Trinity Merger: Broadmark Buyout Presents Attractive Opportunity, But Shareholder Approval In Flux

Trinity Merger Corporation\'s acquisition of the Broadmark family of companies should result in a substantial gain for Trinity shareholders and Broadmark members.

However, the total compensation associated with the deal amounts to an astonishing 12.6% of market capitalization, leaving investors with a interesting conundrum as to whether to vote in favor.

The market is pricing in a very high chance of the deal closing, but a shrewd investor might consider betting against.

Editor's note: Seeking Alpha is proud to welcome Bag Holder as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA PREMIUM. Click here to find out more »

Trinity Merger Corporation (TMCX), a special purpose acquisition company (SPAC), announced a deal to acquire the Broadmark family of companies.

TMCX is currently not priced to reflect the value of the merged entity and represents a very attractive one-way bet. It is also possible that the warrant (TMCXW) is underestimating the likelihood of the deal failing to win shareholder approval, and presents a way to gamble at attractive odds on a binary outcome.

Broadmark consists of an asset management business and four mortgage funds, each focused on a separate geographic area within the US. The asset management business raises capital for the mortgage funds from private investors, and originates and services short-term, first-lien mortgages at 65% loan-to-value (LTV) or less mostly for land development, construction, and rehabilitation. Each fund focuses an a different geographic area within the US, employs no leverage and has reliably returned between 10.5% and 11% to investors for over a decade. The asset management business generates between 5% and 6% of assets under management as net income on top of that. The merged entity combines all of these together with cash from Trinity Merger Corporation, and will trade on the NYSE with the symbol BRMK.

Assuming no investors pull their funds out prior to the deal, the newly merged company will operate as an internally managed mortgage REIT and is expected to have assets of $1,136 million in loans and cash on its balance sheet post-merger including $229 million in cash resulting from the deal itself. Broadmark has convincingly demonstrated its ability to grow and deploy assets under management over the last three years, with a growth rate of 50% in each of the last three years, and management has publicly expressed confidence in its ability to rapidly deploy the new cash. Assuming they are able to do so, Broadmark will generate 2020 earnings of $1.26 and a dividend of $1.20.

In order to facilitate continued growth without resorting to dilutive secondary offerings, the new entity will, in addition to managing its own balance sheet assets, continue to operate and manage a private REIT raising capital from investors on similar terms to those of today.

A detailed analysis and valuation of the merged entity is beyond the scope of this article (I will provide a more comprehensive analysis if the merger is consolidated) but the quick and dirty version, based on comparison with other publicly traded mortgage REITs, is:

And although short-term construction loans are generally viewed as riskier than typical commercial mortgages, there are many reasons to believe Broadmark is a superior business to the average REIT.

Because of these factors I fully expect that Broadmark will eventually trade at a yield of 8% or below, which implies a stock price of at least $14.37.

Trinity shareholders and Broadmark members will effectively be paying $10.45 per share and can reasonably expect a significant gain from the transaction. So surely both sets of shareholders will vote for the deal?

I think the answer to that question is not quite as clear as it might initially seem, and the reason lies in the details of the deal itself and the extraordinary amount of the compensation being siphoned off by the various parties involved.

First let's look at the different parties:

The deal is structured as follows:

Broadmark Members, Trinity Stockholders, Farallon and Broadmark management convert their existing investments into shares of the new merged entity (ticker BRMK) at a reference price that is calculated as the total value of all Trinity's cash and equivalents (as a SPAC, all Trinity's assets are held as cash and equivalents) divided by the total number of shares outstanding at the time of the merger. According to the S4, the reference price is expected to be $10.45. For the purposes of this conversion:

The Trinity Sponsor receives a bonus allocation of 4.8 million shares. Together with the conversion of holdings at the reference price, this results in the following ownership position:

Source: Investor Presentation October 2019

In addition:

Transaction expenses are estimated at $41.6 million (it is not clear to me whether any of these expenses are payable directly to the Trinity sponsor, or whether they are all payable to third parties) with an additional $66.7 million payable to the public warrant holders for a total of $108.3 million.

Special purpose acquisition companies are shell companies that are funded with cash from investors, that acquire a public listing, and that then make a deal with a private company looking to go public.

There is a body of research analyzing the performance of SPACs, and plenty of articles referencing it. The consensus is negative. For example this article, dated March 2016, references research from SPAC Analytics that shows,

In general the poor performance of SPAC investments is attributed either to egregious fees charged by SPAC sponsors or to selection bias (i.e., reflecting the fact that it is usually weaker companies, lacking better options, that resort to this form of “alternative IPO”), or some combination of the two.

The available research itself is largely focused on how the stock of the SPAC itself performs pre- and post-merger, but it is also worth considering the perspective of an investor in the acquisition target - in this case, an investor in one or more of the Broadmark funds.

Let's start by making some fairly simple assumptions to figure out how much Trinity and Farallon are skimming directly off the top in fees and free shares, warrants and options as follows:

Based on these assumptions we can calculate the total fees for the transaction at $184.3 million, comprising $41.6 million in transaction expenses, $50.2 million in sponsor shares awarded to the Trinity sponsor, $66.7 million cash payment to warrant holders, $23.4 million value of the warrants after conversion, $2.4 million value of the Farallon call options. The proposed book value of the merged company is $1.3 billion, including $162.5 million in goodwill for the asset management company, which means the fees amount to an astonishing 14.2% of book value, 16.2% of assets under management, and 12.6% of market capitalization with the stock at reference price. Or looked at from the perspective of Trinity and Farallon, they are investing $435.8 million and immediately receiving 42.4% of that investment back in fees (or 32.8% if the $46.1 million of transaction expenses is all paid to third parties).

None of this necessarily means that this is a bad deal for Broadmark members. As I have already described, the quality of Broadmark's business is such that I fully expect investors to profit handsomely post merger. It is also true that Trinity and Farallon are not just enabling Broadmark to go public; they are providing a significant amount of capital that Broadmark expects to rapidly deploy. I have every expectation the merged company will trade at significantly more than book value and thus this capital is creating additional value to the deal in and of itself.

Nevertheless, it seems pretty clear who the biggest winner is.

All of that brings us to the interesting question of how the Broadmark members will vote.

I am a huge fan of Ben Hunt and his fascinating website Epsilon theory, which examines and interprets the impact of investor psychology on markets through the lens of game theory. Interestingly, two articles have been published on SPACinsider applying game theory to the voting decision faced by Trinity warrant holders in this very deal (Trinity Merger Corp.'s Warrant Amendment Proposal and Trinity Merger Corp. Does a 180 Flip with their Warrants). These articles however were not particularly interesting, not through any fault of the author, but because the decision faced by the warrant holders is relatively simple. The decision facing Broadmark members is more complex and requires considerable thought about the motives and possible motives and actions of the other parties to the deal. First, the basics:

Should our hypothetical Broadmark member hold their nose and vote "yes" despite the fees because of the likely gain? Or should they stoutly refuse to give up such a huge slice of their investment in fees and vote "no", hoping either to retain the status quo (unleveraged first-lien debt funds paying 11% fully secured by real estate at low LTV don't grow on trees), or that management will return to the table with an improved deal?

Before making his decision, perhaps our investor should ask themselves three questions:

1. What would an improved deal look like?

A quick back-of-an-envelope calculation leads to the conclusion that, in this case, Broadmark management are bearing much of the cost of the fees and protecting their members from downside by accepting a low price for the asset management business. They are trading in an asset management business with $33.1 million in TTM net income that has grown AUM at 50% a year for each of the last three years for $162.5 million. As a stand-alone business, the numbers would seem to support a valuation of at least $400 million, and arguably $600 million or more. Even using a $400 million valuation, management's effective contribution of $237.5 million more than offsets the fees. So perhaps an improved deal would just mean that Broadmark management get a better price and members would be no better off.

2. Why is Broadmark management happy with this deal?

Perhaps Broadmark management has been duped into accepting a lowball valuation for their business? Or perhaps they have been fooled by the old Wall Street con of hiding fees in options and warrants (the original merger deal was altered a few weeks ago, and prior to the change the true cost of the warrants was more heavily disguised) and failed to understand the full costs of the deal?

That said, my life experience has taught me that when other people do things that seem hard to understand it is easy to ascribe their actions to foolishness, but it often turns out to be the case that the seeming fools were in possession of information I didn't have or hadn't properly understood, in the light of which their actions were entirely reasonable. In this case Broadmark management know more about the state of, and future prospects for, their business than anyone else. Is their willingness to take this deal perhaps an indicator that the future is less rosy than I believe? And if so, should our hypothetical investor vote "yes" and hope for a quick profit, or vote "no" and reject the fees which will, if the business is less healthy than I believe, perhaps not be more than offset by a stock gain?

3. What will happen in the event members reject this deal?

Will our investor be able to retain their investment? Or will they find themselves redeemed for cash because the Broadmark funds, which are bumping up against limits on the number of members permitted by SEC regulations, elect to continue to grow by ejecting smaller investors in favor of larger ones? Or, alternatively, will they find themselves redeemed for cash because the vote was very close and Broadmark management decided to proceed with the deal by simply redeeming a small number of "no" voters and putting the same deal to another vote?

These questions cannot be answered with any great degree of certainty. And in the face of such uncertainty, I believe that many members will latch on to the only certainty in the deal - that the fees are egregiously high - and vote "no". Perhaps it is not enough to stop the merger going through, but it is far more than you might at first think.

There are two ways to profit from this situation. The first and most obvious way is simply to purchase TMCX at $10.46. The upside is $14 or more and the downside is limited.

However, there is also another option. Based on the behavior of the price of TMCX and TMCXW since the deal was first proposed and when the warrant amendment was changed midway through the process, it is possible to estimate that the warrant is pricing in an approximately 88% chance of the deal completing.

I believe that the deal is indeed more likely to close than not, but perhaps not as much as 88%. One possible way to take advantage of this would be to purchase 1 share of TMCX at $10.46 and sell short 4 TMCXW warrants at $1.54 for a net cost of $4.30.

If the merger fails:

If the merger succeeds, you would be responsible for the warrant amendment payments of $6.40 in total and would own 1 share of BRMK, and be short 1 warrant with an exercise price of $11.50. If you close the position out immediately:

I have used this calculator and assumed 20% volatility to estimate likely warrant prices.

I am/we are long TMCX.

Additional disclosure:

I am an investor in Broadmark's REIT funds and I have also opened a long TMCX, short TMCXW position as a hedge against the possible failure of the merger. Should the merger proceed I would be net long in the merged entity. I have not yet decided which way to vote.