AAMC revisited – A royalty on yield chasing

(AAMC has a market cap of $490M and the shares are fairly illiquid.)

AAMC (original writeup) is the asset manager of RESI.  Asset managers can be extremely attractive investments because they have the potential to grow earnings dramatically.  The underlying business model revolves around buying up non-performing loans (NPLs) and resolving them (e.g. loan mods, selling REO properties, and converting NPLs into rental units).  Over time, RESI will accumulate rental housing units.

I think of AAMC as a play on investors chasing yield in the current low-interest rate environment and doing silly things such as overpaying for dividend yield.

The old and the new management

RESI has higher GAAP returns on equity and dividend yield than its publicly-traded peers (ARPI, SWAY, AMH).  However, I would attribute this performance largely to the old management team (Erbey + Pandey) and not necessarily the current one (Pandey + Ellison).

Thanks to Ocwen’s regulatory troubles with the NY DFS, Bill Erbey agreed to (was forced to) step down from all of his companies where he was the chairman / de-facto CEO.  At AAMC, Bill Erbey stepped down completely.  Ashish Pandey became the executive chairman replacing Erbey.  Pandey stepped down from his role as AAMC’s CEO and is now RESI’s CEO.

AAMC’s new CEO is George G. Ellison.  Mr. Ellison formerly worked for Bank and America and has an impressive work history.  According to AAMC’s press release, Ellison oversaw some of Bank of America’s most difficult and important mortgage-related issues.  He was “the executive leading the team that managed the valuation and disposition of Bank of America’s legacy mortgage loan portfolio and a leading member of Bank of America’s Special Initiatives team that worked to resolve Bank of America’s representation and warranty litigation”.  Unfortunately, I have not figured out whether or not he had good results during his tenure at Bank of America.

In terms of office politics, Ellison seems to have been accused of “unprofessional behavior”.  A news article that talks about a BoA lawsuit against ex-employees states:

The five men [ex-exployees] contend that on a professional trip to Las Vegas with colleagues in March, Ellison “participated in after-hours socializing at an adult entertainment establishment during which he engaged in unprofessional behavior,” according to papers filed in U.S. District Court in Charlotte.

When the group returned, the five contend in papers filed in the case, Ellison called a meeting of male employees in the group and “stated that he was attempting to prevent a `Tailhook’ scandal from affecting the bank and that he would retaliate against any female employee who revealed his activities in Las Vegas.”

AAMC asset management renegotiations

Since becoming AAMC’s CEO, Ellison made a major decision in renegotiating AAMC’s contract with RESI.  Under the old contract, AAMC was attacked by Glaucus Research (Valuewalk article) and Capstone Equities Capital Management (Businesswire article) because the fees were extremely high.  Under the old contract, there were performance-based fees that are similar to the GP/LP structure of many MLPs.  As dividends per share increased, the asset manager would take an increasingly larger cut of the profits.  Whenever RESI issues shares above book value, RESI was pushed deeper and deeper into the the highest tier of fees.

To get out of the high fees, RESI could have terminated its agreement with AAMC and paid the penalty of 3 years of incentive fees (based on the average of the last 2 years’ incentive fees).  However, the downside for RESI is that a one-time outflow of money would reduce the dividends it would be able to issue.  It would take a while for RESI to recover and to start paying dividends again.  It would also presumably take a while before RESI could issue shares above book value again.  On the other hand, AAMC badly needs fees from RESI to pay off its preferred shares.  So, both parties renegotiated the asset management agreement.  The April 1, 2015 Q4 presentation (PDF) goes over the terms of the new contract.

Some important points of the new agreement are as follows:

  • A base incentive fee of 1.5%.  This goes up to 2.0% depending on the number of rental homes.
  • An incentive fee of 20% of the amount above the hurdle rate.  The hurdle rate is 7.0% and may increase up to 8.25% depending on the 10-year treasury rate.  The incentive fee goes up to 25% depending on the number of rental homes.
  • A one-time conversion fee of 1.5% for each house successfully converted into a rental unit, based on the market value of that home (via a broker price opinion).
  • Unlike the old contract, AAMC will not be reimbursed for compensation related expenses of AAMC employees.
  • Initial term of 15 years, with 2 automatic renewal periods that could extend the contract to 25 years in total.
  • Unlike the old contract, RESI cannot pay a penalty and fire AAMC for any reason.
  • If AAMC generates less than a 7% return in any consecutive 2-year period, RESI can pay a “Performance Default Event Termination Fee”.  The fee is 3 times the average incentive fees of the prior 2 years.
  • RESI can decide to make an “Abandonment Decision” and exit the single-family rental business.
  • If RESI becomes regulated under the Investment Company Act, either AAMC or RESI can terminate the contract.
  • AAMC can be fired for cause, without any termination fee.  AAMC has to ensure that RESI’s audit firm does not have a qualified opinion or cease to consider to RESI as a going concern.  If so, AAMC is off the hook if it terminates the employees responsible and the auditor issues a clean opinion.  AAMC has to maintain RESI’s status as a REIT.  AAMC has to avoid material restatements of RESI’s financial statements (caused by the action or inaction of the Manager) that would be materially detrimental.
  • RESI is allowed to pay 25% of the incentive fee in RESI shares.  This is very clever in my opinion.  It provides a means for RESI to perform secondary offerings of its stock without paying underwriting fees or to sell shares at a discount to the market price.
  • AAMC continues to handle RESI’s communications with the press and investors.  AAMC could conceivably cause RESI to be a little promotional.

The broad strokes are:

  1. AAMC’s incentive fees are now back-end loaded.  The base incentive fee starts at 1.5% and will almost certainly rise to 2.0%.  AAMC does not currently meet the requirements for the higher fees due to the number of homes rented out.  It takes years to convert a non-performing loan into a rental home (the foreclosure process lasts years in the US, with a minimum of 5 years in some States).  Because of this, the rental homes will be coming.  Similarly, the 1.5% conversion fee will start kicking in as the rental homes arrive.
  2. Fees are much lower.  In FY2014, actual fees were $74.1M.  If RESI has paid fees under the new contract, the fees would have been $36.0M.  If RESI had paid fees under the highest rates, the fees would have been $44.8M.  (These numbers are according to pages 5 and 12 of the investor presentation.)
  3. AAMC is more difficult to fire.  However, RESI has more protections than some of the GP/LP contracts in the MLP space.
  4. The option for paying a quarter of the incentive fees is favourable to RESI since RESI controls that option.  That option has some value.

RESI/AAMC is a little cynical

Retail investors may not understand that RESI’s current dividend yield does not reflect the future dividend yield.

  1. As mentioned previously, the management fees are back-end loaded and will go up in the future.
  2. RESI uses lots of short-term debt to finance its assets.  It is arguably juicing its returns slightly by taking on more risk.  RESI’s book value was $1,326M as of Dec 2014 (10-K).  RESI had $1,015M of repo debt with short maturities.  RESI had $336M of securitization debt that matures in 2044 and 2054.

#1 could be a telling reflection of current management since the old contract did not have that feature.

I think that AAMC management understands the game that they are playing.  To some degree, some  asset managers do very well because they are able to grow AUM (even if they aren’t good at actually managing assets).  The back-end loading of fees should help AAMC grow AUM due to the deceptive dividend yield.

Does AAMC have a competitive advantage?

One way of answering this question is to look at the parts of the company that are difficult to duplicate.  Virtually anybody can bid on portfolios of NPLs.  Anybody can hire the same servicers as AAMC/RESI.

The AAMC business model is easily duplicated except for:

  1. Skill in attracting AUM (assets under management).  Under previous management (Bill Erbey and Ashish Pandey), AUM grew from roughly $100M to $1,200M.
  2. Skill (or lack thereof) in bidding on pools of non-performing loans.

So far, AAMC under old management managed to significantly outperform its publicly-traded peers that are involved in single-family residential housing.

Issues and risks

All parts of the Erbey complex sold down due to fears that Ocwen’s issues with the NY DFS (and other regulators) would spread.  RESI is spreading its servicing across 3 services instead of relying on Ocwen alone.  I could be wrong but I think that fears about Ocwen are overblown when it comes to RESI.

  • RESI is small in terms of the number of delinquent loans that it owns.  At Dec 2014, RESI owned 10,963 mortgage loans (almost all of which are delinquent).  This is very small relative to Ocwen with hundreds of thousands of delinquent loans.  Regulators generally do not specifically target small companies, though the NY DFS has gone after small companies like Lyft, RelayRides and Condor Capital.
  • RESI has diversified its servicers.
  • One potential risk is that regulators will impose more regulations that affect the economics of NPLs.  For political reasons, it is possible that state regulators could push the mortgage servicers to make fewer servicing errors.  Higher servicing costs could impair the business model of converting NPLs into rental housing.

There are macro risks from too many market participants chasing non-performing loans as an asset class.  In the past, Ocwen exited the business of buying up NPLs due to low returns (and to a lesser extent, the regulatory costs associated with its thrift charter that caused Ocwen to stop being a bank).  NPLs may exhibit some cyclicality as imitators may flood into the asset class.  The asset class is also sensitive to changes in home prices.

From a risk management standpoint, the Erbey complex has not done well.

  1. AAMC, OCN, and ASPS issued debt to buy back shares at prices much higher than current prices.
  2. Historically, Bill Erbey had a habit of giving business partners certain contractual protections or other protections.  In hindsight, these protections have caused his companies to lose money.  In subprime mortgage origination (Ocwen has since exited the business), Ocwen held onto residuals that caused losses as the subprime bubble burst.  In Ocwen’s financing deal with HLSS, the servicer rating clause gave HLSS a lot of leverage on Ocwen.
  3. Erbey underestimated the regulatory risk in mortgage servicing.

Valuation

Here’s my quick back-of-the-envelope calculation.  Suppose that AAMC will eventually qualify for the highest tier of fees.

  • Slide 12 of the Q4 presentation shows pro forma fees of $44.8M for FY2014.
  • Turning to page 47 of the FY2014 10-K, AAMC Stand-alone (excluding NewSource) had $11.150M in expenses and $2.051M in taxes.  Subtracting out these expenses, my scenario shows earnings of $31.6M / year.
  • The current market cap is around $490M.  There are $250M of preferred shares outstanding.  (The preferred pay zero interest and sort of have a call option attached to them with a strike of $1,000.  AAMC’s current share price is around $222.  For simplicity’s sake, I assume that the present value of the preferred is $250M.)  If the enterprise value is $740M ($490M plus $250M), then EV/projected earnings is 23.41.

EDIT (8/10/2015):  I screwed up.  AAMC had $7.011M in expense reimbursements in YE2014 that RESI will no longer cover.  Earnings would be $24.6M / year at the highest incentive tier and with 2014-style returns.  As of Q2 2015, AAMC (excluding NewSource) generated $5.361M of revenue (it did not receive any incentive fees) and had net income of $0.835M.  I believe it will take some time for AAMC to reach the highest incentive tiers.

Future earnings may be significantly higher if there is AUM growth.  Perhaps I am overly optimistic but I think that RESI will be able to grow AUM given that RESI has such a high dividend yield (11.22% with fees under the old contract).

*Disclosure:  I have a very small long position in AAMC.

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5 thoughts on “AAMC revisited – A royalty on yield chasing

  1. Thanks for the helpful post. Today AAMC was closed @~$37. It will be greatly appreciated if you can shed light on the true value of AAMC.

    • It depends on where you think the company is headed. Definitely read the transcript for the last conference call. Either new management screwed things up and AAMC is going generate very little in fees, or there is a short-term problem in the timing of GAAP income recognition.

  2. Pingback: AAMC update Aug 2015 | Glenn Chan's Random Notes on Investing

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