Gramercy Capital (GKK)- this ain't your daddy's net net

One of my favorite new blogs, csinvesting, had this post up for a case study on valuations. Part of the answer key contains notes from famed value investing guru Bruce Greenwald’s class which contains these three quotes (from page 4): 

“The stock goes up from $15 to $50. Management has delivered in spades. Is this a stock that is likely to be overlooked? No.

As an outside value investor, are you like to be the smark one in the trade here? No, you are not. You are the dumb money.

Nothing about this company says value. Nothing says that in buying stock like this, you ought to expect to be smarter than the anonymous person on the other side of the trade.”

All of those quotes got me thinking about the largest position in my portfolio, Gramercy Capital (GKK). The stock’s gone from $35 to under $3. It has an incredibly complex balance sheet that requires enormous amounts of digging to uncover its true value. It’s in an industry so hated that 99% of investors would immediately pass it by rather than look into it. And it’s in an asset class (REIT) that people generally own for income… and not only is the common not paying a dividend, they haven’’t paid dividends in several quarters on their preferreds and thus can’t pay a dividend on the common.

In other words, everything about this company screams “there could be value here!!!!” if you’re just willing to take a look into it.

Let’s start with an overview of the company- Gramercy is an REIT involved in investing in and managing commercial real estate. The company can effectively be divided into three divisions- corporate (the parent company which makes investments but has no operations), finance (a commercial real estate finance arm that basically raises and manages CDOs), and realty (which invests in and manages property).

And at first glance…. boy, is the company a mess. Their most recent 10-Q showed shareholders equity of negative $600 million, or negative $12 per share. With total liabilities of over $5.1B versus total assets of $4.5B, they’ve dug themselves into quite a hole. No, none of those numbers were typos. Last year, the company lost ~$19 per share against a current stock price below $3. Again, not a typo.

So how the heck could there be value in this company? Clearly, it’s going bankrupt, right????

The answer is that all of these losses and liabilities are taking place in their subsidiaries, which are non-recourse to the parent (for those of you who have followed me for a while, this is exactly like ASFI, another net net holding of mine). Gramercy consolidates these losses and shows them on their income statement and balance sheet, but the parent company will never have to pay out for the losses. Currently, these subsidiaries are on the balance sheet with hundreds of millions more in liabilities than assets, thus making shareholders equity negative…. even though Gramercy will never be responsible for those assets.

In other words, you can think of the subsidies like options. If they turn out to be worth more than their liabilities, Gramercy gets to keep all the upside. If they turn out to be worth less, Gramercy only losses what they put into it and not a penny more.

Sound to good to be true? Consider this quote from their most recent 10-q “Due to the non-recourse nature of these VIEs, and other factors discussed below, the Company’s net exposure to loss from investments in these entities is limited to its beneficial interests in these VIEs.”

And also consider this- the company has already struck a deal to literally “turn the keys over” to their massively indebted realty division. Not only did they strike a deal to turn the keys over, but the banks agreed to pay Gramercy to turn the keys over and continue managing the properties. Recently, the company filed an 8-K that shows what their financials would have looked like had they turned over the keys at their last balance sheet (and I do mean recently! They filed it as I finished the article up!). You can see that balance sheet here. The transfer significantly reduces both assets and liabilities while increasing equity by almost $200m and changes last years losses from $19 per share to under $1 per share!

So let’s take another look at Gramercy now that we understand we need to separate their balance sheet into recourse and non-recourse assets. By the way, just for further clarity, this problem isn’t unique to Gramercy. Competitor Newcastle (NCT) has the same structure, only they’re kind enough to provide a breakout of their balance sheet that shows what they look like after separating the non-recourse assets and liabilities instead of making us do the work, read the statements, and piece it together like Gramercy does.

If we do this breakdown after including the realty division turnover, Gramercy would look something like this.

Realty division – Basically nothing. Just the future management fees from the turnover agreement.

Finance division- $2.1B in CDO assets, $2.7B in non-recourse CDO liabilities. We will discuss the value of this later.

Corporate- About $40m in liabilities (accounts payables, wages, etc.) and no debt offset by $160m in cash, $10m or so in other current assets, and $80m in real estate, and some securities. This works out to ~$4.10 in equity value per common share.

However, not all of that value would flow straight through to the common equity. The company has a class of preferred shares outstanding with a liquidation value of $88m, plus accrued dividends of $21m for a total preferred claim of $110m. Backing this out leaves cash and securities at the corporate level of $60 plus the $50-100m net in other investments, or a net asset value of $2-3 per common share. (note- the reason for the range is some of the assets are investments in high ranking debt securities of their CDOs. These are cancelled out in the consolidated balance sheets, but they are certainly assets of the parent company separate from the subs and would be treated as such in any form of liquidation).

In other words, today’s share price basically reflects the value of only the cash in corporate and no value in their ownership of the realty or finance divisions. So is there value in their equity positions?

I certainly believe so. Actually, I’m not alone in believing so- Gramercy is frequently mentioned as a potential buyout candidate.

So where’s the value in subs with almost $1B more in liabilities than assets?

We’ve already discussed the value of the realty division. The contract they struck with their lenders will pay Gramercy $10m per year to manage the properties, plus the potential for a hefty incentive fee.

The real value, however, lies in the finance division. The finance division invests in and manages CDOs. People familiar with Michael Lewis’s book The Big Short will remember a CDO is structured like a waterfall- first payments from their assets goes to pay AAA debt interest, then AA debt interest, etc. Once all classes of bonds have been paid their interest, the equity holder gets to collect the leftover cash flows. As long as the CDO continues to meet all of its cash flow triggers (think of them like covenants in a loan), the equity holder gets to keep collecting the leftover cash. If a trigger is broken, all cash flow goes towards paying down the highest rated security until the trigger is in compliance again, at which point the waterfall resumes. This process continues until the CDO is at the end of its lifetime, when it will begin paying down the principal on all its debt and then distribute any leftovers to the equity.

Gramercy owns all of the equity in the CDOs it manages. So it collects, as manager, a small management fee (runs about $7m per year in total) no matter what, any incentive fees if the structures do well (I believe these are a long shot at this point, but there is certainly a chance to realize some eventually), and any equity dividends from the CDOs.

And the CDOs are generating a whole lot of equity dividends.They currently consolidate 3 CDOs (2005, 2006, and 2007). 2007 is out of compliance with its triggers, so for our sake consider all of its cash flow go to paying down debt and are ignored, though there likely is some value there as well. 2005 is constantly back and forth between compliance and non-compliance, and 2006 is just barely in compliance. So only CDO 2005 and 2006 will pay equity dividends this year. How much will the company receive??? Around $30m in cash flow from 2006 and $20m in cash flow from 2005. Note that this dividend, once received, takes the assets out of the recourse sub and into the non-recourse sub.

That’s right. The common is currently trading for basically the value of the cash and real estate and assigning no value to GKK’s investments in the CDOs, which are yielding $50m, or half the market cap, annually.

So, at this point, you’ve (hopefully) got a decent grasp on the company, why it looks so ugly at first glance, and why I think there’s a ton of hidden value underneath. If not, feel free to read this again before going to the next section. I know it took me quite a few go-throughs before I started grasping all this stuff. Of course, the complication is the reason there’s so much value to be had here. Be sure to check out variantperception’s write ups on the company as another tool to understanding.

So now let’s try to figure out where to find good value investments in the company’s capital structure.

The easiest answer is to play the preferreds. It’s easy to see why they would sell at the wrong price- people generally buy preferreds for the dividends, and they haven’t paid a preferred dividend in almost 2 years. But I believe that’s about to change. As the company finally settles it’s real estate situation, I believe they’ll either 1) sell the company or 2) start paying dividends on the common again, both of which would result in immediate pay down of all accrued dividends on the preferreds.

The preferreds have a par value of $25, accrued dividends of over $6 per share, and trade for $25. In other words, they trade for an almost 25% discount to their liquidation value. Their liquidation is completely covered over by the cash value at the parent company and again by the real estate and other assets. Perhaps best of all, a hedge fund bought 20% of the company’s preferreds, and invoked the company’s charter that said the preferreds could elect a board member if their dividends weren’t paid for 6 or more quarters. The company is cooperating and the board member will be elected in January. This should serve as a hard catalyst for preferred dividend reinstatement and appreciation.

While the preferreds are nice in terms of risk/reward because of their significant asset coverage, the common offers some pretty fantastic upside.

For our first crack at valuation, we could just look at asset values. That’s how one of their activists (Indaba Capital, run by Derek Schrier) did it in this letter to the board demanding a restatement of the preferred dividends. The company has between $2.40-3.00 in net cash and investments at the corporate level. Let’s call it $2.70. That equals today’s share price. They’ll get about $10m per year from the realty management contract and $50m per year from their finance division. Because both of these cash flows are diminishing (the management contract will end when the bank manages to offload the portfolio, and the finance flows will decrease as the CDOs eventually wind down) they probably deserve a low multiple. Give them a 2x multiple and you arrive at a final valuation of $120m…. or $2.20 per share. That’s almost a double when you add it to the cash and securities earlier.

Does that sound crazy to you? It’s how the activist who is getting a board member elected values the company (see appendix 1)…. but it’s likely too conservative.

Why? Because it completely ignores the value of 1) optionality/flexibility and 2) the fact that Gramercy’s platform is self managed.

Let’s start with the self managed portion. All of their competitors in the CDO investment / management REIT space are basically just investment vehicles. They raise the money and hire an outside manager to manage and invest the funds it for them. The outside manager charges a management fee and an incentive fee (very similar to what a hedge fund does). Gramercy, on the other hand, is self managed. This makes them very, very attractive to competitors. Think about it. The manager (who makes all capital raising decisions) cares about growing big in order to increase their management fee, not rewarding shareholders. They can’t really consolidate because most of the competitors are locked into similar asset management contracts. But if a manager acquired Gramercy, they’d grab all of Gramercy’s assets, throw them into the management fee and collect a nice Christmas bonus!

Then think about the platform. Gramercy is managing over $2 billion in CDO money. A good bit of it is still in the reinvestment portion, meaning that any principal that is repaid can immediately be reinvested regardless of how the compliance triggers are performing. And because Gramercy manages its own money, that means they literally get to decide how millions and millions of dollars are invested on a weekly basis. That platform for money investment would be incredibly valuable for, say, a real estate focused private equity fund. It would give them a dedicated source of funds for investing in the debt of all of their real estate deals! This is why Gramercy is attracting so much buyout interest!

Then there’s the optionality and flexibility. Most of these CDO bonds are selling at huge discounts to par because people simply aren’t interested in CDOs any more. CDOs were originally marketed as a super safe way to make more than government bonds paid. Now that we know that isn’t true, the original buyers of CDO paper have fled the market, and there really aren’t any new buyers… except for the CDO managers themselves. Gramercy can (and has) been buying the debt of its CDO. When it does this, it can do two things- 1) keep it as an investment or 2) immediately retire the debt to help the CDO pass its coverage tests and keep the equity flows coming. That’s flexibility.

There’s also the optionality that the CDOs could turn around and be worth much more than they’re on the books for. If that happened, because of the huge leverage in the CDO structure, Gramercy would be worth a multiple of today’s price. Is this likely? Probably not… but by buying debt at huge discounts to face and retiring it immediately, Gramercy can simulate a portion of the effect.

If you’re still with me, I know the post has been long. Hopefully, you’ve found it somewhat insightful. Here’s a brief sum of everything we’ve talked about
1- Gramercy is debt free at the corporate level and has cash and investments equal to today’s price. Any upside from their CDOs is free.
2- Gramercy has significant upside in both the preferreds and common. The common is likely to be bought out. If not, an activist is pushing for dividend reinstatement, which would yield a big dividend for the preferreds and likely result in an immediate and much higher valuation for Gramercy.
3- There are several catalysts on the horizon. In addition to the buy-out and activist, Gramercy is an REIT. They will have to start making dividend payments eventually, which will show everyone how strong their cash flows are coming in.

Disclosure- Long GKK, GKK’s preferreds, NCT preferreds, and ASFI