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Trinity Merger: Broadmark Buyout Presents Attractive Opportunity, But Shareholder Approval In Flux

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Trinity Merger Corporation (TMCX), a special purpose acquisition company ((SPAC)), announced a deal to acquire the Broadmark family of companies.

TMCX is currently not priced to reflect the value of the merged entity and represents a very attractive one-way bet. It is also possible that the warrant (TMCXW) is underestimating the likelihood of the deal failing to win shareholder approval, and presents a way to gamble at attractive odds on a binary outcome.

Broadmark consists of an asset management business and four mortgage funds, each focused on a separate geographic area within the US. The asset management business raises capital for the mortgage funds from private investors, and originates and services short-term, first-lien mortgages at 65% loan-to-value ((LTV)) or less mostly for land development, construction, and rehabilitation. Each fund focuses on a different geographic area within the US, employs no leverage, and has reliably returned between 10.5% and 11% to investors for nearly a decade. The asset management business generates between 5% and 6% of assets under management as net income on top of that. The merged entity combines all of these together with cash from Trinity Merger Corporation, and will trade on the NYSE with the symbol BRMK.

Assuming no investors pull their funds out prior to the deal, the newly merged company will operate as an internally managed mortgage REIT and is expected to have assets of $1,136 million in loans and cash on its balance sheet post-merger, including $229 million in cash resulting from the deal itself. Broadmark has convincingly demonstrated its ability to grow and deploy assets under management over the last three years, with a growth rate of 50% in each of the last three years, and management has publicly expressed confidence in its ability to rapidly deploy the new cash. Assuming they are able to do so, Broadmark will generate 2020 earnings of $1.26 and a dividend of $1.20.

In order to facilitate continued growth without resorting to dilutive secondary offerings, the new entity will, in addition to managing its own balance sheet assets, continue to operate and manage a private REIT raising capital from investors on similar terms as it does today.

A detailed analysis and valuation of the merged entity is beyond the scope of this article (I will provide a more comprehensive analysis if the merger is consolidated) but the quick and dirty version, based on comparison with other publicly traded mortgage REITs, is:

  • Using book value is problematic owing to the complexity of the typical mortgage REIT's balance sheet and the consequent difficulty of comparing apples to apples, so we will focus primarily on yield.
  • About half of the publicly traded mortgage REITs are pure interest rate arbitrage plays that are really not comparable with Broadmark, so we will ignore them.
  • The remaining mortgage REITs, the ones which actually originate and service loans, yield between 6.9% and 12.0% with an average yield of 8.7%.
  • Based on a dividend of $1.20, an 8.7% yield implies a market cap of $1.926 billion and, allowing for warrant dilution, a stock price of $13.30.

And although short-term construction loans are generally viewed as riskier than typical commercial mortgages, there are many reasons to believe Broadmark is a superior business to the average REIT.

  • Broadmark is internally managed, whereas the majority of publicly traded REITs are externally managed. The latter causes a conflict of interest between the shareholders and manager, frequently resulting in excessive fees and growth at the expense of shareholder dilution.
  • The private REIT offers a proven model for growth that is accretive to shareholders, and there is a three-year track record of 50% AUM growth.
  • Broadmark does not employ any leverage, whereas all of its peers employ leverage ranging from 46% to well over 600%.
  • Broadmark's rigorous underwriting and conservative lending has resulted in realized losses of only 0.02% of capital since inception.
  • There are only two publicly traded REITs that are truly similar to Broadmark in business model (Sachem Capital (SACH) and Manhattan Bridge Capital (LOAN)). And, while both are internally managed, neither appears to have the ability to grow income accretively by raising private capital, and both are less than 10% of Broadmark's size.

Because of these factors, I fully expect that Broadmark will eventually trade at a yield of 8% or below, which implies a stock price of at least $14.37.

Trinity shareholders and Broadmark members will effectively be paying $10.45 per share and can reasonably expect a significant gain from the transaction. So, surely, both sets of shareholders will vote for the deal?

I think the answer to that question is not quite as clear as it might initially seem, and the reason lies in the details of the deal itself and the extraordinary amount of the compensation being siphoned off by some of parties involved.

First, let's look at all the parties:

  • Broadmark management, who operate the asset management business described above which, on a standalone basis, produced $33.1 million in net income as of June 2019 ((TTM)), and has grown assets under management by 50% a year for each of the last three years;
  • the Broadmark fund members, who have invested a total of $907 million in the four mortgage funds;
  • the Trinity Sponsor, who set up Trinity Merger Corporation with capital raised from Trinity shareholders;
  • Trinity shareholders, who contributed $360.8 million in capital in return for shares and warrants in Trinity Merger Corporation; and
  • Farallon, a private equity group, which is injecting $75 million of additional capital into the deal.

The deal is structured as follows:

Broadmark Members, Trinity Stockholders, Farallon and Broadmark management convert their existing investments into shares of the new merged entity (ticker BRMK) at a reference price that is calculated as the total value of all Trinity's cash and equivalents (as a SPAC, all Trinity's assets are held as cash and equivalents) divided by the total number of shares outstanding at the time of the merger. According to the S4, the reference price is expected to be $10.45. For the purposes of this conversion:

  • Trinity stock is valued at the reference price, so each Trinity share is effectively exchanged for 1 share of the merged entity.
  • Broadmark members' funds are valued at the capital contribution, less any loan loss reserve, and converted to stock at the reference price, so a member with a balance of $104,500 on their most recent statement would receive 10,000 shares of the merged entity.
  • Farallon purchases shares at the reference price, so they would exchange their $75 million for 7.16 million shares.
  • The Broadmark management companies are valued at $162.5 million, with $98.2 million paid to the owners in cash and the remaining $64.3 million converted to shares.

The Trinity Sponsor receives a bonus allocation of 4.8 million shares. Together with the conversion of holdings at the reference price, this results in the following ownership position:

Source: Investor Presentation October 2019

In addition:

  • The existing 46.9 million Trinity warrants (comprising 34.5 million public warrants and 12.4 million private warrants) will be amended to allow BRMK to pay dividends as a REIT without triggering repricing of the warrants.
  • The Trinity sponsor will surrender 7.2 million private warrants in return for Farallon receiving 7.2 million public warrants prior to the merger.
  • The 41.7 million public warrants (including Farallon's warrants) will receive a taxable cash payment of $1.60 on the effective date of the merger and each public warrant will be exchanged for a Broadmark warrant, granting the right to purchase a quarter-share of Broadmark at an exercise price of $2.875 (equivalent to $11.50 per full share) on or before May 2024.
  • The remaining 5.2 million private warrants held by the Trinity sponsor will not receive any cash payment. Instead, they will be exchanged for a Broadmark warrant granting the right to purchase a full share of Broadmark at an exercise price of $11.50.
  • As a consequence of the various warrant provisions, post merger, there will effectively be a total of 15.6 million full Broadmark warrants outstanding with an $11.50 exercise price.
  • Farallon will have a 12-month option to purchase an additional $25 million of BRMK stock at the reference price (equivalent to 2.4 million call options at a strike price of $10.45).

Transaction expenses are estimated at $41.6 million (it is not clear to me whether any of these expenses are payable directly to the Trinity sponsor, or whether they are all payable to third parties) with an additional $66.7 million payable to the public warrant holders for a total of $108.3 million.

Special purpose acquisition companies are shell companies that are funded with cash from investors, acquire a public listing, and then make a deal with a private company looking to go public.

There is a body of research analyzing the performance of SPACs, and plenty of articles referencing it. The consensus is negative. For example, this article, dated March 2016, references research from SPAC Analytics that shows,

...of the 130 SPACs that have completed an acquisition since 2003, the average annual return has been a 15.3 percent loss, versus the Russell 2000 index’s annualized return of 4.5 percent over that period.

In general, the poor performance of SPAC investments is attributed either to egregious fees charged by SPAC sponsors or to selection bias (i.e., reflecting the fact that it is usually weaker companies, lacking better options, that resort to this form of “alternative IPO”), or some combination of the two.

The available research itself is largely focused on how the stock of the SPAC itself performs pre- and post-merger, but it is also worth considering the perspective of an investor in the acquisition target - in this case, an investor in one or more of the Broadmark funds.

Let's start by making some fairly simple assumptions to figure out how much Trinity and Farallon are skimming directly off the top in fees and free shares, warrants and options as follows:

  • We will value stock at the reference price.
  • We will estimate market values for the 12-month options and five-year warrants at $1.00 and $1.50, respectively, again assuming the stock trades at the reference price.
  • We will assess the cost of warrants and options as their market value, in accordance with Benjamin Graham's suggestion, with which we wholeheartedly agree.

Based on these assumptions, we can calculate the total fees for the transaction at $184.3 million, comprising $41.6 million in transaction expenses, $50.2 million in sponsor shares awarded to the Trinity sponsor, $66.7 million cash payment to warrant holders, $23.4 million value of the warrants after conversion, $2.4 million value of the Farallon call options. The proposed book value of the merged company is $1.3 billion, including $162.5 million in goodwill for the asset management company, which means the fees amount to an astonishing 14.2% of book value, 16.2% of assets under management, and 12.6% of market capitalization with the stock at reference price. Or looked at from the perspective of Trinity and Farallon, they are investing $435.8 million and immediately receiving 42.4% of that investment back in fees (or 32.8% if the $46.1 million of transaction expenses is all paid to third parties).

None of this necessarily means that this is a bad deal for Broadmark members. As I have already described, the quality of Broadmark's business is such that I fully expect investors to profit handsomely post merger. It is also true that Trinity and Farallon are not just enabling Broadmark to go public; they are providing a significant amount of capital that Broadmark expects to rapidly deploy. I have every expectation the merged company will trade at significantly more than book value, and thus, this capital is creating additional value to the deal in and of itself.

Nevertheless, it seems pretty clear who the biggest winner is.

All of that brings us to the interesting question of how the Broadmark members will vote.

I am a fan of Ben Hunt and his fascinating website Epsilon theory, which examines and interprets the impact of investor psychology on markets through the lens of game theory. Interestingly, two articles have been published on SPACInsider applying game theory to the voting decision faced by Trinity warrant holders in this very deal (Trinity Merger Corp.'s Warrant Amendment Proposal and Trinity Merger Corp. Does a 180 Flip with their Warrants). These articles however were not particularly interesting, not through any fault of the author, but because the decision faced by the warrant holders is relatively simple. The decision facing Broadmark members is more complex and requires considerable thought about the possible motives and actions of the other parties to the deal. First, the basics:

  • As we have seen, there is reason to believe that the merged entity stock price will be over $14, although that is of course not certain.
  • The fees associated with the deal are astonishingly high.
  • Voting "no" also grants the voter dissenter's rights - the ability to withdraw their investment prior to the merger happening, which is essentially a free put option.

Should our hypothetical Broadmark member hold their nose and vote "yes" despite the fees because of the likely gain? Or should they stoutly refuse to give up such a huge slice of their investment in fees and vote "no", hoping either to retain the status quo (unleveraged first-lien debt funds paying 11% fully secured by real estate at low LTV don't grow on trees), or that management will return to the table with an improved deal?

Before making his decision, perhaps our investor should ask themselves three questions:

1. What would an improved deal look like?

A quick back-of-an-envelope calculation leads to the conclusion that, in this case, Broadmark management are bearing much of the cost of the fees and protecting their members from downside by accepting a low price for the asset management business. They are trading in an asset management business with $33.1 million in TTM net income that has grown AUM at 50% a year for each of the last three years for $162.5 million. As a stand-alone business, the numbers would seem to support a valuation of at least $400 million, and arguably $600 million or more. Even using a $400 million valuation, management's effective contribution of $237.5 million more than offsets the fees. So, perhaps an improved deal would just mean that Broadmark management get a better price and members would be no better off.

2. Why is Broadmark management happy with this deal?

Perhaps Broadmark management has been duped into accepting a lowball valuation for their business? Or perhaps they have been fooled by the old Wall Street con of hiding fees in options and warrants (the original merger deal was altered a few weeks ago, and prior to the change the true cost of the warrants was more heavily disguised) and failed to understand the full costs of the deal?

That said, my life experience has taught me that when other people do things that seem hard to understand it is easy to ascribe their actions to foolishness, but it often turns out to be the case that the seeming fools were in possession of information I didn't have or hadn't properly understood, in the light of which their actions were entirely reasonable. In this case, Broadmark management knows more about the state of, and future prospects for, their business than anyone else. Is their willingness to take this deal perhaps an indicator that the future is less rosy than I believe? And if so, should our hypothetical investor vote "yes" and hope for a quick profit, or vote "no" and reject the fees which will, if the business is less healthy than I believe, perhaps not be more than offset by a stock gain?

3. What will happen in the event members reject this deal?

Will our investor be able to retain their investment? Or will they find themselves redeemed for cash because the Broadmark funds, which are bumping up against limits on the number of members permitted by SEC regulations, elect to continue to grow by ejecting smaller investors in favor of larger ones? Or, alternatively, will they find themselves redeemed for cash because the vote was very close and Broadmark management decided to proceed with the deal by simply redeeming a small number of "no" voters and putting the same deal to another vote?

These questions cannot be answered with any great degree of certainty. And in the face of such uncertainty, I believe that many members will latch on to the only certainty in the deal - that the fees are egregiously high - and vote "no". Perhaps not enough of them to stop the merger going through, but far more than you might at first think.

There are two ways to profit from this situation. The first and most obvious way is simply to purchase TMCX at $10.46. The upside is $14 or more and the downside is limited.

  • In the event the merger fails, it is unlikely that the shares would trade too far below the cash value of $10.45, especially given the significant probability that Trinity would wind up operations and simply return cash to shareholders.
  • In the event the merger proceeds, a price of $10.46 would result in a fast-growing, internally managed, unleveraged mortgage REIT yielding 11.3%. Again, it is hard to see the price falling far below $10.46 absent a market event.

However, there is also another option. Based on the behavior of the price of TMCX and TMCXW since the deal was first proposed and when the warrant amendment was changed midway through the process, it is possible to estimate that the warrant is pricing in an approximately 88% chance of the deal completing.

I believe that the deal is indeed more likely to close than not, but perhaps not as much as 88%. One possible way to take advantage of this would be to purchase 1 share of TMCX at $10.46 and sell short 4 TMCXW warrants at $1.54 for a net cost of $4.30.

If the merger fails:

  • The warrants would likely revert to their pre-announcement price of $0.30, or perhaps less, to reflect the significant chance that Trinity would wind up operations and the warrants would expire worthless.
  • And the stock might fall back to $10, but is unlikely to fall further, given that the balance sheet is essentially all cash.
  • The net gain would be $4.50.

If the merger succeeds, you would be responsible for the warrant amendment payments of $6.40 in total and would own 1 share of BRMK, and be short the equivalent of a single warrant for a full share of Broadmark with an exercise price of $11.50 (you will actually be short four warrants each for a quarter share, but it is easier to think in whole warrants). If you close the position out immediately:

  • At a stock price of $14, and assuming the hypothetical full warrants trade at $4, you would lose 70c.
  • If BRMK were to trade at the reference price of $10.45, and the hypothetical full warrant at $1.50, your loss would be $1.80.
  • If BRMK trades below the reference price, you will be exposed to the downside.

I have used this calculator and assumed 20% volatility to estimate likely warrant prices.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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