I believe SWKH is a highly attractive opportunity for PA’s, and for small funds willing to invest in less liquid equities.  It has been written up twice on VIC (late 2010 at 93c and late 2011 at 85c) as a shell company with cash and NOL’s trading at a slight discount to cash, but the idea has not been adequately updated since they adopted their current strategy and hired current management to execute it.  I believe that some shareholders have been disappointed that a corporate acquisition was not made, and the stock has languished as a result.  The stock currently trades below book value of almost 87c a share, however SWKH is poised to earn an attractive RoE that could surpass 20% within a couple of years. 

SWKH was recently a shell company with approximately $37m in cash (burning very slowly) and approximately $450m in NOL’s.  Former management was tasked with finding a stable business for purchase capable of producing significant taxable income (to create value from their significant NOL position).  The former management team focused on the business services sector, hoping to find a distressed seller (e.g. a family business with internal conflict), however they were unable to locate a target at the right price.  Carlson Capital owns 28% of the stock, and they seem to have steered the process back toward the Dallas hedge fund community, ultimately bringing in the management team of a small healthcare royalty finance hedge fund to deploy the cash into pharma royalty finance deals through a corporate structure, rather than a fund structure, utilizing the NOL’s to offset corporate taxes and allowing shareholders to pay LT gains on a strategy that produces significant interest income, as well as enjoy the benefits of both leverage and advisory fees earned on external capital which co-invests in each deal.  The managers seem to have seen an opportunity for a permanent capital base with the ability to leverage Carlson’s marketing efforts and other fundraising relationships to layer on outside capital, and they wound down their small fund and rolled a few small legacy deals into SWKH. 

Management is receptive to discussing their strategy with informed shareholders.  Brett Pope, CEO, and Winston Black (his younger partner, now Managing Director), are the investment team at this point.  There is also a CFO.  They work out of small office in Dallas and keep costs low.  They are compensated as follows:

-          Each receives a $200k base salary

-          They share approximately 11-12% of pre-tax profits as a bonus pool

-          They each received 750,000 ten-year options, struck at 83c… BUT these only vest according to the attainment for 60 days of the following average share prices within five years (beginning May 2012):

% vested             Share Price         Deadline

25%                        $1.24                     May 2017

25%                        $1.66                     May 2017

25%                        $2.07                     May 2017

25%                        $2.49                     May 2017

The bonus pool both incentivizes management to maintain a lean cost structure and also incentivizes them to raise external capital.  The key is that all external capital must pay fees to an RIA owned by SWKH… management cannot bypass SWKH (and its shareholders), as per the employment agreements they have each signed.  The agreements include two-year non-competes, with limited exceptions… so the opportunity for SWKH shareholders is not unlike participating in an attractively structured seed deal.  I do not see the total bonus pool exceeding $1m for at least several years, and it is to be shared, so the stock options (which at a $2.49 stock price would be worth over $1.2m to each manager) are a significant component of compensation.  Finally, they seem to want more exposure to the stock – Pope just acquired $130k in the open market, and Black and a director each made smaller purchases (all around 79-80c, so a few cents lower than where we are now quoted). 

The result of the new structure is a more predictable future than would have been the case had former management purchased an operating company.  We have a niche specialty finance company capable of generating highly attractive returns, with excellent shareholder alignment, trading below book value.  If they are able to continue to produce the returns their strategy has produced in the past, and they can lever these returns to some extent both with modest financial leverage and also by charging advisory fees to outside investors who co-invest in their deals, an RoE in the high teens (or better) is likely.  It is important to note that their returns are not tied to any market, but rather to the discrete performance of the different pharma royalty streams supporting each investment they make, as well as the supply/demand dynamics of the type of capital they provide to smaller pharma companies who need/want capital and can’t borrow on traditional terms, but don’t want to settle for the dilution of more equity.  I would think they could garner at least a 1.5x BV multiple, and that this along with growth in book value over the next couple of years could result in over a double for the stock by the end of 2015.  There is significantly more upside potential if the RoE exceeds my base expectations and the market prices in the sustainability of these returns.  Downside, on the other hand, seems quite limited.  Management is incentivized to maximize the share price, and so I would think they would buy back stock aggressively should it trade materially below book value.  It is worth noting that there is no buyback currently authorized, and management would need to consider both protecting the NOLs from Sec 382 limitations triggered by pulling sub-5% holders above the 5% limit, as well as the merits of having excess capital when markets are distressed… so I doubt we see share buybacks unless the discount become irresistible, but at least the incentives are in place such that at some level buybacks are attractive to all parties (unlike a BDC, where management will almost never be compelled to repurchase shares no matter how large the discount or how strong the rationale to do so). 

Since coming onboard in the fall, Pope (CEO) and Black (Pope's partner at their former fund) have put to work half of the $37m in three deals.  These deals have all involved co-invested capital, on which they (we) earn advisory fees.  Once the $37m is all put to work (potentially as soon as year-end 2013), they will likely seek to employ modest leverage (up to 1:1, max) and make more investments.  So, expect a concentrated portfolio of 6-12 investments, each with $5-8m of SWKH capital deployed, in addition to external co-invested capital.  These deals have typically targeted (successfully) mid-high teens gross returns, consisting mostly of quarterly cash payments, with additional, smaller upside participation if royalties exceed forecasts.  They are structured in many different ways, but I would refer interested readers to the recent 10-Q and 8-K to read about the three first deals, which conveniently represent the more typical different structures they are most likely to pursue. 

Generally, SWKH likes to invest in years 3-8 or thereabouts of the lifecycle of a royalty stream.  Therefore, the product has become commercially established, and SWKH can predict with greater ease the future royalty income.  Note that becoming established does not necessarily preclude the borrower from needing more cash to fund R&D on other drugs, corporate overhead, etc.  This is essentially acceleration capital for the borrower, and while it isn’t cheap, it avoids dilution to the equity owners. 

Here are summaries of the three deals they have done so far:

Their first deal, struck in December 2012, involves a 5-year term loan to a neurology-focused specialty pharma company at a 16% rate (minimum). There is an additional kicker on top of this in the form of an exit fee, which could add a couple percent to the IRR.  SWKH invested $6.5m, while farming out an additional $16m to external clients who will pay management and incentive fees to SWKH (free leverage).  Terms with external investors are typically around a 0.75% management fee and a 5% incentive fee, so I assume 1.5% all-in annually (based on a 15% gross return). 

The second deal, also reached in December, was the $13m acquisition of US marketing authorization rights for InnoPran XL, a hypertension beta blocker.  SWKH receives 87% of cash flow until a 1.0x return is reached, at which point the % swept to SWKH declines until it reaches 45%.  I do not know how to handicap the IRR on this deal, except to understand that SWKH does not seem to sign up for situations where the base case doesn’t get them to a 15% IRR or better.  SWKH kept $6mand farmed out $7m to co-investors, again receiving advisory fees. 

The third deal, just reached in early April, was the $15m acquisition of a royalty stream for Besivance, an ophthalmic antibiotic, from InSite Vision.  The drug is marketed globally by Bausch & Lomb.  SWKH kept $6m and farmed the rest out to Bess Royalty, LP, which I understand is an anonymous partner with deep pockets who looks for similar opportunities as SWKH (which seems like a nice strategic relationship).  In return for sourcing the deal, SWKH gets slightly advantaged economics vs. Bess Royalty.  InSite has earned royalties of $1.2m in 2011 and $2.1m in 2012, and we believe it continues to grow.  InSite will recover 25% of royalties above $4.2m annually, once investors realize a 1.0x return.  After realizing a 2.75x return, all royalties revert to InSite.  Playing with the numbers, it seems SWKH will earn anywhere from a mid-teens to a low-20s IRR over the life of this deal.  While they don’t earn advisory fees on the deal, as their external partner is an active investor as well, the advantaged economics should result in a similar net result to SWKH.  (For example, SWKH gets slightly more than the 40% economics implied by their $6m investment, driven primarily by a $1m milestone payment which will need to be paid 100% by Bess Royalty). 

So in total, SWKH has committed $18.5m, or roughly 50% of their cash.  They have also attracted co-investments (of various types) totaling $32m, representing over a 1.7:1.0 ratio of external capital to internal capital.  I believe 2:1 is easily attainable, and that management will pursue a higher ratio of external capital over time. 

Modeling the potential earnings stream over the next few years requires some assumptions, but is relatively simple.  I assume a base case where they earn a top line equal to approximately 15% of capital deployed, causing a revenue ramp over the next 18 months as they complete investment of the first $37m and then potentially invest borrowed funds (as well as incremental cash flow).  I assume they pay 7.5% for any borrowed funds, based on conversations with potential lenders.  I assume operating expenses of only $1.5m-$1.6m, consisting of $400k in base salaries to Pope/Black, as well as other corporate costs (rent, CFO, advisory fees, public company fees).  They expensed $390k in Q1.  There could be slippage here over time, but I don’t expect there will be much given the incentives to maximize pre-tax income and management’s pledge to keep costs low. Then we must deduct the bonus pool, which is 10.5% multiplied by one plus 50% of the RoE attained, so call it 10.5% * [1 + (50% * 18%)] if they are very successful, or ~11.5%.  Importantly, it is safe to assume they pay virtually no taxes. 

My earnings model results in the following:

Once the full $37m is deployed, they should earn a 9-10% RoE and 8c EPS before collecting fees on co-invested capital. 

After adding $35m in leverage and fully deploying this incremental capital, they should earn a 15-16% RoE and 13-14c EPS. 

If we also assume 2:1 co-invested capital to internal capital, RoE increases to 21% and EPS is almost 18c. 

Raising more external capital, allowing for a 3:1 or 4:1 ratio, results in a 23-26% RoE and 20-22c EPS. 

I have little conviction in timing, as it depends on the pace at which they ramp, but some stabs in the dark result in the following possible forecast:

               BV/Shr    RoE      EPS
2012       $0.87                    
2013       $0.92         6%        5c
2014       $1.06       15%      14c
2015       $1.25       18%      19c
2016       $1.47       18%      22c
2017       $1.74       18%      26c

In this scenario, I believe management’s options might all vest, earning us a triple over the next four years, although the 18% RoE assumption is admittedly unproven and deserves to be discounted at this early stage. 

Comparison to a Fund Investment

I believe an investment in SWKH is superior to a similar hedge fund investment for several reasons. 

-          In a hedge fund structure, you buy and sell at NAV.  With SWKH, we can buy at or below NAV, and potentially sell at a significant premium. 

-          A fund structure does not benefit from advisory fees on co-invested capital. 

-          Taxes in a fund structure likely result in ST capital gains rates for tax-paying LP’s, whereas an investment in SWKH allows the investor to pay only LT capital gains taxes on share appreciation. 

Risks

The primary concerns which could prevent SWKH from trading at a premium to book value would normally be that management could issue more shares in order to grow the business and increase compensation.  I don’t see this happening:

-          Carlson is in charge here ultimately, and they want a good return on their capital. 

-          Management is incentivized directly to grow the share price, and they can grow external capital if they want to increase their take-home pay.

-          Long term, I expect they will look to issue shares, but only if they can attain a specialty finance multiple (significant premium to book value).

Competition is the largest risk in my mind.  There should be enough diversification in the portfolio such that a poor deal or two can be absorbed with acceptable impact, especially if several deals come in ahead of plan.  However, if there is a flood of capital into this asset class, given the attractive yield profile, IRR’s could become compressed and cause SWKH to settle for lower shareholder returns.  There are certainly competitors, however it seems there are more than enough deals to go around at this point.  Larger funds will be too big to compete for $10m to $30m deals, and smaller funds are less common.  I have spoken to competitors, and it seems most are targeting larger deals.  All seem to agree that there are more than enough deals to go around.  The fact that SWKH has not used a broker to source any of its first three deals (all three were sourced independently) supports the notion that their market is still fairly inefficient, and returns will not easily be competed away.