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Dismal Performance and a Legal Rebuke Isn’t Stopping This Credit Fund
“How do I say this nicely? It’s a manager that basically should not exist,” according to Cliffwater’s CEO.
Even though two directors of a money losing business development company called Medley Capital Corp. were found to be in violation of their fiduciary duty by a Delaware Court in March, they’re still up for reelection on June 4.
It’s just the latest move in an almost year-long battle in the world of BDCs — investment vehicles for private loans that are similar in structure to real estate investment trusts (REITs). The fight could take a decisive turn at the annual meeting when shareholders vote on the reelection of a special committee that includes the two men: Seth Taube and Arthur Ainsberg.
Earlier this month, proxy advisors Institutional Shareholders Services and Glass Lewis issued reports recommending that shareholders vote against the two incumbents and instead vote for two independent directors nominated by NexPoint Advisors, an affiliate of asset manager Highland Capital. In January, NexPoint made a proposal to the board to take over as adviser to Medley Capital Corp. (MCC), which is among the worst performing BDCs. The total shareholder return was -37.7 percent between January 19, 2011, when MCC went public, and May 17, 2019, according to ISS. MCC’s track record puts the BDC 65.1 percentage points below the index and 96.2 percentage points below its median peer.
A spokesman for Medley declined to comment.
Institutional investors’ interest in BDCs has increased in recent years, but the Medley saga comes as a reminder of the sector’s wild-west reputation. While BDCs are registered with the Securities and Exchange Commission, they have some less than shareholder-friendly attributes. For one, activist investors are largely absent from the space. Hedge funds, mutual funds, and other investment firms can’t own more than 3 percent of a BDC. This means they cannot build up a meaningful stake and pressure management for change, as they frequently do in other public markets. The SEC has two BDC shareholder proposals out for public comment, including one that would raise the amount that hedge funds and other investment shops can own of a BDC.
[II Deep Dive: Be Damned Careful]
The Medley saga dates back to August 2018 when adviser Medley Management proposed a three-way merger. First, two of its affiliated BDCs — private Sierra Income Corp. and MCC — would merge. Then affiliated Medley Management, the advisor, would become a subsidiary of the combined BDC.
But the deal was riddled with conflicts, experts say.
The three organizations are essentially run by the same people. Brook Taube, chairman and CEO of MCC, is also co-CEO and co-chairman with his brother Seth Taube, of Medley Management. Brook and Seth Taube along with a younger brother own the majority of Medley Management. Brook Taube is a director of Sierra Income. Seth Taube, who is up for reelection as an MCC director in the June 4 election, is board chairman and CEO of Sierra Income. The August 2018 merger proposal required an exemption from the SEC to allow the BDC’s advisor to become a subsidiary of the BDC itself, an unusual arrangement. The deal also included a $75 million cash payment from the new combined BDC to Medley Management as well as a new advisory contract for Medley Management, despite MCC’s poor performance.
In court documents, one of the BDC’s largest shareholders — FrontFour Capital — said the transaction represented a 100 percent premium for Medley Management.
“It’s true that big investors need to see crap like this wiped out” said one executive at a large private equity firm with a BDC. “Medley is large enough that it can’t be ignored. It would be good news for retail investors, who now dominate BDCs, if institutions started playing a bigger role and then demanded higher standards.”
Steve Nesbitt, CEO of alternatives advisory firm Cliffwater, told Institutional Investor, “Medley is a definite fourth quartile performer. How do I say this nicely? It’s a manager that basically should not exist.”
In January, NexPoint put an alternative to Medley on the table to manage the BDC, which included lower management and incentive fees that NexPoint claims will lower expenses by $5.7 million annually. The deal also included a lump sum payment to MCC and an agreement to buy back shares in an attempt to narrow the discount at which MCC is trading. But the board’s special committee charged with negotiating the Medley merger never responded, according to public documents. NexPoint then submitted a sweetened second proposal. In both offers, NexPoint said it would be willing to negotiate further.
By the end of February, FrontFour filed a lawsuit over Medley Management’s alleged breach of its fiduciary duty and other matters.
On March 11, a Delaware court found that the MCC board violated its fiduciary duties in approving the Medley mergers. Board members cited in the court’s opinion included Brook Taube and Seth Taube, “whose financial interests lie with Medley Management over MCC,” according to the opinion. But only two board members resigned.
The opinion was a flaming reprimand of the board, according to several people familiar with the decision and the court’s thinking, as well as a straightforward reading of the text.
“In the end, the Special Committee allowed Medley Management to extract a huge premium while Medley Capital stockholders received none,” according to the documents. The court said the board’s supposedly arm’s length relationship with MCC, Sierra, and Medley Management was only believable “at a distance.” As the court wrote, “In reality, when the Taube brothers proposed the transactions in June 2018, Medley Management was facing enormous financial pressure. Medley Management had engaged in two sales processes in 2017, both of which failed, which left merging with affiliates as Medley Management’s only solution.”
What came out in the discovery process was that the Taube brothers tried to sell Medley Management in 2017 and got agreements from approximately 30 potential bidders. The process prevented the bidders from a broad array of activities, including advisory deals with MCC (or the two BDCs). That meant few competitors would be in a position to challenge Medley Management’s contract with MCC, even though investors were suffering from its poor performance.
After the decision, FrontFour reached a settlement with MCC that included two board appointments to replace two resigning directors named in the Delaware court opinion. One of FrontFour’s directors will lead the special committee. That still left five of the seven directors in place.
After what NexPoint considered failed negotiations with MCC’s board, NexPoint decided the only way that third-party proposals, including its own, would get a fair review was to improve governance and nominate two independent directors to replace two directors up for reelection, according to a presentation to MCC stockholders by NexPoint.
“We believe the misalignment of interests and influence of entrenched insiders — not to mention the fact that the Delaware Chancery Court found that five of the existing directors violated their fiduciary duties — prevents the current MCC board from properly evaluating any proposal that challenges the Taubes and Medley Management,” wrote Thomas Surgent, partner and chief compliance officer at Highland/NexPoint, in an email.
“Even though we are seeking to become the company’s external manager, our interests are completely aligned with stockholders, because our goal in this election is simply to ensure that there is an even playing field for all participants in the go-shop process. We didn’t nominate NexPoint affiliates; in fact, we have absolutely no prior relationship with our nominees.”
According to a May investor presentation from MCC, the company says the addition of NexPoint nominees is not warranted because two investor nominees from FrontFour were recently appointed. In addition, according to the investor presentation, NexPoint’s nominees are conflicted because the manager wants to also become MCC’s outside advisor. In the presentation, MCC also claims NexPoint has a “concerning record,” and lists a number of articles and regulatory actions, including an investor lawsuit stemming from a Highland hedge fund that was shuttered during the financial crisis.
ISS, the proxy advisor, pointed out in its recommendation to vote against the incumbent directors a number of concerns for stockholders in MCC, including the status of notes issued by the BDC. “There are multiple worrying trends in the company’s operating performance, but the most troubling is the decline in the value of net assets... [NexPoint] pointed out that MCC’s 2024 notes have a financial covenant requiring a minimum net asset level of $275 million or more. As of the end of the first quarter, MCC's balance sheet has $278 million in net assets. If the net asset value is below that threshold for two consecutive quarters the notes could be accelerated, creating substantial distress for the company.”
In its full report, ISS also stated that “further change at the board level is warranted” as a result of “inferior shareholder returns during the incumbents’ tenure;” “troubling operating performance;” and “the Delaware memorandum opinion that found the company’s nominees breached their fiduciary duties.”
In Glass Lewis’s report, the proxy advisory called out the directors specifically. The proxy adviser said, “Arthur Ainsberg has failed to represent the best interests of MCC shareholders.” It noted his “fail[ure] to understand that the prior sale process for MDLY [Medley Management] did not ‘effectively’ shop MCC.” Glass Lewis described that failure as “an egregious error for the chairman of a special committee tasked with seeking the best alternative for shareholders.”
Cliffwater’s Nesbitt said the battle comes down to corporate governance. “It’s like any public company. Without activists — if you can’t get control of the board — you’re looking at a slow death. The 3 percent rule allows this to exist,” said Nesbitt. “The good news is things are changing. Big shareholder-friendly shops like Benefit Street Partners, Oaktree, and Crescent are entering this space with reasonable fees — even if not the cheapest — and good boards.”