Description

Sachem Capital Pairs Trade

Please note: This trade is only small enough for smaller funds or your PA. If you get comfortable with the long only idea that can be sized up a bit bigger (or shorting equity as the pair versus pref).

I started to research Sachem originally as a long a few weeks ago. Having done some hard money lending in my time I am familiar with their business model, and have referred them business in the past (with good reviews). 

They are quite the incredible story. Jeff and John Villano were two accountants who had clients who wanted to buy fix and flip properties in 2008-2009 and couldn’t access capital. Jeff and John started to lend to them (as they knew their own clients financials quite well!), passed the proverbial hat around  and Sachem Capital was born. They later went public in a tiny IPO (I believe less than $20mm)  led by Gunner & Co in 2017 and have now bootstrapped themselves up to over $500mm in assets. Truly an amazing journey and a great hard work story.

During the 2020 crash I purchased their baby bonds at single digit prices and it worked out wonderfully and it felt like a good time to revisit.

The Good

Sachem started as a “fix and flip lender” focused on Connecticut. It was a strategy I appreciated as charging 2 points + 12% interest to renovate in a relatively stable market with a significantly older housing supply was appealing. The typical loan was small, <200k, and generally less than 12 months of duration with a first lien on a property plus a personal guarantee.  Further the company was (and is!) still lightly levered (particularly when compared to a typical mortgage reit.

While the average loan balance is now meaningfully larger at ~500k; it is still mostly single family homes with the majority of it being in Connecticut.

Lending to SFR in a lower volatility market is a good business plan in my opinion and Connecticut fits the bill as the land of steady habits.

The balance sheet I consider to be in good shape:

The Company has a 70% LTV target; the majority of their debt is in the baby bonds and they have basically zero mark to market risk and only $45mm drawn on the repo facility PLUS ~$70 million still sitting in cash and treasury mutual funds on their balance sheet to be put out with even stricter lending policies factoring in a higher fed funds rate.  One needs to assume pretty draconian assumptions for impairment.

Let's assume all of the cash is put to work and the mortgage receivables grow to $520 million, that all other assets are worth zero and that the repo facility is fully senior as well as the line of credit. These balance sheet adjustments would still leave approximately $470 mm of mortgages to cover $280 million of debt at face.

The average LTV of the original collateral assumption (between asset and personal guarantees) would have to approach 40% in order for the bonds to be impaired at face and at market it would need to be closer to the mid 30% range, this would require horrific underwriting that would defy common sense or a monumental asset collapse.

A significant amount of the debt was raised this year (so the capital is fresh), the company is lightly levered with (in my opinion) the historic business being a safer low risk business versus a typical commercial mortgage REIT and I believe one is being well compensated in the bonds. I like the SCCG baby bonds @ 20.65 (82.6) and a yield of 14%. These are 2027 maturities so they should accrete in a meaningful fashion annually.

If the market stabilizes, the Company performs and the notes trade back to par (where the complex was back in September) it would be a total return of 30.6% over the next year (not too shabby for a debt instrument with the above characteristics).

The Bad

“The Bad” here wasn’t too bad for me when thinking about the business model and if it was just this, I still would have stuck with a long only trade just on a risk reward basis.

The Company does have a decent amount of their book currently in default:

At September 30, 2022 there were 92 loans having an aggregate unpaid principal balance of approximately $45.0 million that were past maturity and either in foreclosure or in the process of being extended. Of the 477 mortgage loans in the Company’s portfolio, 44 were the subject of foreclosure proceedings. The aggregate outstanding principal balance of these loans and the accrued but unpaid interest and borrower charges as of September 30, 2022 was approximately $21.4 million. 

The average size of these loans is around $480k; and while the company specifically states they believe the collateral in each case exceeds the loan balance; it is noteworthy that 10% of the Company’s current loans are in default. Not great but in the game of hard money lending you want some loans to default to get those sweet fees and 18% running interest. As long as your collateral is sufficient, those fees will come to you as a lender.

I also am not in love with their recent move into commercial and construction lending. The Company has a niche and a great business and this foray into these types of more institutional loans is a bit frightening. The only mitigant is (as of right now) they are going to be one of the few lenders around so they should have their pick of loans. 

As a lender I want a more diversified, safer and lower vol loan pool. I will be keeping an eye out on the amount of senior leverage in front of these bonds, but as of right now I think these bonds are still rock solid.

The Ugly

So here is where I started to get queasy. Most of this can be explained from where they started and how fast they have grown but there comes a time where one needs to institutionalize and the red flags are too numerous for me to recommend anything outright.

Related party transactions

Taken from the latest 10-Q 

1. In the ordinary course of business, the Company may originate, fund, manage and service loans to shareholders. The underwriting process on these loans adheres to prevailing Company policy. The terms of such loans, including the interest rate, income, origination fees and other closing costs are the same as those applicable to loans made to unrelated third parties in the portfolio. As of September 30, 2022, and 2021, loans to known shareholders totaled $20,932,994 and $13,200,972 . 

It is possible these may be great loans, and occasionally it wouldn’t bother me but at 4.5% of their mortgage receivable…thats a big number. Further are these to friends or family members of the management team or board? 

      2) The wife of the Company’s chief executive officer was employed by the Company as its director of finance until the third quarter of 2022 when she retired.

(ok well she did retire recently…) but…

In December 2021, the Company hired the daughter of the Company’s chief executive officer to perform certain internal audit and compliance services….

Having your family work with you isn’t the biggest problem I guess, but why does it have to be in finance and audit.

 But at least there is an auditor!

    3) The Firm’s audits are done by  Hoberman & Lesser, CPA’s, LLP. 

This is certainly one of the smaller auditing firms I have come across, which unto itself isn't necessarily a problem (and they are probably doing a fine job). A little research on Sachem will quickly point out that CEO is very focused on keeping costs low and  that can explain some of the reasons for a smaller auditor, however particularly with the above related party items combined with the size of the company today I would think a more name brand firm would be appropriate.

4) The Company recently instituted a share buyback; but continues to smack the ATM at the same time (and in fact there is a 150% debt/equity covenant that they are close to that would even allow then to do buybacks). 

Effective on October 7, 2022, the Company’s Board of Directors adopted a stock repurchase plan pursuant to which the Company may repurchase up to an aggregate of $7.5 million of its outstanding common shares in the open market at prevailing market prices….From October 1, 2022 through November 9, 2022, the Company sold an aggregate of 405,037 common shares under its at-the-market offering facility realizing gross proceeds of approximately $1.6 million.

It is a bad look particularly with your stock yielding 15%+..

All of this would make some sort of shock restatement  not a shock; they have a huge number of loans, and a  small staff. While a restatement is not necessarily likely either, I just can’t look the other way entirely.

However even easier than that, looking at the rest of the capital stack it feels to me like the preferred stock is just mispriced relative to the bonds. 

The prefs are trading @ $18.75 with a current yield of 10.3%; this is just mispriced in my opinion versus the bonds which have a current yield of 9.6%. 

The prefs have a much thinner cushion and are smaller making the short difficult @ only $18mm; however I also think any move up will be met with strong resistance as there is an ATM available to sell up to $75mm of these. This should keep a strong lid on the price of the prefs (particularly with them willing to sell equity @ double digit yields).

The Trade -

I like a pair trade of the SCCG baby bonds @ 20.65 and short the Prefs @ 18.75. I think you can do this 1.5x1.0 but 2.0x1 wouldn’t bother me either. I could also see a larger 2.5x1 against the common equity which is a bit easier to put on (particularly with the ATM in place in the common as well)

Catalyst

Improved performance or the Fed slowing down

A dividend cut