Ali Meshkati July Newsletter (WMIH Highlights)
The exploitation of NOLs as a form of leveraged profits allowing for rapid growth within a corporation is by no means a new strategy. NOLs have been exploited by financial luminaries like Sam Zell and Carl Icahn since the early 80s. More recently, David Einhorn and Phil Falcone have joined in through separate investment vehicles both structured exclusively as a means of turbo charging growth through the reinvestment of tax savings provided by NOLs into further acquisitions.
What is interesting in the case of the courtship between KKR and WMIH is that KKR has no experience in the field of NOL cultivation. Now I'm sure they have utilized NOLs in the past to offset profits, but they have never expressly purchased a corporation purely for the exploitation
of its NOLs as they seem to have done with WMIH.
In fact, if you look into the recent history of KKR's M&A activity they have actually sidestepped NOLs when they are available, preferring to carve them out into a separate entity that KKR itself has no further interest in. The most likely reason for this is that Section 382 restrictions would restrict or void the NOLs, making them useless following the acquisition.
KKR, however, has never worked around Section 382 restrictions through creative financing and timelines in the manner they are with WMIH.
Take the case of KANA Software, for example. After some period of suffering as an independent company, KANA executives decided to sell the company to KKR in 2009 for $48.9 million in cash. KKR decided at the onset that they only wanted KANA's operating business,
including software, services and licensing that would then operate privately under the KANA label, with KKR, of course, being the final decision maker.
KANA would go on to make numerous acquisitions through the strategy that KKR developed for the company. Eventually, KKR led KANA would be sold to Verint in 2014 for $514 million or a better than 1000% return for KKR in a short five year time span.
In the meantime, a company trading on the pink sheets under the symbol SWKH remained inactive and barely noticed by investors. SWKH was the remnants of KANA, trading under a new symbol with NOLs and some cash attached. The mission: To find a viable merger candidate to exploit the NOLs. KKR had no stake in this venture, seemingly disinterested in the vehicle altogether.
Why then has KKR recently taken an interest in what is a pure NOL shell?
I can come up with three reasons:
1. The size of the NOLs create such a substantial offset of future profits that it was worth KKR's time and effort to creatively exploit the tax asset.
2. KKR wants to utilize WMIH as an exit vehicle. In this scenario, a deal similar to what David Einhorn, Biofuel and what is now GRBK would take place. KKR would exit a current investment by selling it to WMIH, while providing the financing at the same time. KKR would
then retain a substantial equity stake in WMIH, essentially controlling a business that has enhanced profitability due to the tax advantaged profits.
This type of deal provides KKR with three separate avenues of profit:
a) selling an existing business to WMIH
b) providing financing to WMIH
c) retaining a substantial equity interest in the new company.
3. The value of WMMRC (reinsurance) or WMIIC (investment corporation) is greater than what we are being led to believe. This is the hidden asset scenario. I am aware of the ongoing escrow discussion taking place among long-time investors in Washington Mutual. Since I am not an escrow holder, investing in WMIH after its reemergence, I have not researched this
scenario thoroughly to decide where it is I stand. I do believe that given the speed, nature and size of the bankruptcy that took place, it is only natural that certain assets could be leftover.
Whether the board, management and partners that we have in place are resourceful or have been timely enough to rescue these assets is another issue entirely. During their Q2 conference call, KKR did mention WMIH explicitly for the first time outside of press releases that accompany specific WMIH related news. As an investment manager that
comments to investors regarding various investments on a monthly basis, I can only assume that highlighting WMIH as not just a current investment but one that they invested an additional $200 million into recently is not without reason. The commentary in and of itself tells of the
optimistic nature of their investment.
Here is the actual commentary during the recent Q2 conference call:
“On the right-hand side of the page, you can see how we are using the freed up balance sheet capital. We listed 3 of the larger uses of funds, including an additional $200 million investment we made in WMI Holdings, the former holding company for Washington Mutual. We made this
investment opportunistically, as we think WMI is a great vehicle through which to facilitate acquisitions. WMI's stock is up 27% through June 30, so our investment is performing well so far.”
NOL shells provide an inherent margin of safety due to the fact that Wall Street cannot properly factor in future growth, consistently undervaluing the NOLs as they pertain to a future operating business. WMIH certainly possesses the inherent margin of safety that nearly all pre-revenue
NOL shells have been party to. The enhancement in WMIH versus current and former shells comes with the fact that it is better capitalized, with non-dilutive debt capitalization to come with the announcement of M&A in addition to the current cash; possesses more substantial
partnerships through its relationship with KKR; and has the possibility of hidden assets working through the shell at some point in the future.
The size of the NOL along with the capitalization provided, partnerships and executives involved continues to point to a multi-billion dollar deal in the pipeline that I expect to be announced before year end.
