Does the Colony Northstar Merger Offer Fair Value to NSAM Shareholders?

Activist shareholders of Northstar Asset Management (NYSE:NSAM) have signaled an intention to vote against the proposed three way merger with Colony Capital and Northstar Realty Finance.  Background in prior articles

• Colony Northstar: Will this team of overpaid former all-stars end up like the Brooklyn Nets? describes the merger transaction and the problems at NSAM and Northstar Realty Finance (NRF).
• Colony Northstar: Merger Pros and Cons for NSAM compares the treatment of key issues under the proposed merger against statements by opponents (future business plan, future management, resolution of legacy compensation, potential shareholder return, and rationale for higher future valuation).

Merger opponents have offered little or no analysis of what they believe would be a fair price.  My analysis:

• NSAM’s current business may only be worth $11.57/share.  The share price and Colony Northstar merger consideration fully reflects the company’s current value.
• The review of strategic alternatives involved many parties, was widely publicized, and no offer superior to the Colony Northstar merger was received.
• If the merger is completed, long-term value over $20/share could be achieved with greater clarity about the post-merger business strategy, expense level and compensation policy
• In the absence of a merger, higher value for NSAM would require a significant reduction in G&A and an improvement in NRF’s financial condition

Sections:

1. Statements Opposing the Merger
2. Summary of NSAM’s Business
3. NSAM’s Review of Strategic Alternatives
4. What is NSAM Worth as a Standalone Business?
5. What is the Value of NSAM in the Colony Northstar Merger?
6. What Changes Could Enhance the Value of Colony Northstar?
7. What Could Enhance the Value of NSAM if the Merger is not Approved?
8. Investment Implications

Statements Opposing the Merger

MSD Capital, NSAM’s largest shareholder with a 10.2% stake, issued a press release stating:

We agree that the proposed combination has the potential to create significant value though scale, cost synergies, strategic focus and enhanced valuation.  The combination could be a positive transformational transaction for all three companies.  However, we also believe that, as currently structured, the proposed combination does not provide sufficient value to NSAM’s stockholders.   In addition, the currently proposed governance structure for the combined company falls short of good governance norms in many key respects.  We believe these shortcomings will hinder the interest of all three companies’ stockholders in achieving the type of full valuation for the combined company that is rightfully accorded to public companies with the highest governance standards and with the best possible management alignment with shareholders. 

We have communicated to both the Special Committee’s advisors and the management of Colony that we do not intend to vote for the transaction as currently proposed. 

This follows brief comments in a 13D filing by Abrams Capital which has a 5.8% stake in NSAM:

 

Land and Buildings (L&B), holder of a 2.0% stake in NSAM, issued a new letter to NSAM shareholders in which it stated:

In our view, the NSAM consideration must be improved and the exchange ratio adjusted to reflect at least $2.9 billion to represent an acceptable alternative for shareholders. While it is up to the boards of each company to determine how this additional consideration is paid for, we believe NSAM’s management contract is a liability of NRF as is confirmed in the fairness opinions and thus should be reflected in a lower exchange ratio in the tri-party merger for NRF.

Activists also released this video presentation of their demands.

Summary of NSAM’s business

Estimation of NSAM’s value requires a review of the key elements of its business 1) Management of the listed companies Northstar Realty Finance and Northstar Realty Europe, 2) Management of 5 unlisted companies, 3) acquired interests in external management platforms

Northstar Realty Finance (NRF) – the relationship between NSAM and its former parent company has been extensively described in prior articles.  SInce the 2014 spinoff of NSAM, NRF’s performance has been quite poor with reported GAAP losses of $751mm.  Cash available for distribution (CAD) per share has been falling and will fall sharply in 2017 according to the management projections in the Colony Northstar S-4 filing:

NRF’s management contract with NSAM provides very high guaranteed fees payable for a very long duration.  The only risks:

• Termination for cause (e.g. fraud, bad faith, or gross negligence).   Likelihood of this is hard to assess, but should be very low while NRF/NRE/NSAM share common management.
• Insolvency followed by cancellation of the contract as part of a bankruptcy proceeding.  Likelihood of this can be assessed with reference to NRF’s cost of capital.

Northstar Realty Europe (NRE) – the relationship between NSAM and NRE is essentially similar to the NRF relationship described extensively in prior posts

Unlisted Companies currently comprise 3 non-traded REITs and 2 non-traded closed-end funds.  They are marketed by independent brokers and financial advisors as “Alternative Investments” (see brochure) suitable for qualified investors.  They seek to provide a high predictable distribution yield of 6-8%, steady net asset value, sophisticated management not available elsewhere to retail investors, and an indication of a “liquidity event” in 5-8 years.  The companies have high sales loads and high expense ratios.  The agreements with the non-traded REITs are subject to annual renewal by the Independent Directors of each company.  Each entity may terminate its advisory agreement upon 60 days written notice and without penalty.  It’s very unlikely that the Northstar friendly “independent” Directors would cancel these contracts  under ordinary circumstances and it is extremely unlikely that an activist could accumulate a significant holding of the non-traded shares.  However, cancellation is possible if an entity suffered an extended period of poor returns or if there were major changes at the advisor (Northstar Asset Management).  Each company claims that it depends on key NSAM staff:

“Our success depends to a significant degree upon the contributions of key personnel at our Sponsor or its affiliates, such as Messrs. Hamamoto, Tylis, Gilbert, Lieberman, Gatenio, Jeanneault, Saracino and Bath and Ms. Hess, among others, each of whom would be difficult to replace. We cannot assure stockholders that Messrs. Hamamoto, Tylis, Gilbert, Lieberman, Gatenio, Jeanneault, Saracino and Bath and Ms. Hess will continue to be associated with our Sponsor or its affiliates in the future. If any of these persons were to cease their association with us or our Sponsor or its affiliates, our operating results could suffer.”

Looking at each unlisted company advised by NSAM in more detail:

• Northstar Real Estate Income Trust is a non-traded REIT (link to SEC filings).  Net book value of assets at 6/30/16 was $1.0Bn and the estimated fair value of net assets at 12/31/15 (assessed by Duff & Phelps) was $1.2Bn.  Since the company was closed to new investors in 2013 the Net Asset Value has been stable and investors have received an annual distribution yield of about 8%.    The company’s portfolio is somewhat similar to NRF (Note that “equity” in the table below refers to equity ownership of real estate):

• Northstar Healthcare Income is a non-traded REIT (link to SEC filings).  Net book value of assets at 12/31/15 was $1.41Bn and the estimated fair value of net assets was $1.55Bn (assessed by Stanger & Co).  The company closed to new investors in 2015.  Net asset value has fallen modestly and investors have been receiving a distribution yield of about 7%.  The company’s portfolio is somewhat similar to NRF’s healthcare investments and in 2016 the company purchased some assets from NRF.
• Northstar Real Estate Income II is a non-traded REIT (link to SEC filings).  Net book value of assets at 6/30/16 was $0.84Bn.  The company is still raising funds and investors are receiving a distribution yield of about 7%.  The company’s portfolio is somewhat similar to NRF and Northstar Real Estate Income Trust:

• Northstar/RXR New York Metro Real Estate is a non-traded REIT (link to SEC filings).  50% of the management and incentive fees received by NSAM are paid to RXR as sub-adviser.  The company is early in its offering period and held $2.5mm of net assets at 6/30/16.
• Northstar Global Corporate Income Fund is an unlisted closed-end fund (link to SEC filings).  50% of the management and incentive fees received by NSAM are paid to Och-Ziff as sub-adviser.  The company is very early in its offering period and had not yet raised funds at 6/30/16.
• Northstar Real Estate Capital Income Fund will be an unlisted closed-end fund (link to SEC filings).  It will invest in the same broad categories currently held by NRF: real estate equity, debt, real estate securities, and real estate private equity.

External management platforms were independent asset managers in which NSAM invested after its spinoff:

• 43% ownership of American Healthcare Investors which manages $8.3Bn in assets including several non-traded REITs (link to SEC filings for “Griffin-American Healthcare“).  This business appears to be a very good fit with NSAM.
• 45% ownership of Island Hospitality Management which operates over 160 branded hotels for third-party owners
• 84% ownership of Townsend Holdings which manages $14.7Bn of real estate assets for institutional clients (primarily pension funds).  This business appears to be a very good fit with NSAM.

NSAM’s Review of Strategic Alternatives

Before attempting a fresh valuation of NSAM, one must acknowledge that the company has already been extensively analyzed by the financial advisors to the Colony Northstar merger and by potential buyers.  NSAM contacted 128 potential buyers and 25 signed confidentiality agreements.  Excerpts from the Colony Northstar S-4 filing:

“Between February 18 and February 22, 2016, several parties submitted preliminary non-binding indications of interest for potential transactions with NSAM, including:

NRF, which proposed an at-market, stock-for-stock merger with NSAM;

a privately-held commercial real estate services and investment management services company, referred to as Party C, which proposed a combination of Party C and NSAM in which NSAM stockholders would receive $4.07 per NSAM share in cash and shares representing an approximately 45% ownership interest in the combined company, which Party C valued at $7.73 per NSAM share;

a publicly traded alternative asset manager, referred to as Party D, which proposed to acquire NSAM for cash and stock consideration with a value of $11.50 per NSAM share; and another publicly traded alternative asset manager, referred to as Party E, which proposed an acquisition in which NSAM stockholders would receive stock consideration (together with a simultaneous cash dividend payment) with an estimated value of $11.77 per NSAM share or, alternatively, an acquisition by Party E of one of NSAM’s management contracts.

In addition, a non-U.S. financial services company, which we refer to as Party F, submitted an informal e-mail indication of interest based solely on public information to acquire NSAM for $13.19 per share in cash. Another non-US financial services company, which we refer to as Party G, proposed to purchase between 10% and 25% of NSAM’s outstanding shares at a price of $10.25 in cash (a price below NSAM’s then-current trading price). No indication of interest was submitted by Party B.

Also on March 30, 2016, Mr. Hamamoto had a lunch meeting with Richard B. Saltzman, Chief Executive Officer and President of Colony. At the meeting, Mr. Saltzman indicated that Colony had not been interested in pursuing a transaction solely with NSAM but may be interested in pursuing a transaction with both of NSAM and NRF. Given the ongoing strategic alternatives process at NSAM, Mr. Hamamoto suggested that Colony contact NRF and UBS to discuss a potential transaction, and Colony subsequently did so.

Also on April 19, 2016, NSAM received two proposals—a proposal in the form of a letter from Party C (without Party E) and a joint proposal, consisting of a proposal letter, a proposed draft merger agreement and supporting documentation, from NRF and Colony. Party C proposed a transaction in which NSAM and Party C would combine, with investors in Party C receiving approximately 32% of the equity of the combined company with the NSAM stockholders receiving the remaining 68% of the equity of the combined company, no cash distribution to NSAM stockholders and, as a condition to closing, the combined company would have been required to raise an additional $100 to $150 million of convertible preferred equity capital for which no commitments (preliminary or otherwise) had been obtained. According to Party C, its proposed transaction would value the total equity of NSAM at $2.35 billion.During the April 29, 2016 meeting, the NSAM special committee and its advisors discussed the merits of Party C’s proposal and related considerations, as compared to the potential transaction involving NRF and Colony. The NSAM special committee and its advisors also discussed Party C’s continued difficulty in securing financing for a potential transaction and its request for exclusivity. After a detailed discussion, the NSAM special committee determined that the proposal from Party C was not in the best interests of NSAM’s stockholders and instructed Evercore to inform Party C that the NSAM special committee did not intend to pursue Party C’s proposal at that time.”

No serious bidder for NSAM offered a significant immediate premium to its market valuation.

What is NSAM Worth as a Standalone Business?

A sum of the parts analysis is most appropriate because dissatisfied NSAM shareholders argue that the NRF/NRE management contracts are unique assets with unique value that could be realized through a sale.

Part 1.  The NRF/NRE Contract values can be estimated using estimations of cash flow and a targeted earnings yield (this was the approach used by L&B in its 01/22/16 letter)

Annual revenue from the contracts is $200mm ($186mm NRF and $14mm NRE)

Cost of revenue can be estimated using NSAM financial statements which show an EBITDA Margin of 50%:

The assertion in NSAM’s Investor Presentation that “2016 projected efficient operating structure: 70-75% EBITDA margin” seems to assume that equity compensation is not a real cost of operating this business (see “Super Adjusted EBITDA in the above table).  L&B’s 01/22/16 letter asserted that the business could operate at a 90% EBITDA margin, but this does not provide a rational basis for valuing the company in the absence of any plan to implement this 80% expense reduction.

The deterioration of NRF’s financial condition under NSAM’s management has raised NRF’s cost of capital to a level where it must be considered as a significant input in the valuation of the NRF management contract.  The largely perpetual nature of the contract and high risk of loss in the event of bankruptcy make it similar to a subordinated interest like NRF’s outstanding preferred stock.  The lowest current  coupon rate on NRF preferred is 8.25% for NRF-B and it is trading around par (net of an accrual towards the 11/15 dividend payment).

In its January 22 2016 letter L&B suggested that the contract would be fairly valued at a 7% yield, but that does not reflect NRF’s weak financial condition.  It would be unwise for NRF to retire a perpetual 7% liability.

Using the 50% EBITDA Margin and the 8.25% cost of subordinated capital leads to a $1.2Bn fair value of the NRF/NRE contracts:

Part 2.  The value of the non-traded company advisory business can be estimated in a similar manner as the NRF/NRE contracts.

Annual revenue is $112mm based on 2X 1H16 results.  Note that the NSAM presentation says $137mm.  If they continue raising funds from offerings currently available for sale then the higher number may be correct.

Cost of revenue can be estimated using NSAM’s actual EBITDA margin of 50%

A fair valuation multiple or earnings yield can be estimated in reference to “Alternative Asset Managers”.  These firms earn income in several ways:

1. Base Fee-related earnings – Base management fees on capital committed to funds for multiple years. This is the most highly valued income stream and is comparable to NSAM’s earnings from its managed unlisted companies.
2. Performance Fees – Incentive fees on realization of earnings in excess of hurdles. This is volatile, hard to forecast, and may even disappear in unfavorable market conditions. This income stream earns a low valuation.  NSAM has not earned meaningful incentive income.
3. Return on Firm Capital – Each firm has proprietary investments plus holdings in its public funds. The importance varies considerably from one firm to another. Earnings on this capital are volatile, hard to forecast, and may even disappear in unfavorable market conditions. This income stream earns a low valuation.  The market may value firm capital at a discount like a closed-end fund and assign no premium at all for earnings.

I estimate a 7% yield reflects the current valuation of base fees earned by Alternative Asset Manager and is comparable to NSAM’s advisory fees from the non-traded companies .  Using a lower yield than the NRF contracts is reasonable because these managed companies are in more secure financial condition and the revenues have more potential to grow over time through launch of additional offerings.

Part 3.  NSAM has only disclosed limited information about the platform investments, but these recent acquisitions are likely to be worth about their balance sheet value.

Combined Value

The fair value per share is in the range of the acquisition offers received by NSAM.

What is the Value of NSAM in the Colony Northstar Merger?

One current share of NSAM ($12.93 on 9/30) will receive one future share of Colony Northstar plus a special dividend of $128mm (approximately $0.67/share).  An additional $223mm ($1.17/share) in value will be consumed by “change of control” payments to executives.  Total consideration of $14.77/share or $2.8Bn for the company already provides more than the current standalone fair value of NSAM’s current business.  The price reasonably reflects an expectation that Colony will be able to convert some of the hypes and hopes of higher margins and lower cost of capital into reality.

What Changes Could Enhance the Value of Colony Northstar?

With no premium paid to any of the three participants in the Colony Northstar merger-of-equals, appreciation relies on expectation that the combined company will generate higher earnings and earn a higher valuation multiple.  The potential appeal of the co-investment business model was widely recognized but merger opponents have correctly pointed out that details provided to date have been sparse.  To select a simple example from the transcript of the merger conference call:

<Q – Jade Rahmani>: Okay. And then just finally the long-term portfolio, you said there were six main verticals, would you mind just summarizing what those main verticals are?

<A – Richard Brett Saltzman>: Well, I don’t think we know yet, to be fair.

Four months have passed since the merger was announced.  The companies should now have an idea what their “verticals” will be.  An update would be welcome.

L&B issued a public letter on July 27 with many constructive suggestions that would add clarity to the post-merger business plan and governance:

 Business Strategy/Communication
To date in our discussions with the presumptive management team, we are concerned that they are reluctant to let go of the more complicated real estate investments of their past, and at the same time embrace changes which would maximize value for all shareholders.
In order to maximize shareholder value, we believe Colony NorthStar should:
 Clearly state that Colony NorthStar will be an equity REIT which will concentrate on the
ownership of core and core plus traditional real estate in predetermined sectors, such as
warehouse, rental residential, net lease and healthcare.
 Clearly state that the company will generate outsized returns in these asset classes by making co-investments in funds which Colony sponsors, generating additional fee revenue on top of traditional real estate returns.
 Clearly state that the company will avoid esoteric investments which have hurt both Colony’s and NorthStar’s valuations over time.
 Articulate a strategy that will drive G&A/operating margins higher and leverage lower.

Corporate Governance
Given the NorthStar complex’s checkered history, in our view, with respect to executive compensation, conflicts of interest and other critical governance matters, starting off on the right foot in this area will be critical for the merged company.
In order to maximize shareholder value, we believe Colony NorthStar should:
 Reduce the proposed size of the Board, given that a 13 person board could be unwieldy and
expensive.
 Add a highly regarded shareholder representative, to a smaller more nimble board, who can help craft a clear, compelling strategy for fellow shareholders.
 Require board members to step down from the board, if the person’s investment in the Company goes below a predetermined threshold.
 Have a de-staggered board and permanently opt out of the Maryland Unsolicited Takeover Act (MUTA), which would eliminate the Company’s ability to re-stagger the board without shareholder approval.
 Clearly state that Colony NorthStar will strive for best in class corporate governance in all facets.

L&B seeks to discourage future investment in “complicated” and “esoteric” sectors.  That might be difficult because such strategies are a significant element in the public images of both Northstar and Colony.  NSAM charges premium fees based on the expectation that it will provide investors with access to private equity, CMBS, and other investments not available through retail ETFs and mutual funds.  These “complicated” investments may provide attractive risk-adjusted returns over time.  However the valuations of  Alternative Asset Managers show that predictable fee-based income earns the highest market valuation while returns on the firm’s own capital earn the lowest or even a negative valuation like a discounted closed-end fund.  The challenge and the opportunity for Colony Northstar is to transition the current proprietary portfolios into managed entities that generate predictable fee income with limited balance sheet risk.  Brookfield Asset Management provides an excellent example (see Brookfield Investor Presentation):

Brookfield explains: “85% of our Invested Capital is held through listed securities, creating strong levels of financial flexibility and increased transparency“.  Colony Northstar cited Brookfield as a model for what they would like to achieve, but have not yet given much explanation for how they will execute this transformation:

• What will happen to Colony and Northstar’s large portfolios of “complicated” and “esoteric” assets?  Can these be placed into fee-paying managed funds or companies?
• What will happen to Northstar’s large real estate portfolio (healthcare, hotels, net lease property)?  Can these assets be placed into fee-paying managed funds or companies?
• Will Colony Northstar be a co-investor in the non-traded companies currently offered for distribution by NSAM?  If so then how much marketing benefit can be realized from the improved alignment of interests between the manager and outside investors?
• What plans are there to distribute Colony asset management services through current NSAM channels such as non-traded companies and Townsend?
• What controls will exist over compensation and other operating expenses?

Colony Northstar provided 2017 guidance of Cash Available for Distribution in a range of $1.55-$1.75/share.  Based on the pro-forma 1H16 run rate, this may include $0.12/share of equity compensation.  Subtracting equity comp leaves a number more comparable to the “Funds From Operations” reported by REITs.  At a 10X multiple the company would be fairly valued at $15.30 per current NSAM share.  However the multiple is heavily dependent on market perception of the company’s transformation.  If Colony Northstar looks like a complex proprietary investment portfolio (like Colony or NRF right now) then it may only trade at 7X, below the current NSAM share price.  On the other hand, if the merger reduces risk, increase transparency, and adds substantial fees from third party investors then over time the company could earn substantially higher earnings AND receive a multiple as high as 15X (a future valuation over $20/share).  At this point it’s reasonable for NSAM’s major shareholders to seek assurances that the company is on the correct path.

What Could Enhance the Value of NSAM if the Merger is not Approved?

Opposition to the merger is an idle threat without an alternative vision for realizing fair value from NSAM’s business.  Major shareholders voting against the transaction should have plans for:

• How will a new Board of Directors reduce G&A, especially compensation expense?
• How will a new Board of Directors resolve legacy compensation issues, ie. the contracts with Hamamoto, Tylis, Gilbert etc…  ?
• How will a new Board of Directors manage business relationships with companies where the Boards of Directors are controlled by Hamamoto Tylis Gilbert and connected parties?  In particular, how will NSAM avoid the cancellation of the management contracts with the non-traded companies?
• What steps can NSAM take to improve the performance and market valuation of NRF?  In its weakening condition NRF is not well-positioned to pay anything like the price that L&B wants for internalization of the management contract.

Investment Implications

• NSAM has significant downside risk if the merger is rejected.  The current business is not as valuable as has been claimed by management and activists.  Rejection would introduce new risks during a possibly messy period of transition to new management.
• NRF has significant downside risk if the merger is rejected.  Projected cash flow for 2017 and 2018 will not be sufficient to support the current dividend.  Uncertainty about the management of NSAM may bring significant changes to NRF over which NRF shareholders have little or no control.
• Colony has limited downside risk if the merger is rejected.  The main loss would be the opportunity to achieve a higher valuation through transformation to a leading real estate asset manager with an appealing co-investment business model.

The complaints of merger opponents about excessive compensation and insufficient commitments about the future business plan are valid.  Shareholders of all three companies would benefit if enhancements and compromises can be made so that the merger can be completed.