Medley Management (MDLY) – Merger Arbitrage – 25%+ Upside

Current Price – $2.81

Merger Consideration – $3.55+

Upside – 25%+

Expiration date – TBD

Merger Presentation

 

MDLY / MCC / Sierra merger saga is ongoing already for more than a year. Materially amended merger agreement was signed at the end of July'19. Recent developments indicate that we might be nearing the finish line. The key risk has been eliminated by the amended merger terms. A settlement with the activist make the transaction more likely. The spread stands at 25% for hedged trade and 34%+ for the unhedged trade with cash portion accounting for more than the current MDLY share price.

Management was targeting Q4'19 to close the transaction, but probably this will be delayed till Q1'20. Meetings to vote on the amended merger agreement are expected to be announced shortly.

Market likely gave up on this transaction after more than a year of delays, proxy fights, conflicted management and etc. This should explain at least part of the spread. Complicated transaction structure coupled with tiny market caps (c. $100m) accounts for a further portion of the spread.

Most importantly, the amended merger terms have eliminated the key risk - MCC shareholder approval is no longer required for MDLY to merge with Sierra. So now all will depend on whether Sierra Income (unlisted BDC) unitholders approve the transaction. And I think they will mostly due to liquidity advantages of the public market listing and internalization of the asset manager. All the proxy fights during 2018/2019 were on the MCC side, so it is a bit hard to guess what is Sierra shareholders' opinion towards this merger.

 

Previous merger agreement

The initial situation with previous merger terms was posted on SSI back in Aug'18 and I refer to this write-up for background. In a nutshell, MDLY (management company, 82% owned by insiders) intended (and still does) to merge with two BDCs it operates - listed MCC and unlisted Sierra Income - with Sierra as a sole surviving entity. Merger terms were very favorable for MDLY and insiders. MCC activist shareholders revolted and with the settlement received two seats on the board and special committee as well as extracted additional merger consideration for MCC shareholders to be paid directly by insiders.

The main reason for delays were MCC proxy fights. Now with MDLY/Sierra merger not conditioned on MCC shareholder approval, the process is likely to proceed more smoothly.

 

Events since

  • Jun 4th - During the annual meeting MCC shareholders re-elect two incumbent directors against advice of ISS and Glass Lewis. Another activist NexPoint had suggested competing slate of directors, but got voted down (15.6m shares against 21.7m shares). Nexpoint argued that incumbents won only because of votes of insiders and their affiliates.
  • Jul 29th - amended merger agreement signed, terms outlined below. "Go Shop" period starts to find better proposal for MCC.
  • Sep 9th - 13G with 9.3% MCC ownership filed by Glacier Point Advisors.
  • Oct 14th - "Go Shop" ends with no superior proposal to the amended merger agreement.
  • Nov 11th - 13G with 14.2% MCC ownership filed by Fortress Investment Group.
  • Nov 19th - Court Approval of the settlement between MCC and FrontFour - court approval was one of the conditions to close the merger. Following this approval I am expecting announcements on shareholder meetings shortly.

 

MDLY/Sierra merger not conditioned on MCC/Sierra merger

Wording of the previous merger agreement:

The MDLY Merger is directly related to and contingent upon the merger of Medley Capital Corporation (“MCC”) with and into Sierra, with Sierra as the surviving company in such merger (the “MCC Merger”)

Contrasting this wording in the current agreement:

Pursuant to terms of the Amended MCC Merger Agreement, the consummation of the MCC Merger is conditioned upon the satisfaction or waiver of each of the conditions to closing under the Amended MDLY Merger Agreement and the consummation of the MDLY Merger. However, pursuant to the terms of the Amended MDLY Merger Agreement, the consummation of the MDLY Merger is not conditioned upon the consummation of the MCC Merger. If the MDLY Merger is consummated and the MCC Merger is not consummated, the investment portfolios of Sierra and MCC would not be combined and Sierra would continue with Merger Sub, the surviving company in the MDLY Merger, as its wholly owned registered investment adviser.

 

Amended merger agreement

The terms of the new agreement are somewhat more favorable for MCC/Sierra shareholders compared to the previous one, the main difference being $47m settlement fund that will be paid out to MCC shareholders from the pockets of management. The structure is quite complicated:

  • MCC shareholders will receive 0.68 shares of Sierra for each share of MCC. Additionally, shareholders unaffiliated with MDLY will get additional distributions from the Settlement Fund consisting of $17m in cash and $30m in Sierra common stock (valued at NAV, which is $6/share). Per my calculation this works out to 0.79 Sierra shares and $0.37 cash for each MCC share.
  • MDLY shareholders other than LLC unit owners (i.e. insiders) will get 0.2668 shares of Sierra and $2.96 cash for each share.
  • MDLY Management will receive 0.2072 shares of Sierra and $2.66 in cash for each unit. Part of this will be contributed to MCC shareholder settlement fund noted above.
  • Sierra Income shareholders will continue to own the units they currently do, but the company will be listed.

The simpliest way to look at merger consideration per MDLY share is by applying apply discount to Sierra Income NAV ($6 share as of Sep'19). Even assuming 50% discount to NAV (where MCC trades currently due to lack of scale and profitability), consideration per MDLY share works out to $3.76 or 34% upside to current prices. I believe 50% discount to NAV is very conservative estimate on where the merged MDLY/Sierra Income would trade, so the actual realized upside is probably higher than that.

For the hedged trade and assuming merger closes between all three companies, using current MCC price ($2.1/share) I arrive at the implied price of the merged company of $2.19/share. This in turn translates into consideration of $3.55 for each MDLY share, or 25% spread.

 

Risk of shareholder approvals

This merger is still a cash out by MDLY management as they will pocket $54m in total (or $70m if MCC/Sierra merger fails) and maintain only limited ownership of the merged company (vs 82% economic interest in MDLY currently). However, I think the likelihood of transaction closing has increased for both full merger as well as only MDLY/Sierra merger.

MDLY approval is a done deal due to voting control by management. I expect Sierra Income shareholders to be in favor of the merger as that is the only short term prospect to get shares listed and trade-able on the exchange. Whether small dilution and material cash payout (equivalent to 14% of NAV) to get the asset manager internalized is worth these advantages remains a question mark. Recent developments with MCC and lack of superior proposal serve as an indication that better terms might be hard to extract for Sierra shareholders. On the MCC side the likelihood of approval has improved due to:

  • Settlement signed with FrontFour who will vote their shares for the merger.
  • Two incumbent directors reelected in MCC meeting received a total of 13.5m of unaffiliated votes (vs 15.6m shares that were voted for other nominees). I assume that at least that many votes will be cast in favor of the merger.
  • "Go Shop" period ended with no superior offers. So it does not seem like there are any other options are on the table.
  • MCC is currently trading at 54% discount to NAV and administrative costs consume all investment income. In contrast larger scale Sierra Income generates healthy investment income after management fees. Thus the discount will likely be narrower for the larger scale company after merger with Sierra and with internalization of the asset manager.
  • NexPoint has not raised any further issues after the annual meeting. Although these might resurface again following shareholder meeting announcements.
  • Two new large holders accumulated a combined 23% position in MCC after the amended merger terms were announced. Both filed 13G instead of 13D. I take these new positions as a sign that they will be in favor of the merger.

13 COMMENTS

  1. mcg

    > Two new large holders accumulated a combined 23% position in MCC after the amended merger terms were announced.

    If you are referring to Fortress, they aren’t a new holder. The shares were distributed as part of the dissolution of a JV.

    1. dt

      Agreed on Fortress. Do you have any thoughts on how Glacier Point received MCC ownership?

  2. nostradamus

    A few quick comments:

    – As far as I know, the exchange ratio for the MCC shares into Sierra is 0.66x plus the other numbers you mentioned, not 0.68x.

    – This article doesn’t mention a lawsuit by Sierra shareholders that’s still pending right now. The lawsuit is very much like the MCC lawsuit that was settled.. I know nothing about the potential of this lawsuit to stop the merger, or if a potential settlement could possibly affect he MDLY exchange ratio, but I think it’s a risk.

    – For this merger to close, apart from the shareholder vote, the SEC needs to grant exemptive relief. From what I’ve read there’s no clear precedent on this happening. It might be a formality, or it might not be: who knows. Or, the SEC will want the Sierra lawsuit to be settled first. I have no knowledge on these issues at all, I’m just relaying what I’ve read in the filings and random people commenting on random websites.

    – Personally, I feel the downside risk with MDLY is a lot bigger if the merger falls than MCC’s downside risk. You own a potentially worthless loss-making asset manager with a hideous track record. With MCC at least you have assets underneath the share price.
    Anyway, I don’t mind a risky bet like this, the spread is juicy, so I’m long some, but I do think this situation has issues which are very difficult to properly handicap by anyone without very specific legal knowledge.

    1. dt

      Thanks for pushback. Addressing your point below.

      – You are correct on the 0.66x exchange ratio, but that has only negligible impact. MCC shares convert into Sierra at ratio 0.66x – 0.68x depending on the costs of litigation with FrontFour. If these expenses are below $10m then exchange ratio will be 0.68x, if above $15m then exchange ratio stands at 0.66x. From the 8-k filled on the 21st of Nov, it seems that total expenses on this case be c. $15.5m. Initially I failed to include the counsel award, and therefore thought exchange ratio would stand at 0.68x.

      – Regarding litigation, there are 3 cases outstanding, two from MCC shareholders and one from Sierra shareholders. The two cases on MCC side relate to previous merger agreement and preliminary conference on these cases was scheduled to take place on the 19th of Nov. As these relate to previous merger agreement I do not think they are that relevant. The case from Sierra shareholders is more recent – amended complaint (reflecting the amended merger terms) was filed on the 8th of November. I am not a legal expert, but my thoughts were that Sierra shareholders can easily vote against the offer if they belief it is unfair. I do not think the merger is conditioned on resolution of these lawsuits and would expect shareholder votes to proceed regardless.

      – Exemptive Relief – unable to comment how easily will SEC grant this. My understanding that this relief mainly relates to internalization of the asset manager into BDC, which should be a rather standard procedure. However, the structure of MDLY insiders paying-off MCC shareholders through Settlement Fund is the main hurdle for this. However, that would affect only the MCC merger and should have zero effect on MDLY/Sierra merger. However, I am just speculating here and have no legal expertise on this.

      – Finally on downside risk, I think it is really hard to assess. As you suggest MDLY stock might effectively be worthless due to $130m debt load even if the company has $4.3bn in AUM (out of which $2.3bn are fee earning AUM). Stock was trading only 30% higher before the merger announcement last year, and since then both revenues and AUM continued to decline and common shareholders were further diluted by LLC unit holders. So MDLY stock is clearly expected to drop if the merger falls apart. The downside risk might be smaller with MCC, but chances of MCC merger passing are also lower.

  3. Martin Hernon

    From the II article posted by Ratel (thanks), “The SEC, which has that very mandate [protecting investors], still needs to approve the Medley deal after shareholders vote.” Final sentence of the article; fwiw, the writer thinks the SEC might be an issue.

  4. lngtrminvestor1

    If this deal does close, I wouldn’t want to be left holding the bag- likely some serious selling pressure from arbs and Sierra shareholders. I’ve seen other examples where there is already a buyback authorized for the surviving entity.

    1. dt

      I think your concerns are misplaced.

      The only bag-holders will be MDLY shareholders if the merger fails. If the merger gets approved I see only upside from being long MDLY or MCC.

      One can play this merger arbitrage both hedged and unhedged. Also only a small part of MDLY merger consideration will be paid out in shares.

      Finally keep in mind that MCC is already trading at 50% discount to NAV – how much lower can this go after the merger? I don’t think much. From downside perspective might even be better to arbitrage by going long MCC instead of MDLY, however chances of approval are somewhat slimmer.

  5. Zulu Investor

    Hi any updates in light of the recent market? I can’t see how MDLY and Sierra are to be affected drastically by either the virus or the oil price war.

    1. dt

      Apparently there are rumors that the merger will get terminated, although company’s IR seems to deny this. Have a look at some commentary on twitter https://twitter.com/search?q=%24mdly&src=typed_query
      I also think the sell-off is exaggerated by very low liquidity in the stocks – total weekly volume for MDLY stands at only $300k, so exiting even a relatively small position might materially affect market prices.
      If merger indeed breaks, MDLY is likely to go bankrupt, but MCC looks very interesting here, given NAV=$4.05 vs P=$1.16, even for a badly managed BDC the discount appears to be far too large.

      1. Zulu Investor

        I just think it’s awfully convenient that in the midst of this bear market this rumor pops up despite months of MDLY being relatively quiet. And the fact there is a short position this does make this a very suspicious announcement. It’s either a rumor or inside trading. If it’s inside trading and the information turns out to be real, well fine, this will be my loss this time around. Disappointing to see people cheating the financials markets.I personally think it’s a rumor that has a ulterior motive behind it. People will put their mouths where their money is at the end of the day.

  6. Zulu Investor

    Hi DT,

    Are there any other contingent risk you see why this deal won’t close other than rumors? Any contingent rules such as market drops, (I didn’t find anything like that) that could make this deal break? Given the huge drop, is it possible for Sierra management to cancel the shares and just buy the shares in the open market? My understanding is that that is considered market manipulation, but I am not sure if thats the case.

    1. dt

      Zulu, this merger was quite risky and a shady even before the whole corona virus situation. Now with markets/economies in panic mode I think all the mergers are on question mark, and MDLY/MCC/Sierra is no exception.

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