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Financial engineering proposals involving control of operating assets


Source: The Deal, October 27, 2014 article

Ronald Orol Senior Editor,

Financial Regulation

Activist investors search for 'magical' properties

by Ronald Orol in Washington  |  Published October 27, 2014 at 3:18 PM



When Jeff Smith's activist hedge fund Starboard Value LP got all of its dozen nominees voted to the board of Darden Restaurants Inc. (DRI) earlier this month, it raised the expectations that the restaurant chain would spin off its real estate holdings in a publicly traded REIT.

If that were to happen, and Smith had been advocating for it when he first set his sights on Darden, it would be the first time a restaurant REIT was spun off in response to an activist's efforts.

REIT spinoffs are one of the arrows in many activists' financial engineering quiver; sale-leasebacks are another. The theory is that it's better to rake in dividends, as well as to get additional tax benefits, than to simply hold real estate -- which isn't what the business actually does.

"In the last few years efforts to [separate real estate] have become in vogue for activists to pursue as a way of getting quick cash and buy back stock at a premium," said Stephen Lechner, a research analyst at Proxy Mosaic, a corporate governance research firm.

Or, as one activist adviser described the financial engineering involved, it can be nothing short of "magical."

According to data compiled by Factset Sharkrepellent, there were eight activist campaigns in 2014 where insurgent pressure tactics included some effort to separate real estate or create a REIT structure. That was on par with the eight that took place in 2013 and up significantly from one such effort in each of 2012 and 2011 and 2010.

But coming up with the charts and graphics to persuade institutional investors that a REIT is good for the company and winning them over are two entirely different things. Some analysts and advisers view it as giving a boost to short-term returns for the activist without doing much for the company in the longer term, while others contend that it simply strips vital assets that are critical in the long-term as a buffer against hard economic times.

Consider, for example, the infamous REIT campaign at Target Corp. (TGT), launched by Bill Ackman's Pershing Square Capital Management LP in 2009. Investors sided with management and sent the activist packing, after Ackman had raised a targeted $2 billion fund for that effort.

THERE HAVE BEEN a couple of successful REIT conversions where an activist was involved. Under pressure from Elliott Management Corp. in 2011, document storage company Iron Mountain Inc. (IRM) took steps in 2012 to convince the Internal Revenue Service to let it convert into a REIT. The key to its winning argument, according to Morningstar analyst Barbara Noverini, was convincing the IRS that its real estate business -- charging rent to put boxes on warehouse shelves -- was larger than the company's shredding, record destruction and organization operating business.

"The benefit is that they are in a more tax-efficient structure that doesn't have to pay corporate level taxes and they can increase their dividend payout to shareholders," she said.

The other big activist win in the REIT arena was when Corvex Management LP and Marcato Capital Management succeeded in 2012 to getting prison management company Corrections Corp. of America (CXW) to convert to the structure.

Marcato founder Richard McGuire recently took a stake in Life Time Fitness Inc. (LTM) and urged the U.S. and Canadian fitness center chain to do a REIT spinoff. In August, the company hired advisers to consider just such a move. "Many investors and analysts do not fully appreciate the transformational nature of the company's announcement," McGuire said. He noted that, based on his analysis, Life Time's shares -- currently trading at a 60-day-moving average of $47.97 a share -- could reach $70 per share once it separates its real estate.

Gregg Feinstein, managing director at investment bank Houlihan Lokey Inc., said that spinning off real estate assets into a yield vehicle makes sense because, in today's market, the value that is lost for the operating company through added rent expense is significantly less than the value of the shares of the REIT, which not only trade at higher multiples but also have some tax advantages. In addition to tax advantages, REITs trade at high valuations because they are required to distribute almost all earnings to shareholders as dividends.

Feinstein envisioned a situation where an operating business must pay $100 million in rental expenses annually and trades at a multiple of 8 times Ebitda. In that scenario, Feinstein suggests, a company that spins off its real estate into a REIT will have roughly $800 million less in value. However, the REIT would likely generate $1.5 billion to $2 billion in market capitalization as well as absorb debt. "The company might lose $800 million of value but add up to $2 billion in REIT shares," he said.

Using a similar calculation, Starboard estimated that a REIT spinoff of Darden's remaining real estate could generate $1 billion to $2 billion of shareholder value.

James Mitarotonda, CEO of Barington Capital, said that a tax-free REIT spin off at Darden would result in a substantial $2.5 billion restaurant REIT. He also said that the restaurant REIT would become attractive for a larger real estate acquirer such as American Realty Capital Properties Inc. (ARCP). "I fully expect Darden to effectuate a REIT spinoff as part of its plan to create three separate businesses," he said.

Daniel Lewis' activist fund Orange Capital LLC, which is involved with casino operator Pinnacle Entertainment Inc. (PNK), said he expects the company to decide in a few weeks whether it would spin off its real estate assets into a separate REIT. He noted that a top Pinnacle official suggested last month that the company would decide in 45 days whether it was going to make the move.

Lewis noted that Penn National Gaming Inc. (PENN) offers a good comparison. The rival casino and racetrack operator last year decided on its own to spin off its real estate into a REIT. "We think it can trade well," he said. "A casino REIT can grow and acquire more properties in the casino or leisure space. We think it would be a major positive from a shareholder perspective."

Of course, there are other options. An alternative financial engineering approach to separating an operating business' real estate, the sale-leaseback arrangement is also being encouraged, and sometimes, discouraged by activists.

THAT'S WHAT HAPPENED at Darden when the company was trying to defend itself against Starboard's onslaught. When it sold its Red Lobster chain in May for $2.1 billion to Golden Gate Capital, part of the deal was a $1.5 billion sale of the real estate to American Realty Capital Properties. Darden and ARCP executed a sale-leaseback arrangement for the properties.

Since Darden decided to conduct a sale-leaseback instead of the spinoff Starboard wanted, the company reported it had to pay roughly $500 million in taxes and transaction fees, which meant that for the $500 million to $600 million Golden Gate paid for the operating business Darden ended up selling Red Lobster at a very low after-tax multiple. Starboard described it as a "fire sale" price that essentially was a "give away." Feinstein argued that, alternatively, Red Lobster could have spun off the real estate to Darden shareholders and retained the upside in any recovery.

Unlike the REIT spinoff approach, a sale-leaseback generates revenues for the operating company selling it and Darden said it is expecting to use roughly $1 billion of the proceeds to retire outstanding debt. Sterne Agee analyst Lynne Collier said that the Red Lobster sale significantly reduced Darden's debt load and brought it to a level where it no longer needed to be drastically cut back.

Proponents of the activist tactic of pressing a company to divest its real estate and pay rent also argue that it helps the operating business because executives will be forced to re-evaluate each unit.

"If a restaurant company owns real estate, it may be harder to analyze the operating profitability of each of the units," Feinstein said. "As soon as it has to pay a standard market rent to a third party it is sometimes easier to analyze certain aspects of the restaurant's operations and evaluate poorly performing units and what should be done about it."

Opponents of the tactic dispute the notion that a real estate separation is needed to do a deep-dive valuation of each restaurant. "If a company can't figure out the value of a store without doing a sale-leaseback, they really need to hire a new accountant," said Gary Lutin, chairman of the Shareholder Forum.

John Gordon, principal at Pacific Management Consulting Group said Darden did the right thing by "ditching" Red Lobster because it helped the company pay down debt. Nevertheless, he added that there are many negative long-term consequences of separating real estate from a parent company in the restaurant industry, such as new expenses that come with being a tenant in an environment where leases are 15 to 20 years in length and the cost of real estate is continually going up.

"It is tough as hell to be a restaurant tenant," Gordon said. "If someone else controls the property you are always at their whim. They will love to insert a percentage rent hike associated with certain spikes in revenue." In addition, Gordon noted that as a new tenant the operating company has higher expenses, which lessens its ability to fund new projects.

Lutin said that real estate separation typically isn't a good idea because it increases long-term operating business risk. "All the activist variations of leveraging need to be analyzed for two things: Increasing the yield requirement of debt and reducing the company's ability to adapt," he said. "If all you're doing is trading a company's long-term growth potential for a temporary rise in stock price, the credit analysts are justified in complaining about transferring wealth from bondholders to stockholders."

Adapting to recessionary periods can also be difficult. Lutin insisted that an operating company's long-term enterprise value is increased by its ability to adapt to difficult situations or opportunities and owning real estate helps.

Nelson Marchioli, a former CEO of Denny's Corp. (DENN) who was pushed out after activists nearly won board seats at the diner chain in 2010, said he doesn't think it's smart in the long term for a company to sell all its real estate assets. "There is nothing wrong with management looking at its real estate and seeing if some can be sold off or need to be closed down," he said. "There needs to be a balanced approach."

He added that in recessionary periods or when restaurant chains experience tough times banks like to see real estate as collateral when re-negotiating loan terms. "If you don't have a sufficient number of assets, banks can't help you," he said. "Also, with a sale-leaseback, all of a sudden the firm has to pay rent. You need to keep some real estate assets for those rainy days."

THE CYCLICAL NATURE of restaurants, casinos and retail chains mean that property can be a buffer against hard times, said Eileen Appelbaum, a senior economist at the Center for Economic and Policy Research.

She said that activists are predominantly interested in stripping the real estate from the restaurants or casinos and requiring the businesses to pay rent to a real estate company owned by the same shareholders that own the operating company. She said that provides investors with a cash cow that can be exploited to pay dividends or finance share buybacks at the expense of the operating business.

"Doing so greatly increases the risk that the businesses will not be able to make it through an economic downturn without experiencing financial distress, bankruptcy or even liquidation," she said.

Particularly in the restaurant business, Gordon said, where eatery locations have a shorter economically useful life than other forms of real estate, like hotels, the REIT format may not be appropriate. The only other free-standing restaurant REIT Gordon was aware of was the former U.S. Restaurant Properties Inc., which merged wth CNL Financial Group in 2004 to become a publicly traded REIT: Truststreet. In 2007, Truststreet was sold to GE Capital for $2.8 billion.

More restaurant separations may be coming -- Darden, for one -- and possibly at Bob Evans Farms Inc. (BOBE). Thomas Sandell of Sandell Asset Management in September succeeded at installing four dissident directors in a proxy he waged at Bob Evans.

Among Sandell's demands are for the company to enter into a significant sale-lease back transaction to "realize" the significant real estate value in the business. Sandell has other demands of the restaurant chain, like selling off its food processing business, and Miller Tabak analyst Stephen Anderson said he believes that's more likely to happen than a real estate maneuver.

Nevertheless, Anderson said that a compromise could be worked out where Bob Evans sells 141 of its 565 units to franchise owners in fringe markets such as the Middle Atlantic states as part of a sale-leaseback arrangement. He noted that these kinds of transactions are likely far less extensive than what Sandell is looking for but they could generate pre-tax revenue of $255 million and be enough to suit both sides.

As companies with the appropriate financials for an activist to succeed become fewer and farther between, look for more investors to start toting up the value of the real estate, and whether it might help, or hinder, their plea to institutional investors to put dissidents on the board.


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