PennyMac's big discount

Of all the 2009 MREIT IPO's PennyMac Mortgage Investment Trust (PMT) trades at a worst discount to book value. This creates plenty of head scratching as to if PMT is pregnant with opportunity or pregnant with something else.

Reading the S-11's gives a number of reasons not to invest in PMT beyond those concerns with the target asset class; credit impaired residential mortgage assets requiring intensive servicing.

• The people who run this REIT, are same ones who created this mortgage crisis.

  "Certain of the officers of PennyMac who are former employees of Countrywide, including Stanford L. Kurland, our chairman and chief executive officer, who was chief operating officer of Countrywide until September 2006, have been named as defendants in lawsuits in which Countrywide and other employees and former employees of Countrywide are defendants."

• The management fee structure is not attractive. (1.5% base + 20% xs 8%), incentive fee's in a structure with potentially high leverage (typical of RMBS/Residential investors) can be dangerious
• The external manager has split ownership (37% Blackrock, 37% Highfields Capital, and only 26% "Management") which raises potential issues of stability and management buy in at the external manager level.

  "BlackRock and Highfields Capital, PennyMac's strategic investors, are not obligated to provide us with any assistance and could compete with us."

• There is a built in cash leakage due to the assignment of servicing to party related to the manager yet outside the REIT: PennyMac Loan Servicing (PLS). It is so important when dealing with externally managed company's to look at all sources of potential cash leakage in favor of management. What you are trying to avoid is any sort of "gross asset" based compensation arrangement, which is very open to abuse.
• There is an even worse conflict of interest in that PLS may earn origination fee's.

  "This may provide PLS with an incentive to refinance a greater proportion of our loans than it otherwise would and/or to refinance loans on our behalf instead of arranging the refinancings with a third party lender. It may also provide PLS with an incentive to provide financing to facilitate sales to third parties with regard to the disposition of real estate that we acquire through foreclosure."

• The public REIT is competing with two PennyMac managed private investment funds for investment opportunities and does so without co-investment rights. These funds have roughly $300M+ in uncommitted capital.

  "No assurance can be given that PCM will act in our best interests with respect to the allocation of personnel, services and resources to our business."

• Finally the fairly unique risk now facing holders of residential loans: a hostile court system.

  "The borrowers under sub-performing or non-performing mortgage loans may have a variety of rights to contest the enforceability of the mortgage loans and prevent or significantly delay and increase the cost of any foreclosure action, including, without limitation, allegations regarding fraud in the inducement by the original lender or broker, failure of the lender to produce the original documentation, improper recordation of the mortgage, various theories of lender liability, and relief through the U.S. Bankruptcy Code and similar state laws providing debtor relief." This sort of thing has been a real stinger, as judges have been known to vacate a mortgage over the holders inability to produce documentation, or are otherwise unsympathetic to the holders of sub-prime loans.

• Another issue is the companies long URL: www.pennymacmortgageinvestmenttrust.com. No one is ever going to remember or bother to type that into a browser.

Why no BDCs?

One thing that is odd in the rush to file S-11's for new REITs, is the lack of filings of N-2's for new business development companies. So far just three have filed during this landrush to the SEC. The public markets have lost two BDC's (ALD and PCAP) to mergers, along with relatively little capital raising from secondary offerings. This doesn't make sense since the credit conditions in the middle market C&I lending are constrained and profitable.

1. Trian Capital Corp
2. THL Credit
3. Golub Capital BDC

The Trian and THL offerings are boring 2/20-catch up jobs. The Golub offering is interesting, because Golub Capital had previously filed to create Golub Capital Partners LLC. This would have a been an LLC type vehicle similar to Compass Diversified Trust (CODI) in that it was structured as an LLC instead of as an investment company. Golub capital gets credit in my book for having funny advertising. Not often do we get to see the world through the gold colored glasses of a mezzanine lender.

The N-2 for Golub Capital BDC gets an award for the most byzantine management fee arrangement I've ever seen. I'm honestly not sure I even understand it, but it appears to be a traditional 20%+catch incentive fee over an 8% hurdle combined with a moving cumulative total return high water mark based on the relative differences of two different calculations of net investment income and total return. It's honestly not worth figuring out. Hopefully they simplify this fee structure in an N-2/A. Make it a straight 1.25% assets + 20% excess of an 8% hurdle on a four quarter rolling average, and they should be all set.

Financial LLC's (like the original Golub Capital Partners) have been an unpopular form of investment because they are flow through entities which issue K-1 forms instead of 1099-DIVs. An investor in such a entity gets to report his/her allocable share of taxable income which may not be matched by actual cash distributions.

The investor base is limited because tax exempt investors (including mutual funds) cannot jeopardize their status with the Unrealted Business Taxable Income (UBTI) that publicly traded LLC's/LP give off. Unlike traditional natural resource/hard asset MLP's, financial MLPs tend to generate almost no deductions which have the effect of shielding cash dividends from taxation.

This attained ultimate silliness in the S-11's for Michael Vranos's Ellington financial, which was planning to invest in subprime mortgages and related assets. The offering memorandum disclosed that Ellington intended to distribute only 50% of its taxable income each year; resulting in an absurdly high effective tax rate since the IRS would asking shareholders to pay 35% on 100% of the companies taxable income. The effective tax rate on cash distributions would be 70%. So you had a proposed IPO in which institutional investors were both unable to, and too smart to invest in.