SCU - Rithm Capital And Sculptor: No Longer Moving To The Beats Of The Commons

2023-09-03 04:19:37 ET

Summary

• Rithm is trying to close on an acquisition of alternative asset manager Sculptor Capital Management in a bid to diversify into the managed private capital business.
• There might be limited synergies from the acquisition and Rithm's dividend recovery might be impacted by Sculptor's negative operational cash outflow.
• The commons currently offer a 9.7% annualized forward yield and are fully covered by fiscal 2023 second-quarter earnings available for distribution.

It's been almost three months since I swapped my preferreds in Rithm Capital ( RITM ) for its common shares. The ticker has since returned nearly 17% on a total return basis as is continues to build out what management has called Rithm 2.0, a move into a more diversified company with a managed private capital business. The bull case has been seemingly bolstered by the proposed $639 million , around $11.15 per share, acquisition of alternative asset manager Sculptor Capital Management ( SCU ) which will see Rithm expand into asset management with $34 billion of AUM diversified across the multi-strategy, real estate, opportunistic credit, and institutional credit investing spectrum. Critically, the proposed acquisition could be accretive to earnings as soon as 2025 but currently faces closing uncertainty with a higher rival bid for Sculptor threatening to disrupt the proposed buyout.

The underlying intention behind the Sculptor move is for Rithm to expand into private capital, diversifying its investment platform and generating recurring earnings for shareholders by managing third-party capital. Generating growth beyond its core mortgage servicing platform is a long-term strategic benefit despite the mortgage REIT now taking in operational risk. Sculptor has been a controversial ticker since its IPO in 2007 for $320 per share, falling at least 95% since then.

Rithm 2.0

Sculptor generated fiscal 2023 second-quarter revenue of $75.3 million , down 37% from $119.2 million in its year-ago period with a collapse in incentive income to $4.3 million from $44.6 million leading the decline. Bears would be right to flag that Sculptor, previously named Och-Ziff Capital Management, realized a consolidated net loss of $12.3 million during the quarter with higher general, administrative, and other expenses pushing up costs as a Fed funds rate that now sits at a 22-year high of 5.25% to 5.50% saw quarterly interest expenses grow by 82%.

Further, with Rithm not having a comparable asset management platform the possibility of synergies could be limited and a material amount of the current cost base of Sculptor could remain post-merger. Indeed, current Sculptor CEO Jimmy Levin is set to stay on with a $30 million compensation package. This was possibly a factor behind Sculptor's decision to spurn the higher $12.76 per share bid from an unnamed consortium. However, Sculptor closed Friday trading at $11.75 per share, 60 cents more than Rithm's bid to imply that the deal as currently proposed will not close and that Rithm could find itself in a bidding war for the loss-making asset manager.

Whilst I'm a fan of Rithm 2.0, a bidding war for Sculptor would not be in the interest of the mREIT's shareholders. Rithm could receive a $16.5 million termination fee in the event its initial bid isn't picked and some shareholders view this as the optimal scenario. AUM for Sculptor has been facing some pressure with fee-paying AUM of $28.5 billion, around 82% of total AUM, dipping 5.3% from its year-ago comp as of the end of Sculptor's second quarter. Further, Levin's total compensation is set to be a huge 7.7% of trailing 12-month revenue as of the end of the second quarter.

Fund Performance And The Dividend

Rithm would face a challenge with Sculptor to reverse earnings in decline and flagging AUM. However, some of the decline realized by Sculptor has been driven by the broader macroeconomic backdrop and capital markets that are trading below their year-ago figures. The last 18 months have been incredibly turbulent for both the debt and equity capital markets and Sculptor has managed to bring in gross inflows of $14 million into its multi-strategy funds and $87 million across its platform during the second quarter. Performance across Sculptor funds during the second quarter was also ahead of its peer indices.

With Rithm yet to concretely set out how it intends to realize synergies from the acquisition, the mREIT could pass on a bidding war especially as they don't have the type of investment platform needed to fully realize benefits from the buyout that the other bidders have. Rithm last declared a quarterly cash dividend of $0.25 per share , in line with its prior payment and for a 9.7% annualized forward yield. This was supported by earnings available for distribution of $297 million , around $0.62 per share.

This number included a $0.20 gain from the sale of excess MSRs. The risk is that Sculptor's negative operational cash outflow disrupts the pathway for the recovery of Rithm's quarterly dividend back to its pre-pandemic level if the deal closes. Sculptor's trailing 12-month cash burn from operations was $82 million , this figure was a huge $312 million for trailing 12 months from the first quarter. Hence, my enthusiasm for Rithm is reduced by the pending acquisition, especially if the mREIT ups its Sculptor bid. I'm neutral on the commons even though I own a position and will likely exit on the back of any bidding war.

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