Medley Capital BDC and the high fees and dilution.

Medley Capital BDC has filed its latest N-2/A detailing plans to sell 13.3 million shares at $15.00/share. The initial portfolio will be contributed by some of the managers private funds, who will exchange loan assets for shares in the new BDC. This is similar to what THL capital did for its IPO. However unlike THL Credit (TCRD) Medley's fee structure is much more favorable to the manager, being (2% gross assets + 20% xs of quarterly 8% hurdle with a catchup). Unlike THL there is no total return requirement, nor any exception on paying an incentive fee for non-cash PIK interest.

The most worrysome aspect of Medley Capital's offering statement is that the company intends to pay 50% of the management incentive fee in shares of stock issued at the then current market price. This could lead to incredible dilution if the company manages to have decent earnings while trading below NAV. Constant issuance of new shares may also become a drag on total returns because of insidious dilution.

Subject to receipt of exemptive relief, we have agreed pursuant to the investment management agreement with our adviser to pay 50% of the net after-tax incentive fee in the form of shares of our stock at the then current market price, which may be below our NAV; this may affect the market price of our stock and may result in dilution to existing stockholders.

As we describe under “The Adviser”, pursuant to the investment management agreement with our adviser, subject to receipt of exemptive relief from the SEC, we have agreed to pay 50% of the net after-tax incentive fee in the form of shares of our stock at their then current market price. This may result in the issuance of shares to our adviser at a price that is below our then current NAV (if our market price is below our NAV on the issuance date of the shares). Any issuances below NAV may have a negative effect on our stock price. In addition, the interests of existing stockholders may be diluted. The extent of the dilution that may be incurred is not calculable.

The 1940 Act prohibits us from selling shares of our common stock at a price below the current NAV of such stock, with certain exceptions. One such exception would permit us to sell or otherwise issue shares of our common stock during the next year at a price below our then current NAV if our stockholders approve such a sale and our directors make certain determinations. At our next annual shareholders’ meeting, we will seek approval to continue this arrangement.

May brings plenty of filings for new BDC's and some oddball REITs

Oodles of S-11's and N-2's have been filed recently; and so this list is not exhaustive.

1. Legacy Healthcare Properties Trust.

Equity healthcare reit started by ex-CNL folks. These folks are veterans of the non-public reit market (scam). Statements in the prospectus such as "In addition, we will grant an aggregate of ????? shares of our common stock to our executive officers upon completion of this offering which, together with the shares they will purchase in the concurrent private placement, will result in ownership by our management team of approximately ?.??% of our outstanding common stock upon the completion of this offering and the concurrent private placement. These shares will be fully vested upon grant." should be viewed with suspicion.

2. Reunion Hospitality trust.

A bizarrely structured offering creating a hotel reit involving a trust account, forced investment period and passive participation shares equal to 5% of the public offering. This will probably not attract much interest , since there are already enough blind pool hotel reties to keep anyone happy (Pebblebrook Hotel Trust, Chatham Lodging Trust, Chesapeake Lodging Trust etc.)

3. Two Harbors's Investment Corp.

Filed a registration statement for various securities underlying warrants left over from the companies days as a SPAC. Two harbors is my personal pick in the RMBS reit space due to management's expertise and enunciated conservative business strategy, and sensible approach to hedging interest rate risk.

However management hurt its credibility by recently canceling a stock offering because it would be excessively dilutive, and then doing an offering of roughly the same size, with only slightly more favorable conditions.

This has highlighted a risk for the externally managed reits with a flat fee management structure. Namely that management is incentivized to raise equity, since that is the only way to increase the earnings of management.

4. Various potentially high cost, externally managed BDC's.

• White Oak Capital Corporation
• OFS Capital Corporation
• Full Circle Capital Corporation
• Medley Capital Corporation

Several of private-to-public BDC conversion's have filed N-2's with the SEC. These filings are mostly the same, but with subtle differences. There is some, inconclusive evidence that folks are becoming aware of what does and doesn't work in the IPO market. For example the N-2 for OFS capital corporation, includes a total return hurdle and non realized PIK interest exclusion in the calculation of the incentive fee; similar to that seen in THL credit (TCRD).

5. Madison Square Capital.

Finally, Paul Ullman deserves an award for persistence, because Madison Square Capital has gone through 12 (count'em !!) S-11/A's since first filing to go public back in April 25 2008. You can sort of chart the wreckage and drama, through the S-11's posted from 2008 to 2010 as the company switches from being internally to externally managed, gains and loses a co-investment commitment from Leucadia National etc. In its current incarnation, Madison Square hopes to be high rolling Agency RMBS Reit like American Capital Agency (AGNC) with big leverage and big dividends. Sort of the opposite approach that Two Harbors is taking.

Plenty of new S-11's in mid April

The lawyers are busy as several REIT's have filed new (DLC Realty Trust/Younan Properties) or updated S-11's (Welsh Property Trust/Excel Trust/Hudson Pacific Properties, and Two Harbors Investment Corp).

DLC Realty Trust

DLC Realty plans to be a "a vertically integrated, self-administered and self-managed real estate investment trust, or REIT, that acquires, manages, leases, repositions and redevelops grocery-anchored and value-focused open air shopping centers primarily in the Southeast, Northeast, Midwest and Mid-Atlantic United States." The company is a roll-up of various previous investments funds and management companies into a new UPREIT structure. The company claims that to be the 12th largest private owner of shopping centers in the United States as of December 2009. The S-11 helpfully notes:

Certain members of our senior management team exercised significant influence with respect to the terms of the formation transactions.
We did not conduct arm’s-length negotiations with the continuing investors that are members of our senior management team with respect to all of the terms of the formation transactions. In the course of structuring the formation transactions, certain members of our senior management team had the ability to influence the type and level of benefits that they and our other officers will receive from us. In addition, certain members of our senior management team had substantial pre-existing ownership interests in our predecessor and will receive substantial economic benefits as a result of the formation transactions.

Welsh Property Trust

Welsh has updated its S-11 to reflect a planned post-IPO transaction to buy roughly $78 million of new properties, mostly outside of Welsh's core rust belt markets.

Concurrently with the closing of this offering, we plan to expand our significant real property holdings through the acquisition of five additional industrial properties in four states containing an aggregate of 2.5 million leasable square feet, for consideration of $78.2 million. We plan to use net proceeds from this offering, issuance of OP units and new debt financing to acquire our acquisition portfolio. Our acquisition portfolio complements our existing portfolio by adding additional holdings in some of our existing markets and contiguous markets. In addition to our acquisition portfolio, we are currently engaged in negotiations to acquire of $181.4 million of additional industrial properties in our acquisition pipeline. Consistent with our acquisition strategy, four of the five properties in our acquisition portfolio were sourced off-market and 14 of the 19 properties in our acquisition pipeline were sourced off-market.

Younan Properties

Younan Properties claims to be "a fully integrated, self-administered and self-managed owner and operator of primarily Class “A” office properties located in five major U.S. office markets: Dallas-Fort Worth, Chicago, Houston, Phoenix and Los Angeles." The REIT is strongly weighted towards texas, getting roughly 70% of its gross revenue from the Dallas (50% of gross rent) and Houston (20%) markets. Looking at the IPO "use of proceeds" section suggests that this IPO is mostly a deleveraging play. A CoStar interview with Zaya Younan from July 2007 is quite interesting.

THL Credit and Horizon Technology Finance putting out new N-2's

THL Credit

THL Credit has uploaded its second revised form N-2/A with a bunch of changes that make it non-comparable to previous filings. Most notably the management fee structure has changed from being (1.5% Base + 15% xs of 8% with a catch up) calculated quarterly with no cap, to being 1.5% + 20% xs of 8% with a catch up, but also being subject to cumulative total return hurdle. Most importantly under the new scheme, PIK (paid in kind) interest is excluded from the calculation of the incentive fee.

In addition, THL Credit Advisors will not be paid the pro-rata portion of such incentive fee that is attributable to deferred interest (sometimes referred to as payment-in-kind interest, or PIK, or original issue discount, or OID) until we actually receive such interest in cash

Very notable and hopefully this is the start of new trend in externally managed BDC's, which shows an attempt to reduce the incentive for management to be focus on maximising quarterly results, rather than long term results. It never made sense to me that management would be paid an incentive fee for "earning" PIK interest. The rest of the changes to the N-2/A relate to pre-IPO schedule for the roll up of the existing THL Credit fund into the new public BDC.

Horizon Technology Finance Corporation

Horizon Technology Finance Corporation has filed a prospectus describing a new BDC that intends to "invest in development-stage companies in the technology, life science, healthcare information and services, and cleantech industries." My initial impression is that this will be an high cost externally managed version of Hercules Technology Growth Capital. The management fee is 2/20 with a catch-up on a 7% hurdle rate measured quarterly.

Ellington Financial files 7'th S-11/A

Ellington Financial has filed a new S-11/A with the SEC. Thi filing removes the aspect that I think lead the previous IPO attempt to fail. Viz, that the company inteded to pay out only 50% of taxable income as cash dividends, while shareholders would be paying cash taxes on 100% of the companies income. This implied a very high effective tax rate on any cash distributions.

As of March 17th 2010:

Our present intention is to pay quarterly and special dividends to our common shareholders so that approximately 100% of our net income attributable to our common shares each calendar year, beginning with the 2010 calendar year, has been distributed prior to April of the subsequent calendar year, subject to potential adjustments for changes in common shares outstanding. In setting our dividends, our board of directors takes into account, among other things, our earnings, our financial condition, our working capital needs and new investment opportunities.

New prospectisii?

Couple of new S-11's/N-2's out there.

Plainfield Direct

A Plainfield Direct is is an externally managed business development Company with a 2/20 (7% hurdle + catch up) management fee structure. CEO is Max Holmes is ex-DE Shaw/Drexel Burnham Lambert etc. Interestingly Since 1993, he has taught “Bankruptcy and Reorganization” at New York University Stern Graduate School of Business, where he remains an Adjunct Professor of Finance. Another member of the board of directors is also an adjunct professor of finance at the University of Chicago Graduate School of Business. This looks like a smart crew, but does the market really need any more 2/20 BDC's?

Welsh property trust

• Vertically integrated real estate company with in house management abilitity, (Owned portfolio of 9.2 Million Sf, while providing services to another 17 million+ sf of externally owned real estate)
• Targeting Office and Industrial properties.
• Initial formation will involve the exchange of interests in various property investment funds for OP units of the new REIT. Shades of Douglas Emmet's pre-IPO drama. "We did not conduct arm’s-length negotiations with our principals with respect to all of the terms of the formation transactions. In the course of structuring the formation transactions, our principals had the ability to influence the type and level of benefits that they and our other officers will receive from us. In addition, we have not obtained any recent third-party appraisals of the properties and other assets to be acquired by us in connection with the formation transactions. As a result, the price to be paid by us to the prior investors, including our principals and certain of our executive officers, for the acquisition of the assets in the formation transactions may exceed the fair market value of those assets."
• Industrial portfolio is in the central US rust belt "Our industrial properties are primarily located in the central United States. In our existing portfolio, approximately 8.6 million leasable square feet, or 93.1% of the total portfolio square footage, is within eight contiguous central U.S. states: Minnesota, Wisconsin, Iowa, Missouri, Michigan, Ohio, Indiana and Illinois." These are exactly the locations that the new Terreno REIT intends to avoid.
• This is kind of an odd IPO, in that existing portfolio is in an unpopular part of an unpopular sector. The real estate services business is interesting. I really have no clue what the public valuation for this might be.

Weekend/Weekly Update on new REITs and IPOs

This and last week saw several IPO's/secondary offerings.

Terreno Realty

Terreno Realty IPO'd with a reduced offering of 8.75 Million shares at $20/sh. I'm not sure how much of the reduction from the original plan was due to general hostility to IPO's vs the specific business that Terreno wanted to persue. On paper, iwning property at a 9% cap rate with 40% leverage won'tgenerate the mid teens IRR's that folks are looking for these days. At the same time, the industrial REITs (especially the big ones like AMB) tend to trade a premium market multiple. So a fully invested TRNO could generate an impressive IRR from multiple expansion vs high cash dividend payouts.

Solar Capital

Solar Capital, a BDC entered the public markets with an offering of 5 million shares at 18.50/sh. This BDC is run by ex-Apollo/AINV folks, which makes it similar to PennantPark Investment Corporation (PNNT). This was a classic take under type IPO in which a company goes public at less than book value. The main purpose of the IPO was to create lqiuidty and stabilize the companies credit facility. The big question with Solar Capital is does the market need another BDC with a 2/20 management fee structure.

Piedmont Office Realty Trust

Piedmont Office Realty Trust, is finally public after years of pre-IPO drama, when it was known as Wells Real Estate Investment Trust. Like most non-traded REITs, Wells REIT became a cancerous monster, endlessly raising capital and buying new assets. After the company internalized management in 2007 it entered a multi-year dead zone while seeking a final liquidity event. During this time, the Lex-Win partnership of LXP + FUR launched a hostile tender offer, to shake things up and accelerate the "liquidity event". That event finally happened on Feb. 9, 2010 with the offering of 12 million shares at 14.50/sh, which was far below NAV. After the IPO, shares have floated upwards towards NAV (>16.50/sh) and if PDM's earnings power was given the same multiple as comparable REITs (BXP, DEI, SLD, CLI) the stock price would be much higher.

Hudson Pacific Properties

Hudson Pacific Properties, has filed an S-11, describing a new REIT intended to be "a full-service, vertically integrated real estate company focused on owning, operating and acquiring high-quality office properties in select growth markets primarily in Northern and Southern California." Senior managenment are ex-Arden Realty folks. Arden was the first of the really big public-to-private transactions when it sold for 4.8 Billion to GE Real Estate. The new REIT is born in the context of formation transactions which involve various funds and people assocated with Farallon Capital Management and Morgan Stanley.

PennyMac's big 4Q09 loss.

Okidata, PennyMac has reported results 4Q09, of a loss of $0.07 cents per share. This isn't that surprising given the companies high cost structure and relatively low percentage of invested assets (the company claims to have invested ~37% of IPO proceeds so far). At this pace I would expect them to be mostly invested by late 2010. The companies ultimate ability to generate FAD is hard to predict, since they plan on buying non-performing assets and the servicing intensive assets will cause incremental G&A expense. It's still unclear how much of an advantage there is in buying whole loans vs discounted RMBS.

I am impressed that PMT management has decided not to do the easy thing which would have been to acquire Agency RMBS with repo leverage, and start earning the incentive fee. Investing in Agency RMBS would also hold the company over until it could acquire desirable assets.

Stanford L. Kurland, Chairman and Chief Executive Officer of PMT, stated:

"At this early stage in PMT's development, it is not surprising that operating costs have exceeded investment income. Over the past several months, our manager has focused significant attention on its ability to adapt and react to changing dynamics in the mortgage marketplace, including a low volume of available performing mortgage transactions, which offer greater opportunity for value enhancement, and less attractive trading levels for the pools that have been marketed. As it waits for the market to further develop, our manager has placed particular emphasis on expanding the operational capabilities and the range of sources for attractive investment opportunities available to PMT. This expanded menu of capabilities and opportunities includes: a conduit platform that will allow PMT to purchase newly originated loans from small mortgage lenders and repackage those loans for securitization and sale; increased participation in structured transaction and securitization activities; opportunities to acquire mortgage assets that result from distressed condo development projects that may include real estate development loans, existing residential loans originated by the developer, and residential loans originated by PennyMac Loan Services on our behalf; and investments in mortgage servicing rights of liquidating and other entities. Ultimately, we remain firm in our commitment to investing wisely on behalf of PMT shareholders who recognize that PMT's unique approach to the distressed residential mortgage arena requires patient, long-term capital resources."

The companies strategy of purchasing non-performing residential loans is capital gains oriented vs being current cash payment oriented. Assembling a portfolio of non-cashflowing assets is problematic given that the management fee must be paid in cash. Buying non-performing whole loans also favors management indirectly by causing cash leakage (aka fee income) in favor of PennyMac Loan Servicing.