Description

Short Diversified Healthcare Trust (DHC)

This is a special situation with an estimated near term return of approximately 50%. On April 11th, 2023 DHC announced an agreement to be acquired by Office Properties Income Trust (OPI) in an all share transaction. If approved, each DHC share will be converted into 0.147 OPI shares. Based on the most recent close (7/17/23), DHC is trading at a 125% premium to the implied OPI share consideration and a 116% premium to the unaffected share price.

DHC has manufactured a going concern situation and is using it as a cudgel to force shareholders to approve the merger. Three activists who collectively own 22% of the shares outstanding have opposed the deal; unfortunately, even if they are successful in blocking the deal, they can’t prevent DHC from doing a massively dilutive offering. If the deal isn’t approved, it is likely DHC does such an offering to “solve” the near term liquidity issue. A useful example is the 2013 Corvex/Related/Sam Zell fight for CommonWealth REIT. This is a superb case study in shareholder activism but even they couldn’t prevent the Portnoys from doing an “emergency” equity offering that was done at a fraction of book value and diluted shareholders by nearly 40%.

DHC trades an average four million shares/day and there are over 10 million shares available to borrow at a bit more than GC last time I checked. Considering the index ownership I’d expect more shares to become available if there is demand.

Summary: If the deal goes through, the short wins. If the deal gets blocked, expect a dilutive secondary offering. The special meeting was initially scheduled to be held on August 9^th but that date has disappeared from the most recent S-4 presumably as DHC works to do everything possible to make sure they have votes.

Background

Both companies are externally managed REITs that are controlled by and arguably run for the benefit of RMR and Adam Portnoy. I count at least 18 VIC write-ups on RMR related entities, they are helpful for context. Despite the fact that these companies have consistently destroyed shareholder value for decades, this is the only short write-up of an RMR related entity on VIC that I am aware of.

DHC owns 27,000 senior living units and 9 million square feet of medical office and life science properties located throughout the United States. OPI is an office REIT with 12 million square feet. Chicago, the greater Washington D.C metro and Atlanta account for half of the office footprint. There is very little industrial logic to the transaction and the companies acknowledge as much with their $2 million to $3 million synergy estimate on $12.4 billion in gross assets.

Covid hit senior living hard. Things are recovering, but it is taking time. DHC’s 2022 company reported adjusted EBITDA was down 65% from 2019 levels. Today, DHC has $2.4 billion in net debt, over 8x 2023 EBITDA estimates. After announcing the transaction they added going concern language to their filings and recently announced an event of default under their credit facility that prohibits future debt refinancing. The company has $700 million coming due in 2024.

DHC has negative cash from operations but OPI is still generating positive CFO, for now. DHC has a near term liquidity situation and OPI has a long term solvency question. The companies argue that by combining, OPI will fix DHC’s near term liquidity situation and that OPI will benefit from the long term secular opportunity in senior living. A more cynical (accurate?) take on the rationale for deal is that maybe by putting them together they will be able to pay more fees to RMR than they would otherwise.

No one likes the deal. OPI fell ~25% on the announcement (which coincided with a dividend cut) and has come off another ~10% while peers have largely traded flat to up over the same time. The problems with office real estate are front page news. With companies like Brookfield and Related tossing back the keys and threatening default, investors are justifiably concerned about office real estate.

Three large shareholders (Flat Footed, 9.8%, D.E. Shaw, 6.1% and H/2 Capital Partners, 6.2%) have filed 13Ds opposing the deal. They all appear more concerned with the DHC debt than they own than they are with their equity investments in the company. As an example, at the time of the transaction announcement, Flat Footed had been selling down their equity holdings and owned fewer than five million shares worth approximately $6 million at the time. In their initial 13D Flat Footed noted that they own $157 million in DHC debt. D.E. Shaw and H/2 have also disclosed that they own a “substantial” amount of DHC’s corporate bonds. The price of DHC’s debt hasn’t moved meaningfully since the transaction was announced but the activist’s investments suggest their primary concern is that they don’t want OPI as a debtor (who can blame them?).

Flat Footed is soliciting proxies to reject the merger but they have not put forth a comprehensive plan detailing how they can force change—they are just asking shareholders to oppose the deal. Regarding how to solve the going concern issue they say “We believe that DHC’s 2024 debt maturities can be easily addressed.” And “If this does not prove possible, the Board has numerous other options – and would need to monetize just a fraction of DHC’s valuable unencumbered assets to pay off a portion, or all, of its maturing debt.”  D.E. Shaw argues that “Better Alternatives Exist for DHC” and list six potential solutions to the current debt situation including selling assets, issuing preferred stock, doing additional JVs and simply waiting to achieve covenant compliance. 

While the above statements are objectively true, they ignore the fact that Mr. Portnoy makes money by charging fees. If DHC or any of the RMR controlled REITs sell assets, the fees go away. So he never sells (I can address the TravelCenters of America exception in the comments, if useful). Maryland law makes it near impossible to change the Portnoy controlled board at DHC and at this point there just isn’t time. The record date was June 16th, so no new share purchases can impact the outcome of the vote. All they can do is send letters. H/2’s June 30th letter indicates that they made a formal refinancing proposal to DHC as far back as November 2022 and they never received a response. Mr. Portnoy isn’t interested in doing a shareholder friendly debt refinancing. The activists can’t force DHC to sell assets to pay down debt and they can’t prevent DHC from doing a massively dilutive offering.  While a dilutive equity raise isn’t the activists’ preferred outcome, considering the additional security it would provide their debt investments it’s not a bad consolation prize. 

To try to ensure that the deal goes through, between May 30th and June 14th Mr. Portnoy acquired roughly 21 million shares and now personally owns 9.7% of DHC. Note that these purchases began one week after the initial Flat Footed 13D filing. Not only will he be able to vote those shares to approve the deal but he will also use the purchases as proof of the soundness of the transaction. Expect his team to make this fact front and center as they lobby ISS and Glass Lewis to recommend approval. From his 13D: “The Reporting Persons believe that an increased ownership stake in the Issuer further aligns the interests of Mr. Portnoy with those of the Issuer’s other shareholders, increases the impact of his vote in favor of the Issuer’s pending merger with Office Properties Income Trust (“OPI”) and that ownership in the merged company presents an attractive investment opportunity.”

During the time Mr. Portnoy was accumulating his shares, Flat Footed and D.E. Shaw were also on buying sprees. These purchases combined with momentum traders and the hope that maybe finally things will finally change have driven DHC shares to trade at this silly premium to the implied deal price.  DHC’s share price suggests the market believes the deal won’t go through and that DHC/RMR/Mr. Portnoy will start to behave in ways that benefit shareholders’ interests.  I believe history suggests otherwise and that if the merger fails it is highly likely that upon announcement, DHC will launch a massively dilutive secondary offering. 

Further, I wouldn’t count out DHC and OPI’s ability to get the votes.  Say what you will about Mr. Portnoy but he pays up for good advice (typically with shareholder’s money).  The special committees of DHC and OPI are represented by Sullivan & Cromwell and Wachtell, Lipton respectively.  These firms didn’t gain their reputations by losing.  Further, the fee that DHC estimates it will pay D.F. King, it’s proxy advisor, has increased from an initial estimated $17,500 before the Flat Footed 13D to “not to exceed $350,000” as of the most recent S-4.  Everyone is working overtime to get this done. 

The deal requires affirmative votes from a majority of both the DHC and OPI shareholders. At DHC’s June 6^th AGM, roughly 86% of shareholders voted (high institutional/index ownership) and 56% of shareholders voted in favor of the executive compensation resolution while only 11% voted against.  At OPI, 87% of shareholders voted, 68% were for the compensation resolution and only 6% voted against.  Obviously a routine vote on executive compensation isn’t determinative of how a vote on the merger will go but it illustrates that it is rare for this shareholder base to vote against the board recommendation.  Nevertheless, with 22% of DHC shareholders already committed to vote no, it will likely be a squeaker.  

Mr. Portnoy paid $2.27 per share for his recent DHC purchases, this compares to an average implied deal price of around $1.13 per share over the same time. This means he paid around $24 million over market value to try to get the deal through (said differently, he could have purchased the same economic interest in the pro-forma company via OPI and saved $24 million).

This premium seems nuts until you consider that Mr. Portnoy has a 53% economic interest in RMR and that RMR is structured as an Up-C company. Over the last three years DHC and OPI paid RMR $354 million in management fees, property fees, liability reductions and expense reimbursements. These don’t include fees the JVs pay to RMR. As an aside, the $354 million in fees compares to a combined OPI and DHC market cap of $840 million prior to the deal announcement. Over the last three years, RMR in turn paid out $394 million in cash distributions with $204 million going directly to Mr. Portnoy and his trust. RMR has net cash, roughly 50% EBITDA margins and almost no capex requirements. I’d argue that RMR is a fixed cost operation and that the DHC and OPI fees and reimbursements are largely incremental cash flow/value to RMR and Mr. Portnoy. Regardless, OPI and DHC are a significant source of RMR’s cash distributions.

Normal income tax considerations don’t appear to be a driving consideration for Mr. Portnoy. Because of the Up-C structure his portion of RMR gains and losses flow directly through the LLC to his trust’s tax return. This avoids corporate taxation on the income from RMR. Further, it is likely that depreciation and paper losses from his private real estate holdings shield much of the taxable income that flows through from RMR. According to conversations other parties had with Mr. Portnoy regarding a previously contemplated deal, he was very clear that he didn’t care about the detrimental tax implications of that deal. Considering these facts, it’s easier to see why Mr. Portnoy paid a $24 million premium to preserve fee streams that deliver ~$70 million in cash to him annually.

Other Items to note

To keep it simple I’m only recommending a short in DHC. You could pair with an OPI long as OPI probably trades up if the deal is blocked. At this point I think the probability that the deal goes through is a coin toss.  While the merger should benefit OPI long term, the market is telling you that right now it doesn’t love the deal, so if it goes through, I don’t expect a lot from OPI near term. Either way, being long OPI means you paying RMR fees, which is a personal preference.

Risks

I believe odds that the deal goes through versus getting blocked are roughly even – either of those should yield satisfactory outcomes for the short. There’s a 10% chance something wonky happens that would be bad for the short. I can think of four examples but there may be others:

--Portnoy personally makes a bid for DHC. Despite the fact that he recently did this at Aleris Life (ALR) a bid for the whole company would be out of character for Mr. Portnoy. The equity check at ALR was small (estimated at $26 million, net of the DHC investment) and ALR owned 20 facilities whose liquidation would cover the price he paid many times over (See NZ’s 8/29/22 ALR write-up). Also, the ~$500 million it would cost to acquire DHC is way beyond the scale of anything he has done previously. The bigger issue is that if he buys DHC personally it no longer makes sense to milk DHC for fees, which is the whole reason RMR exists. Ultimately, if Mr. Portnoy’s master plan were to buy DHC personally he wouldn’t have had OPI make the bid.

--A third party makes a bid for 100% of DHC. This is extremely difficult because of the RMR change of control provisions in the management contract and the debt. If there’s a change of control, RMR is due the NPV of the next 20 years of management fees estimated to be $375 million currently.  This is in addition to the ~$500 million it would cost to buy the equity at a 20% premium to the $1.70/share value of the deal at the time it was approved by the board.  Additionally, the DHC board turned down a $4.00/share bid for the company last year.  That bid was predicated on “the contemporaneous acquisition of another RMR-managed entity,” presumably ALR. Note that ALR manages around 65% of DHC’s senior living units and is now personally owned by Mr. Portnoy which greatly complicates a third party purchase of DHC.

--OPI increases the share consideration to DHC shareholders.  This is unlikely for two reasons: first, it risks triggering a similar activist issue at OPI and second, the animating force behind the DHC activists is that they don’t want OPI as a debtor so it seems no amount of OPI shares would get them to sign on to a revised deal. 

--The deal is blocked and RMR and Mr. Portnoy are so chastened they decide to engage in shareholder friendly behavior. Such behavior would include selling off DHC assets, paying down debt and potentially diluting board control. This would require RMR and Mr. Portnoy to give up management fees they can easily maintain by just diluting shareholders. It would be a complete reversal of a decades-long pattern of behavior.

Disclaimer: the author had short exposure to DHC at the time of submission, 7/18/23. The author has no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. The author makes no representation or warranties as to the accuracy, completeness or timeliness of the information contained in this presentation. The author expressly disclaims all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this presentation.

Catalyst

Shareholder vote (likely in August, maybe September).

Deal is pulled and DHC does a dilutive equity offering.