Description

Description: 
Medley Management ("MDLY") is a permanent-capital, fixed income oriented asset manager that went public in the fall of 2014. Medley is based in New York and employs ~80 people. MDLY is trading at 7x 2015 earnings, while exhibiting rapid AUM growth, a very high cash earnings/GAAP earnings ratio, and paying a sustainable 11% qualified dividend yield with substantial cash on the balance sheet for buybacks/acquisitions. The price is such that the upside/downside asymmetry is highly attractive.

Medley's core business is private lending - and the vehicles it manages can be split into three pools: 

1) Medley Capital Corporation ("MCC"), a public business development company (“BDC”) currently trading below book value and unlikely to exhibit any growth near-term

2) Sierra Income, a private fast-growing business-development company

3) Private SMAs / Insurance accounts (insurance companies invest in the SME debt asset class via managed accounts for capital treatment reasons, and Medley is one of the larger managers in the space). 

Medley charges a fixed management fee on gross assets (increased leverage at a fund = more AUM), as well as a cut of net interest income. Expenses are relatively stable, and the business is straight-forward to model. The underlying assets are 70% senior secured first lien loans, with the rest largely second lien. 80%+ of the portfolios are floating rate. 

The business model is not unlike a lightly leveraged community bank - but with permanent capital. As traditional U.S. banking institutions have pulled away from the SME lending space, private capital in the form of opportunity funds, BDCs, SBICs, etc. have started to capitalize and come into the space. MDLY is one of these players. 

Valuation Metrics:
1) MDLY should earn approximately 25 cents per share in Q3 (25 cents per share were earned in Q1; 22 cents were earned in q2 (25 cents if excluding performance fee reversal)). Annualizing this rate, without assuming AUM growth implies that the company is trading 7x earnings. 

2) Qualified dividend yield of 11% 

3) $70mm of cash on balance sheet on a $240mm market cap with $100mm of debt. The company needs only $20-30mm of cash to operate. The rest can be used to repay debt, repurchase stock or seed/purchase new business ventures. 

Comps Analysis:

There are three paradigms to think about:

1) FSAM is a direct comparable. FSAM manages two public business development companies. It manages little other assets and has no near-term growth potential. It trades at 10-11x 2015 earnings. While the asset base is fully permanent (vs. MDLY’s ~70% permanent assets), the growth is dramatically slower, and the premium valuation to MDLY does not make sense.

2) Alternative Asset Managers. This is a more difficult comp-set. Private Equity firm earnings are highly accrual based, and are effectively levered equity beta. The cash conversion and earnings volatility are much worse and capital is rarely permanent. ARES and NSAM are two credit focused managers, that have some permanent capital and high cash conversion. They trade at 12x and 16x respectively.

3) Yield plays (REITs, BDCs, etc.) At a 11% Qualified Dividend Yield, there are virtually no tax-equivalent yield products out there in the public markets. Assuming a 20% maximum tax rate on QDI income, and a 50% tax rate for a NYC resident; an OI generating asset would have to yield 16% pre-tax to match the after-tax yield of MDLY. BDCs yield 9%-13% (all ordinary income); REITs at best yield mid-high single digits, again all OI.  

Whichever paradigm you use, MDLY appears cheap.

Variant Perception: 
The shares have sold off dramatically since the IPO (over 60%). Recently, the shares have fallen 40% from June levels of $12+ per share. The potential drivers are:

1) Relatively large retail presence in the shares on the back of a limited float in the midst of a sharp sell-off in retail fixed income (closed end funds, BDCs, etc.)

2) Oil concerns: 6% of MCC's assets are linked to oil and gas.

3) Fears about AUM growth: MCC is trading well below book value and is unable / won’t issue equity at these levels. There is even a small buy-back program in place. 

4) Rising interest rates

5) Credit Quality

These risks can be quantified / addressed:

1) Retail flows come and go - and the BDC sector seems to have bottomed for now (WFBDC is the relevant index on Bloomberg). If oil takes a leg down into the 30s this is likely to continue, but real money players have started to enter the BDC space to provide some stability. 

2) 80% of MCC's energy exposure is in AAR Intermediate Holdings. A services company loan that was closed in Fall 2014. The loan also is held by Cyrus Capital Partners in their CMFN BDC. The loan was conservatively structured with

3) Hidden Gem: AUM growth at MCC is non-existent. However, Sierra Income, the private BDC is raising capital at an aggressive pace (see Catalyst discussion below). Managed account growth has been steady over the past several years. 

4) Rising interest rates are actually a positive for MDLY. Because the assets are floating and are levered less than 1 to 1, Net Interest Income should rise as Libor rises. Because many loans have Libor floors (100 bps typically), rates will have to rise above 100 bps for MDLY to see the benefit. Overall however, MDLY is an interesting play into a hiking cycle. 

5) Credit Quality: This is the main risk and is most difficult to underwrite. A protracted credit cycle will reduce MDLY's assets through losses and reduce the pace at which it can gather capital. That said, there are virtually no balance sheet investments at MDLY, and while fees may fall it will be relatively insulated.

Catalysts:
1) The company has instituted a buy-back plan equivalent to 10% of the float. This should provide some stability to the share price.

2) Investors are myopic about MCC trading below book value. While it is true that there is no growth in that segment of the business it is only 1/3 of overall AUM. There is a hidden gem in the form of Sierra, it raises about $25-30mm of equity per month (Sierra files normal public co financials, including 8Ks every month announcing capital raised, as well as 10Qs/10Ks). $25-30mm of equity mean ~40mm of fee-paying AUM per month when accounting for normalized leverage). If Sierra is raising 150mm of new fee-paying assets per quarter, that’s 5% per quarter growth for MDLY as a whole (~3bn of fee paying assets today). Analysts largely focus on MCC rather than Sierra when discussing growth. Equity raised at Sierra on monthly basis in 2015:

3) New Product Launches: Management has discussed opportunities in the CLO space, and in real estate lending. Acquiring a platform would be a positive catalyst given the non-earning cash on balance sheet. 

4) Confusion about the performance fee impact in Q2. Earnings missed estimates on a negative performance fee item in Revenues. MDLY’s Opportunity Fund is structured with an 8% hurdle. It is currently in the catch-up phase, but as a result the entire MTM movement of the $1bn fund passes through MDLY’s earnings. This will persist until either the entire performance fee accrual disappears ($8mm remains); or the fund passes through its catch-up phase at which point it will take 20% of the performance going forward. Management is optimistic on the fund’s performance. The company earned 25 cents this quarter if there were no performance fee impact (positive or negative). In the long-run, performance fees should be positive providing upside to the 25cent figure.

Target Price: 
MDLY is a balance sheet light, high growth, permanent capital focused manager with a large dividend pay-out ratio. The company is on pace to generate $1.00-$1.05 of earnings this year; and assuming continued AUM growth, $1.10-$1.20 per share next year.

MDLY has the advantage of permanent capital, and high quality cash earnings. However, it is smaller, less liquid and more exposed to fixed income markets than some of its asset management peers.

Valuations in the space range from single digits in private equity to mid-high teens for more vanilla asset managers. At 12-14x, MDLY would be in the middle to the lower end of this range, (~$12-$16), and be paying a 6-7% qualified dividend yield (assuming no increase in payout amount). 

Assuming MDLY can reach $12 in the next 12 months, investors will have made a 85% return when including dividends over the period.

Upside/Downside:

The attraction of the trade is the sharp asymmetry in upside/downside. The company is priced for no growth and has a large covered yield. If the company were to sell off 20%; the one year return net of dividends would be -9%; and the stock would end the year yielding 13%, and at 6x trailing earnings. On the other hand, if it can demonstrate growth or revalue closer to peers, the upside is easily 50%+.

Other Considerations and Risks: 
1) With respect to asset managers, it is always worth thinking about their performance.  MCC’s book value performance from going public through June is 9.8% on an IRR basis (net of all fees).

Its opportunity fund is above its hurdle and is currently in the catch-up portion of the pay-out curve.

MDLY has attracted capital to its institutional opportunity fund and SMAs ($100mm just last quarter); providing some institutional validation of performance in that space.

Performance is not heroic, but in line with peers given recent struggles in the high yield space.

2) A broader macro downturn could result in losses - which would shrink AUM. The best protection in this case is price. At 7x earnings this year, even if there is shrinkage, downside risk should be limited. 

3) Private BDCs have been under some scrutiny as it relates to brokers charging aggressive fees to get clients into these vehicles. However performance at Sierra has been good – and there are no complaints out in the public. Brokers are likely to get paid less for selling Sierra – but there is no reason to think the product will disappear. Medley has offered to repurchase a limited number of shares of Sierra quarterly – but has not been fully taken up on its offer.

4) Liquidity is limited due to a dual-class share structure. The founders did not cash out in the IPO, and continue to own the majority of the business. They are paid from their shares exclusively via the dividends that regular investors get paid. Downside is that the public float is only ~40mm of the 210mm market cap. While float is relatively low, it should be easy to put on a $3mm position with limited prime impact in the context of the forecast return. 

Catalyst

1) The company has instituted a buy-back plan equivalent to 10% of the float. This should provide some stability to the share price.

2) Investors are myopic about MCC trading below book value. While it is true that there is no growth in that segment of the business it is only 1/3 of overall AUM. There is a hidden gem in the form of Sierra, it raises about $25-30mm of equity per month (Sierra files normal public co financials, including 8Ks every month announcing capital raised, as well as 10Qs/10Ks). $25-30mm of equity mean ~40mm of fee-paying AUM per month when accounting for normalized leverage). If Sierra is raising 150mm of new fee-paying assets per quarter, that’s 5% per quarter growth for MDLY as a whole (~3bn of fee paying assets today). Analysts largely focus on MCC rather than Sierra when discussing growth. Equity raised at Sierra on monthly basis in 2015:

3) New Product Launches: Management has discussed opportunities in the CLO space, and in real estate lending. Acquiring a platform would be a positive catalyst given the non-earning cash on balance sheet. 

4) Confusion about the performance fee impact in Q2. Earnings missed estimates on a negative performance fee item in Revenues. MDLY’s Opportunity Fund is structured with an 8% hurdle. It is currently in the catch-up phase, but as a result the entire MTM movement of the $1bn fund passes through MDLY’s earnings. This will persist until either the entire performance fee accrual disappears ($8mm remains); or the fund passes through its catch-up phase at which point it will take 20% of the performance going forward. Management is optimistic on the fund’s performance. The company earned 25 cents this quarter if there were no performance fee impact (positive or negative). In the long-run, performance fees should be positive providing upside to the 25cent figure.