Description

Trinity Merger Corp - TMCX ($10.47) Writeup 10-22-2019

Trinity Merger Corp (ticker TMCX) is currently a SPAC that is approximately 3 weeks away from closings its proposed transaction (the “combination” or de-SPAC) with Broadmark Realty, which will be an internally managed mortgage REIT.  Casper719’s write up on the warrants (ticker TMCXW) and the short message thread there (modifying the warrant valuation to account for the high dividend) provides some good background information on the situation. Casper’s trade with the warrants was a very good one – his warrants have traded up 16.9% while the stock has only traded up 0.3% in that time.  The focus of my write up, however, is on the stock itself. From here, I think the stock is much more attractive than the warrants and essentially an entirely different investment proposition (as I will elaborate on near the end of my write up). The stock today also boasts much more trading liquidity than the warrants. 

I believe that TMCX is an attractive long currently and will elaborate on why.  However, I want to state up front that I am a fundamental investor – not a SPAC expert or a SPAC arb.  As such, I worry about being the “patsy” at the table. I’ve tried to dig around to figure out what I may be missing and how I may end up being a casualty in this situation, but am interested to learn more from others more experienced in the Wild West of SPACs!  I also own much less than a full position in TMCX today, to give myself ample capacity to size it up if it trades poorly after closing as most SPACs generally do. On the other hand, I think the current price is attractive on a fundamental basis and can think of many reasons for why this one could potentially be an anomaly might trade well after closing, so I’m happy owning some now.

Here are some links to several of the key source documents. 

Final proxy/prospectus:

https://www.sec.gov/Archives/edgar/data/1731536/000114036119018701/nt10005352x1_defm14a.htm

Slides for netroadshow:

https://www.sec.gov/Archives/edgar/data/1731536/000114036119017510/nc10004023x25_ex99-1.htm

Transcript of netroadshow prepared remarks:

https://www.sec.gov/Archives/edgar/data/1730608/000114036119018160/nt10003828x8_425.htm

Announcement of special meeting dates, etc:

https://www.sec.gov/Archives/edgar/data/1731536/000114036119018731/nc10004023x42_425.htm

Brief article with CEO that includes explanation of warrant mechanics, etc:

https://www.sec.gov/Archives/edgar/data/1607840/000114036119017922/nc10004023x32_425.htm

Broadmark has filled a niche in lending to CRE developers (primarily smaller developers building SF and MF residential).  The borrower base was historically served by local banks that have reduced their lending in the space significantly post GFC.  Broadmark makes short-term 1st lien loans – all with personal guarantees, third party appraisals, maximum LTV of 65%.  Average loan size is ~$4 mm and average duration is ~10 months. Interest rates are 10-13% with a 3-5% origination fee, driving an annualized yield ~16.5%.  With such a fat asset yield, Broadmark’s can generate a strong ROE without having to lever up its balance sheet -- unlike basically all other mREITs. Instead, it is unlevered, with cash on the balance sheet and no debt. 

At first glance, such a high rate implies a low-quality borrower base and significant credit risk.  Trying to put myself in the typical borrower’s shoes, I think the rate is secondary to the speed and flexibility that Broadmark provides as more of a “hard money” lender rather than a bank.  In a world of dramatically stretched subcontractors and trades, receiving construction draws in 24-48 hours instead of a week or longer seems like a real differentiator. Likewise in terms of receiving the fully underwritten loan in 1-2 weeks instead of 2-3 months.  Credit losses since inception of $0.4 mm are misleadingly low for several reasons in my opinion (portfolio growth and lack of seasoning, excludes loans currently in default or REO but net yet fully liquidated or resolved, legacy portfolio began in Washington state, which has been one of the hottest markets in the country since inception in 2010).  That said, the short loan duration, prevalence in non-judiciary states for ease and speed of foreclosure when needed, 65% LTV, 1st lien position, personal guarantees, etc. do reasonably suggest to me that normalized credit losses should be quite low so long as the borrowers themselves and their projects are economically feasible and needed (which seems like a reasonable assumption today as the country continues to significantly under build to normalized demand on top of tremendous cumulative under building over the past 10 years).

Broadmark has historically funded itself via private funds, in which nearly 2,000 underlying high net worth investors invested in equity with a 6% preferred return.  Those fund investors would receive 20% of the origination fees on the loans (management received 80% of origination fees) along with 80% of the interest income or cash flow in excess of the 6% preferred return (management received the other 20% as its incentive or carry).  In total, fund investors generally received total monthly dividends of ~11% annualized. Such fund investors were happy to pay up for the privilege of an illiquidity “premium” (seen more and more this cycle in which private equity investors need not mark to market their investments, and the “apparent” lack of volatility implies they are much safer than public market comparables that “suffer” from the curse of having liquidity).  The private funds also paid a 1% placement fee up front to Broadmark and another annual 0.5% placement fee for future years that such investors remained invested in the funds. 

As part of the combination transaction, the Broadmark management company, general partner, and affiliated broker-dealer that historically received the above fees from the private funds will all be internalized.  The legacy private fund investors will roll into TMCX stock (actually the ticker will switch to BRMK at closing). Legacy private fund investors were given two opportunities to take cash instead of stock – roughly 90%, or $907mm, elected to roll into TMCX stock and 10% took the cash.  That $907mm will now become permanent “on balance sheet” common equity. And instead of losing ~6% of the ~16.5% asset yield to external fees, the newly internalized management fee structure will dramatically reduce that fee burden to more like ~2%. 

Moreover, after closing, Broadmark will restart a new private fund capital raising platform (with the investments into the actual loans being done on a pro rata basis between the on balance sheet public vehicle TMCX and the new crop of private funds).  But this time, all of those fees paid by the new crop of private funds will be paid to the public vehicle, namely TMCX’s taxable REIT subsidiary – instead of being paid directly to management or any external private affiliate.

From the perspective of a legacy private fund investor, I believe that the public equity in TMCX that the $907mm is rolling into will be a significantly superior security for several reasons.  As mentioned, its fee burden will be slashed by roughly 2/3. It will now provide daily liquidity. It will now own a more diversified loan portfolio (combination of 4 legacy fund assets instead of being invested in a single fund).  It will now have the ability to share in the management company and GP fee upside (and potential dividend growth at TMCX going forward) from the new crop of private funds. While it will not have the “benefit” of a 6% preferred return, the all-in dividend yield should be slightly higher anyway (TMCX is targeting a $1.15-1.20 / share annualized dividend paid monthly, translating to 11.0 -11.5% yield today).  And it’s not obvious to me that the preference was worth much in reality since there was essentially no common equity beneath that legacy preferred in the fund structure (just GP carry). Meanwhile, there is also the potential for TMCX to appreciate in value and ultimately trade to a yield tighter than 11%, thus providing capital appreciation for those legacy fund investors are rolling into TMCX.

To summarize the basic fundamental pitch, TMCX will soon become a $1.4 billion market cap, internally managed, unlevered mREIT, with an 11% dividend yield at today’s share price.  But besides being internally managed (in contrast to most of the mREITs other than LADR), it will also have the benefit of a growing, asset-light management company and GP in the taxable REIT subsidiary to benefit from the new crop of private funds.  In an upside case, TMCX trades up to a tighter dividend yield (or other valuation metrics) more in line with its comps set, the $907mm of legacy private fund investors that rolled into TMCX slowly trade out of their TMCX shares and recycle that capital back into the next crop of private funds.  In that way, Broadmark’s total pool of capital could grow significantly over time by expanding well beyond the legacy private fund investors without losing the legacy private fund investors. In this upside scenario, we’d be looking at over a 40% return over a 12 month period or ~25% CAGR over a 24 month period with dividends included.

Perhaps future index inclusion is also in the cards as a $1.4 billion REIT with a hefty dividend yield?  

Here is a snapshot from the roadshow presentation comparing valuation metrics to the peer group.

The transaction is scheduled to close shortly after the relevant votes which are set for November 12.  Here is a breakdown of the transaction sources and uses.

As you can see, in addition to the SPAC shareholders, the SPAC sponsor (Trinity), the Broadmark insiders, the Broadmark private fund investors, Farallon is funding the PIPE.  Farallon is investing $75 million at roughly today’s share price for 7.2 mm shares – technically at the SPAC trust cash redemption value of $10.45 / share (which happens to be close to today’s share price of $10.47).  Farallon will not be able to sell those shares until after they’ve been registered. Farallon will also have the option to purchase another $25 mm at that same price – that option expires 12 months after close. Finally, the SPAC sponsor (Trinity) forfeited / transferred 7.2 mm of its warrants to Farallon.  So Farallon is obviously getting a better deal than someone buying TMCX stock today. However, the terms of the Farallon PIPE were NOT egregiously attractive to them or disadvantageous to SPAC shareholders as I see it. They were not buying in at massive discount to the main deal price. Essentially, Farallon was paying a tiny premium to the market price of TMCX at the time for its shares, but was being subsidized slightly (by the SPAC) with the option to buy another 2.4 mm shares at $10.45 / share and being “greased” by the SPAC sponsor (Trinity) who was handing over 7.2 mm of its warrants to Farallon.  My understanding is that Farallon’s credit and real estate teams diligenced every loan on Broadmark’s books. Besides the requirement that at least $800 mm of the legacy private fund investors would have to roll into TMCX rather than get cashed out (note that such private fund investors were given two opportunities to cash out), I believe Farallon also insisted that a condition precedent to closing would require a majority of SPAC shareholders to also roll into the deal (as opposed to redeem for cash in the trust of $10.45 / share). I believe the combination of these conditions was designed to ensure that the company would continue to have excess cash on the balance sheet and no debt post close.  I believe it was also designed to try to ensure that the majority of SPAC shareholders actually want to fundamentally own the shares post close.

In concert with the transaction, there is also a warrant amendment that is required for the transaction to close.  The warrant amendment does two main things – it reduces the number of underlying shares that a warrant can convert into at $11.50 per share from 1.00 share per warrant to 0.25 share per warrant, and it removes the strike price adjustment when dividends are paid so that the strike price will remain at $11.50 / share instead of ratcheting downward as dividends are paid.  In order to incentivize warrant holders to amend, TMCX initially proposed offering warrant holders $0.30 / warrant in cash in concert with the deal closing. Subsequently, that “amdendment fee” was increased to $1.60 / warrant in cash in concert with the deal closing. (Ultimately, that subsequent bump ended up giving Farallon an unexpected windfall of sorts on their 7.2 mm warrants.  But I believe that was unexpected and that Farallon underwrote their PIPE transaction without any anticipation of receiving that incremental windfall).

Here is a summary of the proposed warrant amendment transaction and a summary of the different warrants and their conversion terms.

As you can see above, the Trinity sponsor warrants will NOT receive the $1.60 per warrant amendment fee.  And while it may seem that the Trinity sponsor warrants are getting an unfair deal in that the 5.2mm warrants that they kept (as distinct from the 7.2mm warrants that they handed over to Farallon) will continue to be able to convert into 1.00 shares of TMCX instead of being altered to convert into only 0.25 shares, I think that is misleading.  The reason is that Trinity is also forfeiting 3.8 mm of its Class B Founder shares (not forfeited to Farallon, but just extinguished altogether). 

At this point, if the combination / de-SPAC transaction does not close as expected in several weeks, I believe shareholders will simply be automatically redeemed with the cash in trust and receive $10.45 / share because the deadline for the SPAC to consummate a transaction is November 17.  At this point, the window for private fund LPs to take cash instead of roll into TMCX has already passed. So the main contingencies now for the deal to close as expected are for the warrant amendment to pass and for less than $125 mm of SPAC shareholders to choose to redeem. So this implies that a minimum of 65% of SPAC shareholders must roll into the deal (i.e. NOT redeem) or else the deal doesn’t close.

Here is what the ownership profile looks like assuming the deal closes and no SPAC shareholders choose to redeem.

And here is what it looks like assuming the deal closes but the maximum $125 mm of SPAC shareholders do redeem.

Risks

The most basic (but also minor) risk is that the deal does not close because the requisite conditions are not met (i.e. more than 35% of SPAC shareholders decide to redeem) and we receive $10.45 per share back in cash from the trust for a negligible loss.

From a fundamental perspective over time, I think the biggest risk is that Broadmark’s borrowers turn out to be the marginal group of developers and projects in the next downturn that are uneconomic – so credit costs on legacy loans and a dearth of quality new loans to originate impair the mREIT’s earnings power.  I think this risk is mitigated but not eliminated by the underwriting traits discussed earlier, including 65% max LTV, short loan term, etc.

Instead, the risk I am most concerned about is more technical (and likely short term) in nature – namely that TMCX is no different than most de-SPAC transactions.  In that case, the deal closes, but the stock immediately gets puked by SPAC arbs, fast money traders, etc. Even worse, many of the private fund investors that rolled into TMCX open up their monthly statements to find that their formerly “stable” investment that was supposed to appreciate in value now after rolling into the public vehicle shares is instead underwater and subject to daily volatility.  Not only do they want out (and represent a massive overhang given they are roughly 2/3 of the pro forma shares), but having been “burned” by Broadmark on this deal, they do not recycle that capital into the new crop of private funds either.

I think that this technical risk is mitigated for a number of reasons and I believe that this transaction is superior to the typical SPAC transaction for many reasons.  First, with the stock trading slightly above trust value, it would seem that any current SPAC shareholder that wants to redeem would be better off just selling into the market now at a slight premium to the redemption value – rather than redeeming for trust value in a few weeks.  And many millions of shares in the last week or two have traded above trust value. My assumption is that most of those sellers have been more traditional SPAC arbs and that most of those buyers have been more fundamental investors (of course, there is probably some contingent of fast money buyers and sellers too).  Second, I believe the operating business is actually an attractive one. Third, this will be a $1.4 billion market cap company post close – much larger and more relevant and actionable than typically is the case. (Even pre-close, this is a larger SPAC than the vast majority are). Fourth, the fact that TMCX secured a PIPE on reasonable terms from a highly respected fundamental investor in Farallon would seem to further reduce the odds that all SPAC shareholders just want to redeem for cash value of the trust.  Fifth, the fact that the deal cannot close unless fewer than 35% of SPAC shareholders redeem for cash would seem to imply the majority of SPAC shareholders actually want to own Broadmark on a fundamental basis. Sixth, the company will have excess cash and no debt – unlike many SPACs that end up with significant debt at closing (and with more than hoped or expected if too many SPAC shareholders redeem). Seventh, the fact that this should have a hefty monthly dividend yield right out of the gates would seem like that ought to provide more of a potential technical floor – in contrast to a typical de-SPAC of an operating company that couldn’t get public the regular way and that has no dividend. 

So why not buy the warrants if I like the stock?  Besides the fact that the stock has ample trading liquidity now while the warrants are far more limited, I think about different potential outcomes simplistically.  To recreate today the same underlying exposure to the stock as 1 share, I would need to buy 4 warrants. With the warrants at $1.485, that means I pay $5.94 for the warrants.  It seems incredibly unlikely at this point that the deal fails to close, but if that happens, the warrants should expire worthless and I lose all $5.94. Whereas if I buy 1 share of stock today at $10.47 and the deal fails to close, I get back $10.45 and lose only $0.02.  Again, the probability of the deal not closing seems incredibly low, but I prefer to risk $0.02 instead of $5.94 per share in that scenario. In the far more likely scenario that the deal does close, I’d get back $1.60 per warrant or $6.40 in total for the $5.94 I paid for the warrants.  So I would have made $0.46 and then retain the right to buy 1 share at $11.50. I like the idea of making $0.46 in all likelihood, but I still don’t like the idea of risking $5.94 to do so. Moreover, on a fundamental basis I like the idea of owning the upside on the stock at $10.47 and beyond rather than at $11.50 and beyond (or at $11.04 and beyond adjusted for the $0.46 of initial profit on the warrants).  And I like the idea of receiving the monthly dividends as a shareholder, rather than losing them entirely as a warrant holder. Said another way, while the warrants have some leveraged upside in a true blue sky scenario of significant capital appreciation in the stock, the are really far more out of the money than they appear because they give up all the monthly dividends along the way.

In summary, I think TMCX is an attractive long on a fundamental basis.  I have confidence that in the long term, if my fundamental work is right, then the stock will ultimately move accordingly (to paraphrase Joel Greenblatt).  My bigger concern at present is the shorter term technical situation – namely, is it foolish to own stock now in advance of the deal closing since most de-SPAC situations trade off hard initially and I’m likely to get a much better entry point with plenty of trading liquidity shortly after the deal closes?  Or am I right to think this one may well prove the exception to the rule, meaning now is the opportunity to build a real position before the seemingly finite supply of shares initially held by SPAC arbs is finally traded through and then it is too late? Trying to balance those shorter term considerations with my fundamental view, my thought is to begin to scale in now, yet leave additional buying capacity in reserve for after the deal close.  But considering I am NOT a SPAC expert, I am particularly interested to hear from those who are as to what other “dirty tricks” are lurking that I have not considered.

Catalysts

Deal closes.  Supply of shares from non-fundamental sellers gets exhausted.

Monthly dividend initiated.

New crop of private funds re-open the spigots in capital raising, with the attendant significant fee growth inuring to the benefit of TMCX shareholders.

REIT or dividend or low volatility index inclusion.

Catalyst

Deal closes.  Supply of shares from non-fundamental sellers gets exhausted.

Monthly dividend initiated.

New crop of private funds re-open the spigots in capital raising, with the attendant significant fee growth inuring to the benefit of TMCX shareholders.

REIT or dividend or low volatility index inclusion.