2023-03-23 10:00:00 ET
Summary
- The iStar and Safehold reverse merger/spinoff is expected to close in the next week.
- Pricing of the deal terms have been mostly finalized, allowing for interesting merger arbitrage dynamics.
- Remaining Star Holdco appears to be underpriced by the market.
Introduction
Let's get something out of the way, I don't analyze or invest in REITs, and the two tickers I'm talking about are both REITs. However, as you'll soon see, the purpose of this analysis, largely isn't about whether these REITs are worthwhile or not, it's about the upcoming merger of the two companies and the possible pricing discrepancies that exist as we approach the consummation of the deal.
The Deal
The deal between iStar ( STAR ) and Safehold ( SAFE ) is very messy and complicated, that's ultimately the reason why I think the market has overlooked a modest opportunity here.
The motivation of the deal was to take STAR's assets and split them into two groups, the legacy asset business would be moved into "Star Holdco", and the new assets that represent their higher growth segment would be merged with SAFE. STAR holders would end up with portions of the two businesses, some SAFE, and some Star Holdco (Proposed ticker is STHO).
The two companies announced their merger (technically a reverse merger) back in August, and the terms looked something like this:
For every 1 share of STAR, you would get:
- 1 share of STAR Holdco (STHO)
- 0.27 shares of SAFE
However, the 0.27 shares of SAFE are based on a pretty complicated calculation:
In the Merger and related transactions, each issued and outstanding share of common stock, par value $0.001 per share, of STAR (“STAR Common Stock”) will, by means of a reverse stock split (the “Reverse Split”), be combined into a fraction of a share of STAR Common Stock equal to (i) ((A)) the number of shares of common stock, par value $0.01 per share, of SAFE (“SAFE Common Stock”) held by STAR and its wholly-owned subsidiaries as of immediately prior to the Reverse Split (after giving effect to ((X)) the Spin-Off, (y) distributions in respect of STAR’s performance incentive program known as “iPIP” and ((Z)) the transaction with MSD Partners, L.P. discussed below), plus ((B)) 1,195,034 (representing $50 million of shares based on recent trading prices), plus ((C)) the number of shares of SAFE Common Stock payable in respect of accrued but unpaid management fees owing to STAR, divided by (ii) the aggregate number of issued and outstanding shares of STAR Common Stock as of immediately prior to the Reverse Split (the “STAR Share Consolidation Ratio”).
Based on the number of shares of STAR Common Stock currently outstanding, each STAR stockholder is expected to receive approximately 0.27 of a share of STAR Common Stock for each share of STAR Common Stock that such stockholder owns, and these shares will remain outstanding as shares of common stock, par value, $0.01 per share, of New SAFE (“New SAFE Common Stock”) from and after the effective time of the Merger (the “Effective Time”). By virtue of the Merger, each share of SAFE Common Stock issued and outstanding immediately prior to the Effective Time will be converted into the right to receive one share of New SAFE Common Stock.
Source: Company 8K
(Note: the wording is particularly confusing because they're saying 1 share of old STAR becomes 0.27 shares of STAR, and then 1 share of STAR becomes 1 share of NEW SAFE. It's also confusing because technically STAR is buying SAFE, but SAFE is the surviving company and ticker, and majority of the operating company, so for all intents and purposes, SAFE is effectively buying STAR.)
The 0.27 is contingent on multiple variables that can and will change over time, and since the deal was first announced, it has changed drastically. As per the company's proxy released in Feb 2023 , the new calculation for the SAFE conversion is 0.153 shares of SAFE. In addition, their press release dated March 17th has finalized that the spinoff of shares of STAR Holdco will be 0.153 shares (instead of the initially proposed 1 share).
To summarize, 1 STAR common share becomes...
Initial Proposal - 0.27 Shares of SAFE, and 1.0 Shares of STHO
Current Expectation - 0.153 Shares of SAFE, and 0.153 Shares of STHO
For someone who engages in merger arb, knowing what you're going to get is extremely important, and on the surface, this looks messy and volatile to the point where it's a clear "pass". And while that may have been true for the past few months as the deal has twisted and contorted in a few different ways, the changes can largely be explained as benign adjustments due to a special dividend, some market price changes, and a stock price adjustment that are all well understood.
For example, the change of 1.0 shares of STHO to 0.153 shares of STHO is purely an artifact of "wanting a higher stock price for STHO". The original proposal is that STHO would be a company worth about $560 Million with about 86 Million shares outstanding (distributed, on a 1:1 basis to STAR holders). That would mean it's about $6 per share. Now, they will give each shareholder only 0.153 shares, so there will be 13.2 STHO Million shares outstanding. That means the price will be about $42 per share. Whether you're getting 1 share worth $6, or 0.153 shares worth $42, is the same thing.
A second change is that the company paid out a special dividend to STAR holders (of SAFE shares) worth about $2/share after they announced the merger, prior to the consummation of the deal. That reduced the value in STAR, and hence, the proceeds from the deal are now lower.
Having spoken with company IR and modelled out the parameters, the 0.153 ratio of SAFE is now reasonably secure, and the 0.153 shares of STHO are explicitly stated, so the uncertainty about the proceeds of this deal in nominal terms, is relatively safe.
In terms of getting the deal done and over the finish line, the votes have passed on both sides, and are awaiting the SEC to declare their Registration Statement Form 10 to be effective. Given the latest changes to their filings are minor, and the fact that the company has repeatedly stated they expect the deal to be closed on/around March 31st, I'm highly confident we'll see it close around that date.
The Trade
This is not an arbitrage play in the typical merger-arb sense. The big picture explanation of the trade is that you can purchase a share of STAR, hedge the SAFE proceeds by shorting it, and be left with a "Very cheap share of the STHO (Star Holdco)". Here's how the math works:
STAR currently trades for $7.00SAFE currently trades for $29.16
If you purchase 1 share of STAR for $7.00, and then short 0.153 shares of SAFE for $29.16 ($29.16*0.153= $4.46), your net cash outlay would be $7 minus $4.46 or $2.54.
Assuming the deal closes, your STAR share will turn into 0.153 shares of STHO and 0.153 shares of SAFE, (which will net against your short position of 0.153 shares of SAFE, meaning that's neutral). Effectively you've purchased 0.153 shares of STHO for $2.54, or, in per-share terms you're buying 1 share of STHO for $16.60. We have no idea what STHO is, so is that a good or bad deal?
The Proceeds, Star Holdco
To decide if this trade is worth it or not, we need to understand what is STAR Holdco, and what it's worth. I warned readers at the start of the article that I don't trade or value REITS, and now we're required to value a REIT.. sort of.
From the company's filings, here's what STAR Holdco is:
The company is comprised of $400M of SAFE shares, $50M of Cash, and some assets worth about $350M. That's offset by $240 of debt. Let's take an extreme case, and assume that the assets are worth zero. You now have a company with $450M of assets (Cash and securities), and $240m of debt, or $210M of Tangible Book Value. Divided by the 13.2 Million Shares outstanding, and you end up with about $16 per share, which is awfully close to the price you're paying for a share at $16.60. But that's assuming the real estate assets are worth zero, and obviously, that isn't a fair metric.
A colleague dug through the filings and put this together as a best estimate of what their legacy asset portfolio looks like:
While I'll repeatedly say I'm not a REIT investor, this doesn't look like a portfolio worth zero. Giving this any modest value results in STHO being worth considerably more than the $16.60 per share that you're able to acquire it for.
While I get that the $400M holdings of SAFE should be discounted by a bit since they're being held in an illiquid vehicle with a 9 month lockup- but given the trading dynamics of SAFE (low borrow rate, small short interest, decent analyst coverage, etc.) it's hard to imagine the market price of SAFE is distorted in any meaningful way. Let's also throw in the fact that Michael Dell's family office MSD is buying $200m worth of SAFE stock as part of the deal, providing some external validation of the company.
Spinoff Dynamics
Dealing with Spinoffs is tricky because they're kind of "orphaned" securities. They just show up one day, and most people don't know about them, quant screens ignore them, indexes don't hold them, etc. There's often low (or zero) liquidity in them. For that purpose, I expect that I'll have to hold STHO for weeks or months before any sensible market for the stock develops. However, this effect is balanced by the fact that anyone looking at STHO should find it to be a fairly easy-to-value asset given its balance sheet is comprised of 3 things, and most of it is tradable/liquid securities.
Conclusion
I've spent far less time on this deal than typical, and that's a product of the fact that I only started looking at this 2 days ago and the deal will likely close in about 2-3 days. The deal piqued my interest because it's a messy and interesting deal, and those are the ones that the market most often gets wrong (Coincidentally, I also get these wrong at a high frequency). Taking a stab at the numbers, as presented above, this looks like a very low risk situation where you're buying an asset with a huge "margin of safety". One could make the argument that STHO is really worth about $40/share, or perhaps even more given the potential of their portfolio, but that requires time ,information, and skills that I do not possess. Getting STHO for $16/share, seems like a bargain. I have a small speculative position on this deal as outlined above.
Questions and corrections are greatly appreciated in the comments below.
Acknowledgement: Jasper Chan contributed to this article.
For further details see:
iStar And Safehold, A Perplexing But Intriguing Merger Arbitrage