5 Demands, Not 1 Less: A Letter To The Independent Directors Of Colony Credit Real Estate

Copied below is the text of my letter to the independent directors of Colony Credit Real Estate.  It advocates for the directors and the corporation to take certain actions.  The text is not intended as investment research.

The text expresses my opinions based on publicly available facts, but my opinions are not themselves facts.  For example, I believe the assets of Colony Credit were misvalued from the time of its formation up to the release of 3Q19 financials, but I cannot prove it as a fact because the the details of the asset-by-asset valuation are not public.  Based on my belief that the assets were overvalued, I believe that management misrepresented their value and outlook to investors, but I cannot prove it as a fact because it’s possible that management did not understand the company’s assets.  The Directors should be able to research these areas of concern and take appropriate action to preserve the value of shareholders’ investment in the company.

The “Internalization” proposal received from Colony Capital would not be subject to a shareholder vote.  Therefore I encourage all shareholders of Colony Credit to directly contact the Independent Directors to express concerns about the proposal, the terrible record of the current management team, and the company’s future direction.

Catherine Rice
Lead Independent Director
c/o General Counsel
Colony Credit Real Estate
590 Madison Avenue 34th Floor
New York City NY 10022

At the time of publication I own shares of Colony Credit Real Estate.  This disclosure should not be interpreted as any recommendation regarding investment in those shares.  My holding could change at any time after publication.

---

Independent Directors
Colony Credit Real Estate
515 S. Flower Street, 44th Floor
Los Angeles, CA 90071

Dear Independent Directors:

My family currently holds [some number] shares of Colony Credit Real Estate. I am writing to express my alarm at the collapse in the company’s value due to provisions and impairments that have reached $725mm (so far). Since launch Colony Credit has provided a uniquely poor total shareholder return of -24% compared to an average of +28% for seven peer companies:

I strongly urge the Independent Directors of Colony Credit to see the large discount of the share price to book value as a signal that the market has no interest in this company as a going concern under the current management team. I strongly urge the Independent Directors to consider the following actions:

1. Terminate the company’s management agreement with Colony Capital “For Cause” and without compensation on the grounds of “Gross Negligence”
2. Demand refund of past management fees paid to Colony Capital that were based on overvaluation of Colony Credit assets.
3. Engage an independent financial advisor to seek the sale of the company or its assets.
4. Apply a high degree of skepticism to financial projections received from Colony Capital in connection with its “Internalization” proposal.
5. Make any payment in connection with “Internalization” proposal entirely contingent on actual future performance of the acquired business.

This letter will review the misvaluation of the company’s assets and misrepresentations by company management and then describe reasons for each of the suggested actions.

MISVALUATIONS AND MISREPRESENTATIONS

I believe that Colony Credit overstated the value of its assets since the time of its formation while CEO Kevin Traenkle and the management team told investors that the values were accurate. I encourage Directors to read transcripts of quarterly conference calls if you have not already done so.

Formation of Colony Credit Real Estate

CLNC’s inaugural press release on 2/1/18 stated:

• “The Company has a book value per share of approximately $25”
• “the Company delivers a stabilized portfolio with an attractive in-place yield“

At the time of CLNC’s formation the assets and liabilities of the acquired Northstar REITs were “measured at their respective fair values at the closing date of the combination”. Subsequent recognition of $725mm of loss provisions and impairments demonstrates those “fair values” were hugely overstated.

Prior to the formation of Colony Credit, all of its assets were either directly owned by Colony Capital or managed by Colony Capital through the two Northstar REITs. Colony Capital should have been very familiar with the performance of the entire portfolio and CLNC’s launch presentation boasted of the manager’s “world class expertise” and “veteran management team”. The manager claimed to follow a “proactive asset management approach for each investment” including:

On an ongoing basis Colony Credit has been required to report impairments and loan losses when operating performance indicates that the carrying values may not be recoverable. CEO Kevin Traenkle and CFOs Sujan Patel and Neale Reddington have certified that each quarterly financial statement “fairly presents, in all material respects, the financial condition and results of operations of the Company”.

Despite these obligations Colony Credit has gradually reported a total of $725mm of loss provisions and impairments relative to the “fair values” established 20 months ago.

Conference call comments suggest that management either did not understand the value of these assets or misrepresented it to investors.

• CEO Kevin Traenkle (4Q18 cc) “we believe these impairments are now behind us and our go forward strategy is the best direction for Colony Credit Real Estate to level-set, efficiently execute our business plan, quickly resolve the identified investment and redeploy capital into higher yielding assets that will enhance core innings in 2019. “

• CEO Kevin Traenkle (4Q18 cc)[Replying to an analyst question – So how do we think about the risk for additional write -downs from here on the existing portfolio?] “ the risks are very low. We’ve gone through the portfolio pretty extensively kind of asset by asset, loan by loan. … The assets that we’re going to put up for sale and we are confident that we’ll be able to get very attractive prices likely kind of clear these trades in the coming months here.” 
• CEO Kevin Traenkle (1Q19 cc) “While executing our portfolio rationalization strategy and deployment goals, we expect to generate a core earnings run rate that covers our dividend by year-end 2019. Through continued execution of our strategic initiatives, we are confident in the long-term outlook for CLNC and our ability to narrow this current trading discount to book value and build long-term shareholder value. “
• CEO Kevin Traenkle (1Q19 cc) “So, our models also show us – covering the dividend on a run rate basis by the end of the year.”

• CEO Kevin Traenkle (2q19 cc) Jumping back out to your first question as to whether we reevaluate it. We do evaluate through issuance of financials, so which will be tomorrow. And no, we don’t see any additional impairments that are related specific to the service to the movement in the bond market in particular, and the outlook.”

The largest contribution to the losses came from the NYC hotel loan package with an unpaid balance of $258mm backed by a single asset which the company has never disclosed, but which I believe is the Row NYC Hotel. The “fair value” of these loans was recorded at the full unpaid balance when Colony Credit was formed but the company subsequently recorded loss provisions of $208mm. If the asset backing these loans is the Row NYC Hotel then media reports in late 2017 that a portion of the rooms were being used by NYC homeless services could have signaled that operating performance was weak and loan recovery was in doubt. Instead management was slow to acknowledge the impairment of this asset:

• CFO Sujan Patel (2Q18 cc) “we believe this asset performance will improve as the New York City hospitality market emerges from recent oversupply issues. Through the first six months of this year, the asset is already seeing positive top and bottom line growth, and 2018 projected NOI has increased approximately 70% from the beginning of the year. “
• CFO Sujan Patel (3Q18 cc) “We continue to work through this asset resolution. However, during the quarter, discussions with the borrower did not progress as anticipated, which has led us to explore additional options for resolution. We’ve prepared a weighted average probability analysis of potential outcomes, which included a recapitalization and earlier than expected receipt and sale of the collateral. Based on this analysis, we recorded a $35 million provision for loan losses for the four loans secured by this hotel. As New York City hotel room additions are beginning to be absorbed, we continue to be New York City lodging market recovery looking ahead to 2019 and 2020. And the 2018 forecasted NOI for this particular hotel is up approximately 70% from its initial 2018 budget.”
• CFO Neale Reddington (4q18 cc) “As part of our ongoing resolution efforts, during the fourth quarter the borrower entered into a listing agreement with a real-estate brokerage firm, and as a result we believe the sale of the underlying collateral and repayment of the four loans is the most likely outcome. As such during the fourth quarter, we recorded an additional provision [$19mm] for loan loss on these four related New York hospitality loans to reflect the estimated proceeds to be received from the borrower following the sale. As New York City hotel room additions are being absorbed, we continue to be optimistic on the New York City lodging market recovery and the ability to exit this recent credit impaired asset.”
• CFO Neale Reddington (2q19 cc) “We initially impaired this asset in the third quarter of last year, based on market pricing estimates provided to the borrower by its broker. The borrower launched the sales process for the property earlier this year, which is adversely impacted by deteriorating hotel market conditions throughout New York City in the second quarter. This resulted in lower bids from potential buyers than originally anticipated. And therefore, during the second quarter, we impaired [$104mm] the asset to a revised estimate of current value. The borrower is monitoring market conditions, and we will share a progress with you in the near future.”

The company reported a further impairment of $50mm on these NY hotel loans in 3Q19 but management did not provide any new comments.

FIVE DEMANDS, NOT ONE LESS

In light of the terrible performance of the company over the past 20 months under the management of Colony Capital and the conflicts of interest inherent in the “Internalization” proposal I strongly urge the independent directors to consider the following actions:

1 – Terminate the company’s management agreement with Colony Capital “For Cause” and without compensation on the grounds of “Gross Negligence”.

I believe Colony Capital significantly overvalued the assets of Colony Credit and the Colony Capital executives responsible for Colony Credit provided misleading comments about the value and outlook for those assets. This negligence resulted in a uniquely poor total shareholder return of -24% as the company’s market capitalization declined by approximately $1Bn.

2 – Demand refund of past management fees paid to Colony Capital that were based on overvaluation of Colony Credit assets.

Colony Capital’s overvaluation of Colony Credit’s assets led to payment of excessive management fees which were based on overstated shareholder’s equity. I estimate that if $725mm of losses and impairments had been correctly reflected in Colony Credit’s financial statements at the time of its formation then cumulative management fees paid would have been $15mm lower.

3 – Engage independent financial advisors to seek the sale of the company or its assets.

I believe the large gap between the price of Colony Credit shares and their reported book value demonstrates the complete lack of investor confidence in the company, its manager Colony Capital, and CEO Kevin Traenkle.

The best way to protect the value of the investment that shareholders have made in Colony Credit would be to sell the company or its assets to a third party. I draw your attention to a comment by KBW analyst Jade Rahmani on the 3Q19 Colony Capital conference call:

“I’ve now followed this company since 2009 and seen a multitude of these value-destroying transactions. And I think you might want to consider whether a third-party would also make sense and weigh the cost benefit of such interest if we were to materialize. I believe that there are numerous debt vehicles that are in a private format right now that would value highly permanent capital that a mortgage REIT offers, and I think that should also be evaluated.”

4 -Apply a high degree of skepticism to the “Internalization” proposal from Colony Capital

The management team from Colony Capital is responsible for the huge losses incurred by Colony Credit and its shareholders. Internalization would not address the problem that this team has done a terrible job.

External management is the industry standard for commercial mortgage REITs. Colony Credit peers Starwood, Blackstone, Apollo, TPG, KKR, Granite Point, and Ares are all externally managed. There is no evidence that investors would prefer an internal structure for Colony Credit.

The internalization proposal is very similar to the 2015 acquisition by Colony Financial of its manager Colony Capital. By any measure it was a disaster as the share price (adjusted for the Northstar merger exchange ratio) of the combined company has fallen 73% since internalization closed on 4/2/15.

The performance of Colony Capital’s external asset management business fell far short of the projections provided to Colony Financial in justifying the 2015 internalization. In the 2015 merger proxy Colony Capital estimated that it would receive $102mm in “Base Management Fees From Private Funds” in 2016 (DEF14A filed 2/24/15), but actually earned only $68mm (10-K EX99.11 filed 2/28/17). Financial projections provided in connection with the merger of Colony Capital, Northstar Realty, and Northstar Asset Management were even more ridiculous. The three companies projected total standalone “Cash Available for Distribution” of $933mm for 2018, but ended up reporting “Core FFO” of only $333mm after the merger.

5 – Make any payment in connection with “Internalization” proposal entirely contingent on future performance of the acquired business

The Internalization Proposal received from Colony Capital is motivated by its promise to its own investors to divest itself of non-technology related assets. Colony Credit has no similarly compelling need to consummate any transaction.

The senior management team led by CEO Kevin Traenkle that Colony Capital proposes to transfer to Colony Credit has been responsible for $725mm of provisions/impairments and the loss of about $1Bn in market cap. This group has been a liability rather than an asset.

Investors did not reward the first Colony Capital internalization transaction and there is no reason to expect a different result this time. There is no investor pressure for internalization and Colony Credit’s peer companies with the highest market valuations are externally managed.

Colony Credit’s Directors and advisors should protect CLNC investors from earnings shortfalls related to any assets acquired from Colony Capital by making 100% of any consideration payable to CLNY contingent on actual future performance. Colony Capital’s letter suggested that consideration could be paid “possibly over time”. The amount of the payment should also be variable.

Thank you for your attention to this letter. I plan to post it online to encourage fellow shareholders to make their opinions heard regarding the company’s performance and future direction.

Best Regards.

John Sheehy

Colony Credit shareholder