 million term loan; (v) real estate securities and private equity fund investment capital returned based on the projected life of each investment; and (vi) full utilization of NRF’s $500 million share repurchase program.“

“In developing the NSAM Standalone Projections, NSAM’s management made numerous material assumptions with respect to NSAM for the periods covered by the NSAM Standalone Projections, including the following material assumptions: (i) no additional capital raised or growth in base management fees from NRF and NRE and no incentive fees; (ii) approximately $1.4 billion, $1.5 billion and $1.6 billion of capital raised in NSAM’s retail companies in 2016, 2017 and 2018, respectively; (iii) approximately $70 million, $285 million and $95 million in purchases of NSAM, NRF and NRE common stock, respectively, over the projection period; and (iv) effective tax rate of 15% on pre-tax CAD.“

Applying the 11 FFO multiple suggested in the L&B presentation to a simple combination of the NRF and NSAM projections:

The modest market cap increase in this simple combination of NRF/NSAM relies on appreciation to an 11X multiple.  L&B generated its 80% return estimate through additional assumptions:

• “NRF/NSAM recombination assumes NRF pays NSAM shareholders $8 per share in cash and $8 per share in NRF stock“
• “NRF 2018 CAD reduced for fewer acquisitions given NSAM cash purchase“

L&B cites an average REIT multiple of 17X based on Citigroup research and believes that 11X would be a conservative valuation, but REIT investors have a strong preference for narrow business models such as Suburban Office, Regional Malls, Self-Storage and so on.  NRF’s current portfolio is a dog’s breakfast with lumps of Senior Housing, Medical Offices, Hotels, Net Lease Property (Industrial+Office+Retail), Private Equity interests, real estate loans, securities, and JV interests.  A combined company would add NSAM’s third party asset management income.  How could one define the scope of the combined entity?  It seems highly likely that an NRF/NSAM combination would trade at a low valuation due to complexity.

The Colony Northstar merger provided a reasonable justification for a higher future valuation multiple by transforming the business into a diversified real estate asset management company supported by a large share buyback.  Alternative paths to an improved valuation (such as simplification through asset sales and a sharp reduction in G&A spending) would be available to an NRF/NSAM combination, but L&B has not yet signaled that its slate of directors would follow them.

Reviewing the Merger Pros and Cons

One could argue that each of the three merger parties has been substantially undervalued by the market.  A key issue in comparing strategic alternatives is guessing which option is most likely to earn a high future valuation multiple.

Information from merger opponents that would reduce the unknowns  would provide shareholders with a clearer choice in their proxy vote.