Okay, pay attention. Medley Management, for all intents and purposes, is really just twin brothers Seth and Brook Taube. They own the majority of Medley Management and are paid by Medley Capital, a business development company — more on this in a bit — to make investment decisions. They have, according to numerous analysts, including Wells Fargo, one of the worst records in doing this job of anyone in the entire industry. And despite a flurry of legal filings, public critiques, and a Delaware court ruling, they are now on the verge of convincing Medley Capital not only to keep paying them, but maybe even to buy them outright. How? Because this is exactly the way the world of BDC management works.
Reader, be warned: This is a story filled with numbers, but numbers are not the story. I could tell you about how the performance of Medley Capital has plummeted since it went public — a feat that happened at the same time as the industry blossomed. I could tell you that BDCs are one of the last areas where serious investors are prohibited from being meaningful stakeholders, and that the law allows things that would be unthinkable in other realms of finance. But what I’m going to tell you is how Medley, Seth and Brook Taube, and the hysteria surrounding their maneuvers is not a bug of the BDC world, but a feature.
What you need to know is this : BDCs are essentially mutual funds that lend money to small and medium-size businesses.
They have exploded in popularity along with the rise of private credit in the past decade. Both BDCs and mutual funds are governed by the Securities and Exchange Commission’s Investment Company Act — written nearly 80 years ago, in 1940. Medley Management makes money by charging incentive fees based on how good it is at picking investments. It also rakes in cash through an annual management fee that is charged whether performance is exceptional or horrible.
Medley’s roots go back to 2005. That’s when Brook and Seth, both of whom have BAs from Harvard University, teamed up with Richard Medley to launch a credit hedge fund with a socially responsible focus. A former adviser to George Soros, Richard Medley left about a year after the founding (he died in 2011), and the firm dropped the impact part of its mandate. During the financial crisis, Medley Management prevented investors from withdrawing their money as it struggled to sell illiquid assets. The firm would later transfer six of the hedge fund’s best-performing assets to what’s now Medley Capital. The twins took the BDC public in 2011. (Through a spokesman at public relations firm Gasthalter & Co., the Taubes declined to comment for this article.)
Medley launched its BDC just as the product was becoming popular with investors and advisers, who were clamoring to earn interest on their investments. Government and corporate bonds paid almost nothing, whereas private debt offered double-digit rates. Medley rode that wave of BDC popularity.
By 2017 the Taube brothers had decided to attempt a sale of Medley Management. Why? Because its finances were in disarray. After years of suffering from bad investments, Medley Capital and other funds it chose investments for — including one called Sierra — were shrinking, depriving Medley Management of lucrative management and incentive fees.
The Taube brothers weren’t entirely crazy to think they could sell the asset manager. After all, BDCs were hot. There were a bunch of lucrative deals happening.
For one, Howard Marks’ Oaktree bought Fifth Street Asset Management — as bad a performer as Medley — for $320 million in cash. This was after Fifth Street settled a class-action lawsuit claiming the manager had inflated the value of its investments, and while the SEC was also investigating the firm. Fifth Street settled with the SEC over the allegations, which included the valuation lapses, at the end of 2018. What’s more, even though the board of Medley Capital could have fired Medley Management at any time, with a new asset manager even paying shareholders for the management contract, the Taubes didn’t need to worry about that either. Josh Easterly, a Goldman veteran and CEO of TPG Specialty Lending’s BDC — one of the industry’s best — failed to win a proxy fight to take over another poorly performing BDC in 2016. TICC Capital, the manager of the BDC, didn’t want anything to do with TPG because it wouldn’t have gained anything in the deal. If Easterly couldn’t do it, according to industry experts, bad managers had nothing to fear.
But the Taubes were wrong about being able to sell — at least at the price they wanted.
When the first attempt to sell that year failed, the brothers fired their bankers and hired new ones. One CEO of a credit shop laughed when a new banker called him about the same deal. It’s true that almost every major credit manager out there took a look at Medley, with many even signing nondisclosure agreements barring them from separately offering to save shareholders and manage investments for Medley Capital directly. But almost none of these firms were seriously interested in buying Medley Management; it had invested in deals that many thought were terrible, with some doubting the prices Medley had assigned to the private assets in its portfolios.
The Taubes might not have been able to convince an asset manager to buy Medley Management, but they might be able to convince the shareholders of Medley Capital to buy Medley Management — the adviser that had lost them half their money.
In the spring of 2018, Brook Taube came up with the idea as he was facing the prospect of another earnings call for Medley Management without being able to offer up some kind of deal.
Here’s what Medley Management ultimately proposed at board meetings in June. Sierra, a private BDC held by retail investors who rarely vote their shares, would merge with Medley Capital. The combined BDC would buy Medley Management at a far higher price — a 100 percent premium to its stock price at the time — than anybody had offered the year before, despite its performance being even worse. Taube argued that the combined BDC would have the advantage of scale and that a few BDCs with so-called internalized managers traded at higher multiples than those with external managers because costs were often lower. The proposal also included lucrative employment contracts at the “internalized manager” for the Taube brothers and a college friend who was also an executive at Medley. For the Taubes, employment contracts were even better than just management fees.
But the Taube brothers needed to deal with the inherent conflicts in a three-way merger where all the organizations were interconnected and had boards filled with many of the same directors. For one, Medley Capital’s inside directors, including the Taubes, also sat on the boards of Medley Management and Sierra. To adhere to governance rules requiring that the deals be done fairly, each board created a special committee made up of independent directors — those presumably without ties to the Taubes — to evaluate the merger.
The problem was that the Medley Capital directors weren’t truly independent. “The proxy creates the misleading impression that the special committee replicated arm’s-length negotiations amid the conflicts tainting the Proposed Transactions,” reads an opinion from the Delaware Chancery Court. The court issued its opinion after a March 2019 trial, when one of Medley Capital’s large shareholders sued to stop the transactions.
Yes, dear reader, it was complicated — yet plenty of law firms, bankers, and consultants were happy to help. And just as happily, BDC rules allowed all these fees to be paid from the assets of Medley Capital and Sierra.
Board members went to work hiring bankers and other advisers to compare executive pay packages and run “comps” on other BDC deals. Though management wasn’t supposed to influence any of the decisions, Brook Taube was busy texting the independent directors of the special committees and their bankers throughout the process, pushing them to speed it up. He admonished them not to consider “interlopers,” or other asset managers that were expressing interest in the deal. Directors in turn were enthusiastically texting and emailing back that they were behind him. One independent director texted Taube, “Are we on track? Anything you need from me?” Taube responded, “Let’s talk soon / Pushing Hard :-),” according to court documents.
Directors were also negotiating with him about continuing their employment as directors on the board of the new organization.
Brook Taube was texting away — but he was also keeping the directors in the dark about key details that could influence their decision, according to documents in the Chancery court case. He didn’t tell them about some of the concessions he had made to potential buyers in 2017. He didn’t tell them that the only serious bidder had dropped its price because of concerns about Medley Management’s performance. He didn’t tell them that firms like Origami Capital Partners had reached out several times to propose a transaction with Medley Capital.
He didn’t even tell them that they probably weren’t going to get too many offers anyway, because many firms had signed agreements back in 2017 not to make a play for Medley Capital. Those agreements, surprisingly, were still in force.
It worked. By August 2018 the boards had greenlighted the deal without considering any alternatives. Now it was time to announce it to shareholders so they could approve the deal at a meeting in early 2019.
Unfortunately for the Taubes, Medley Capital shareholders — at least the larger ones — were livid.
These shareholders have names just as generic and nebulous as Medley’s: Roummel Asset Management, FrontFour Capital, BLR Partners, and Moab Capital, among others. Soon after the boards’ approval, FrontFour called Medley to find out how a deal like this could have happened.
Their investments were worth a fraction of what they paid, they knew, but somehow they were going to buy the very manager that had made those investment decisions.
Shareholders published open letters, detailing what a bad deal it was and calling for others to vote no.
The shareholders were vocal. But in reality they didn’t have a lot of power: Rules prohibit hedge funds from owning more than 3 percent of a BDC, so no one could get a big enough stake to force Medley out.
FrontFour decided to sue in January 2019, pushing Medley Capital to produce books and records. By early February, Medley had postponed the vote on the deal.
Between January and March multiple asset managers, including Marathon Asset Management, expressed interest in a deal to advise Medley Capital. NexPoint, a subsidiary of Highland Capital, published an open letter arguing that the board had never responded to two proposals it had sent to manage the investments of Medley Capital. NexPoint had even offered a lump sum to Medley Capital for the management contract and proposed to buy back shares to help its sinking stock. (Although Highland Capital has filed for bankruptcy protection, NexPoint has not.)
But the special committee didn’t seriously consider any of the offers. As the court said, the special committee’s “attitude is best captured” in a text from an independent director to Brook Taube: “Are we going to respond to every f**ksake on the planet?”
Delaware Chancery Court decided to hear the case in March, before the rescheduled stockholder vote. The trial included more than 800 exhibits, including damning text and email messages between the Taubes and board members and bankers.
The Medley Capital directors were found to have breached their fiduciary duty through both incompetence and by breaking governance rules. The judge wrote a scathing opinion after the trial, declaring the entire process unfair: “This post-trial decision finds that the Proposed Transactions trigger the entire fairness test. FrontFour proved that half of the Medley Capital special committee was beholden to the Taube brothers, and thus the Taube brothers dominated and controlled the board with respect to the Proposed Transactions.”
It also found that the deal was driven by the financial onus on Medley Management. “Rejecting the deal would foreclose Medley Management’s only viable solution to the enormous financial pressure they labored under,” said the opinion.
The court demanded that Medley Capital go back to the drawing board, and disclose to shareholders that its directors had not acted independently and that third-party managers had made counteroffers to take over investment decisions for Medley Capital.
“As relief, FrontFour seeks a curative shopping process, devoid of Medley Management’s influence, free of any deal protections, plus full disclosures. One obstacle prevents the Court from issuing this relief: FrontFour failed to prove that the acquirer, Sierra, aided and abetted in the other defendants’ breaches of fiduciary duties,” wrote the judge in the opinion. Because of that technicality, the court didn’t permanently stop the transaction.
After the trial, FrontFour settled and got two independent directors on the board. As part of the settlement, the merger proposal would include a process to find a “superior” deal for Medley Capital.
Two directors whose humiliating texts were included in the court opinion resigned.
Two months later, though, Medley put one of the Taube brothers and one of the independent directors blasted by the court up for reelection. Even proxy voting firms Institutional Shareholder Services and Glass Lewis advised shareholders to vote against the incumbents. But because of the 3 percent rule and the huge amount of stock owned by the Taube brothers, including through a joint venture, the two were reelected.
For its part, Medley says it addressed performance by changing its investment strategy in 2015. According to an investor presentation, “the Medley lending platform shifted its focus to first lien loans provided to larger, sponsor backed borrowers.” It also says it has hired a new head of investing and a new head of risk, reconfigured its investment committees, added new senior credit investing professionals, and separated origination activities from underwriting.
In August 2019, Medley refiled regulatory documents on the proposed merger with pages and pages of new disclosures required by the Delaware court, including information about the attempt to sell Medley Management in 2017. This time, Medley Capital’s board ran a so-called go-shop, evaluating proposals from asset managers to replace Medley Management. Sources say there were few asset managers interested in the job at this point.
In October 2019, Medley announced that it hadn’t received any proposal that was “superior” to the deal of merging with its sister Sierra and buying Medley Management at a premium.
Some experts believe activists could prevent situations like Medley’s by holding management’s feet to the fire and pushing for changes.
The SEC, as part of a larger effort to modernize its rules, has proposed to increase the amount that one fund can own of another. But the change wouldn’t completely solve the problem, as institutions wouldn’t get more voting power.
In a comment letter to the commission, TPG Specialty Lending made a case to expand the limits that now constrain BDC activism. “The lack of governance accountability as a consequence of ownership and voting limitations has continued to allow poorly managed BDCs to operate without any real threat to management’s incumbency,” CEO Easterly wrote. The letter includes some startling analysis: BDCs in the bottom quartile when it comes to annual return on equity essentially stay there forever.
The complex saga of the Taube brothers could have been a simple one.
A BDC board has the ultimate power: It can fire the manager for doing a bad job. That’s particularly important with BDCs, as investors can’t withdraw their money.
But no board ever fires the manager, even in the larger mutual fund world, which falls under the same decades-old rules. When was the last time Fidelity Investments, Capital Research & Management, or any other asset manager in the $17 trillion mutual fund world was fired for poor performance?
BDCs are a small part of the fund world, but one player tested whether governance rules truly protect investors. The SEC, which has that very mandate, still needs to approve the Medley deal after shareholders vote.
Investors will want to pay attention to the decision.