ECT NA - Eurocastle Investment Limited - The best way to 'play' an Italian recovery.

Eurocastle Investment Limited is a Guernsey closed-end investment company focused on three primary segments: German investment properties; debt investments; Italian investments. It is listed on Euronext Amsterdam (‘under the symbol ‘ECT’) and is externally managed by Fortress Investment Group LLC (NYSE listed under the symbol ‘FIG’), a global investment manager with approximately $62 billion in AUM as of December 31, 2013.

In order to understand better this stock I think it’s a good idea to have a view about the manager, Fortress (our source will be their last 10-k, the annual report as of December 31, 2013). Fortress has three primary sources of income from the Fortress Funds: management fees, incentive income, and investment income on its principal investments in the funds. Their history is mainly in strategies commonly defined as ‘alternative investments’ as: 1) private equity (--> $15.6 bln. of AUM, two business segments i) general buyout and sector-specific funds; ii) publicly traded permanent capital vehicles); 2) liquid hedge funds (--> $7.4 bln. of AUM); 3) credit funds (--> $13.4 bln. of AUM, two business segments i) credit hedge funds; ii) credit private equity funds). Then they also make money with a 4) traditional asset management business, Logan Circle (which has $25.4 bln. of AUM); and 5) investing capital in each of its alternative investment businesses (where they have investments in and commitments to their funds of $1.5 bln.).

Eurocastle, together with Newcastle Investment Corp. (NYSE: NCT) and New Residential Investment Corp. (NYSE: NRZ), are inside Fortress’s private equity funds’ segment, precisely they are permanent capital vehicles. “(…) These permanent capital vehicles were raised with broad investment mandates to make investments in a wide variety of real estate related assets, including securities, loans and real estate properties. Pursuant to our management agreements, we earn management fees from each permanent capital vehicle equal to 1.5% of the company's equity (as defined in such agreements). In addition, we earn incentive income equal to 25% of the company's applicable supplemental measure of operating performance, in excess of specified returns to the company's shareholders. In addition to these fees, we also receive, for services provided, options to purchase shares of their common stock in connection with each of their common stock offerings (…)”. So the core strategy of these vehicles is investing in ‘real estate related assets’ and for this work they are well paid (as we all know, alternative asset managers are able to charge more for their mandates so we are seeing here how much expensive they are with these three layer of fees).

We continue our digression on Eurocastle through the Fortress’s 10-k words and in the ‘Risk Factors’ section they explain well how these vehicles work: “(…) Certain of our permanent capital vehicles and funds could be adversely affected by a contraction of the structured finance and mortgage markets. Certain of our permanent capital vehicles have historically relied on the structured finance and mortgage markets in order to obtain leverage and thereby increase the yield on substantially all of their investments. To the extent that volatility in those credit markets leads to a situation where financing of that type is unavailable or limited (as was the case during the 2008 financial crisis and currently continues to be limited), Newcastle, New Residential or Eurocastle may be unable to make new investments on a basis that is as profitable as during periods when such financing was available. Furthermore, it could significantly reduce the yield available for reinvesting capital received from prior investments, thereby reducing profits (...). Many of our funds also have relied on the structured finance markets. To the extent that financing of that type is unavailable or limited, such funds may be unable to make certain types of investments as the yield on those investments will be outside of the funds' target range without leverage. This could reduce the overall rate of return such funds obtain from their investments and could lead to a reduction in overall investments by those funds and a slower rate of growth of fee paying assets under management in those funds, with a commensurate decrease in the rate of growth of our management fees (…)”. In practice these are vehicles that have those mix of characteristics (leverage) and that use (they ‘rely on’!) those instruments (structured finance, mortgage markets) that were at the epicenter of the recent 2008 financial crisis. Is this enough to stop here my analysis? Not (for now), because my objective is to understand in what kind of ‘Italian investments’ Eurocastle is investing.

Here a bit of history about Eurocastle “(…) In April 2013, Eurocastle Investment Limited ("Eurocastle") completed a restructuring process that resulted in the conversion of its outstanding convertible debt. As part of that restructuring, Fortress entered into an amended management agreement with Eurocastle that reduced the AUM used to compute Eurocastle's management fees from €1.5 billion to €0.3 billion as of April 1, 2013, and in doing so also reduced the earnings threshold required for Fortress to earn incentive income from Eurocastle. Following the conversion of its outstanding convertible debt, Eurocastle effected a one for two hundred reverse split of its common stock (…)”. Nice, it seems that during 2013 Eurocastle was re-capitalized and Fortress lowered the fees. Here there is a table with some data (Aum, Returns, etc. …). Then, some numbers ...

Talking about ‘returns’, the note explicit that “(…) For permanent capital vehicles, returns represent the current dividend yield which is calculated by annualizing the most recently declared base dividend and dividing the result by the closing stock price for the period. Excludes the impact of special dividends declared in connection with REIT compliance, which may increase returns (…)”. Uhm, this method of representing returns for ‘permanent capital vehicles’ is quite strange: 1) they report data only for the last 3 years; 2) they don’t report dividend per share;  --> in my opinion this is not representative of their true performance …

(Table 1. Newcastle Investment Corp’s Shares Outstanding, Price, Dividend per share, Source: Bloomberg).

Here about how much money Fortress has invested in Eurocastle: “(…) As of December 31, 2013, we had a $4.8 million investment in Eurocastle (…) which are accounted for at fair value (…)”. It seems not enough to consider them aligned from a minority shareholder point a view … . Finally, in ‘Notes to Consolidated Financial Statements’, a lot of interesting facts (transactions between funds and permanent vehicles, how they calculate their fees, etc. …) related to Eurocastle that I’m not able to understand but seems interesting to take note: “(…) 

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Anyway, the reason why I was interested to Eurocastle is that, after having raised new capital in 2013, the strategy is transitioning from:

- the legacy business (that they are slowly liquidating) where they invested in high quality German commercial properties (--> revenues from rental income) and in real estate related debt (--> revenues from interest on securities, loans and receivables); to

- the new strategy (called ‘Italian investments’) where they invest primarily in Italian bank loan portfolios, performing and NPLs (--> deriving income from loan collections) and Italian real estate closed end funds (--> profiting from disconnections between Nav and price).  

Here from Eurocastle’s last presentation (2014 Q1) how they synthetize the market opportunity about Italian bank loans …

and about Italian real estate closed end funds …

Finally, in this slide, we have a view of what will be this vehicle at the end of their restructuring:

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What’s the price and what’s the value.

As at 31 March 2014, there were 32,632,502 shares outstanding, last available price @ May 23, 2014 is 6.7, for a total market cap of € 218 mln. The last nav reported (as at 31 March 2014) is 9.6 for a discount to book value of 30% (price to book of 0.7). Net asset value is represented here, visualizing the ‘old’ and the ‘new’ business:

If we assign a discount of 20% for their ‘legacy business’ estimated Nav (80% * 143 --> 114), we would have a total ‘adjusted Nav of 284 mln. € (8.7 € per share) and we would conservatively buying 1€ for 77 cents/€. Then, consider that they are already paying dividends for 16.4 mln. €/year (0.125 per share for 4 quarters --> 0.5 € per share/year) which translates to a 5.7% dividend yield: if they are able to re-invest that new money at a rate similar to their estimated 16% IRR

that could yield up to 0.16 * 4 --> 0.64 € per share/year or more than 7% of dividend yield.

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I think this is the best way to ‘play’ the recovery in Italy:

- not by buying etfs on Italian equities (--> there is only less than 30% in banks in the index, Ftse Mib);

- not by buying ‘Italian banks’ (--> of the 9 Italian banks in the STOXX 600 Banks, the cheaper is trading at 73% of tangible book value and I’m not so sure they have stopped raising capital plus they are on the wrong side of the trade because they are forced seller of these loans);

+ (while, in practice) by buying ECT you should be able to take exposure in an interesting, while illiquid and difficult to invest, asset class, otherwise available in an hedge funds only format, managed by a specialist, at discount to book value.

(Graph 1. Eurocastle’s performance and value traded, Source: Bloomberg).

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.