Asset managers can be wonderful businesses that benefit from recurring revenue and operating leverage. The biggest risk with an asset manager is that when assets decline, the operating leverage works in reverse. In other words, if assets decline by 50%, often earnings will decline by more than 50% because there is a base level of fixed costs. Asset managers that are unlikely to lose their assets should be highly prized and trade at a premium. RMR Group (RMR) is an unusual situation with many ingredients for meaningful appreciation. Let’s start with what they do.

In the company’s words, “RMR is an alternative asset management company with $21.0 billion of assets under management, including more than 1,300 real estate properties. RMR’s business primarily consists of providing management services to: Four publicly traded REITs, three real estate operating companies, and one real estate securities closed end fund. RMR has over 400 professionals in its corporate headquarters in Newton, MA and 25 offices throughout the U.S.” I love asset managers and I had never heard of RMR Group before reading about the company in David Brown’s “Value Investor Insight” January interview, since the company did not exist in its present form before December 2015.

Let’s turn back the clock just a little bit to 2007… I was working in an operating business and having a lot of success investing in a personal account. I had decided that I wanted to work at a hedge fund to better monetize my skills and learn from others. Because of the laws of supply and demand, this is easier said than done. There are a lot of people who want to work in potentially high-paying places, and there are just not that many hedge funds that are hiring. After months of looking, a college roommate (and current investor in Greenhaven Road) got me in for an interview with a fund in which he was invested. I knew it was essentially a courtesy interview, but it was a foot in the door, and the only door that was opening even a little bit. As part of the interview process, the portfolio manager asked me to analyze TravelCenters of America (TA). This company is a truck stop operator recently spun off from a REIT. I spent an enormous amount of time visiting truck stops, learning the ins and outs of the truck stop business, and looking at TravelCenters of America from top to bottom, which was about as sexy as it sounds. I then began looking past the numbers and started to think about the motivations of the different parties, concluding that TA was burdened with leases that were very favorable to the parent company. It was as if the REIT wanted as much of the economics as possible to flow back to the parent company at the expense of the newly public company. If I had to invest, I was more interested in the parent company than the spinoff. I also learned the fund I was interviewing with was a top 5 holder of TravelCenters of America, and it was one of their largest positions. It did not take a genius to figure out the portfolio manager liked the company. The portfolio manager did not agree with my analysis, and I did not get the job. The stock later went from $30 to $2, and the leases were renegotiated. The reason I bring up this anecdote is that the holders of those leases, the people who structured the deal, are the same people who created RMR Group – the Portnoys. These are smart people with shrewd deal-making skills.

RMR Group came public in a highly unusual manner. In 2014, the Portnoys lost a REIT management contract they had with Commonwealth REIT to two activist investors. There were multiple lawsuits and a lot of mud was slung. If there is a “story” on the Portnoys, it is that they managed the REIT for their benefit, not that of the REIT shareholders. The incentives were such that the larger the REIT was, the more the Portnoys made. Their incentives were to grow the REIT larger and larger, managing more and more properties. They were taking home $50M+ management fees annually while the REIT was dramatically underperforming its peers. To simplify, the narrative is Portnoys = greedy at the shareholders’ expense. Remember, they may be greedy, which is legal last time I checked, but they are also clever. They were managing four more REITS and they were rightfully concerned about losing the contracts for these as well. I have never written these words before, but whatever they paid their lawyers, it was worth it. The Portnoys and their legal team came up with a way to not only protect their REIT management contracts, but also to effectively make the management contracts permanent. RMR Group engaged in an “Up-C” transaction where the owners of the REITS were given shares in RMR in conjunction with their agreeing to new management contracts. This was effectively a tax efficient IPO of RMR Group that placed the shares with the owners of the managed REITS. When shares were distributed on December 14, an investor who owned $1,000 worth of REIT shares received approximately $10 worth of RMR stock – an immaterial amount. The Portnoys gave up ownership in half of their company but got shares in the managed REITS, ironclad management contracts on the REITS, and a tax asset that increases in value if the share price rises.

Let’s look at these one at a time. The shares in the REIT are straightforward and align the Portnoys and the REIT holders. The contracts have a 20-year duration that renews every year, so they are effectively perpetual contracts. The fees to break a contract are onerous, as you would expect when shrewd negotiators are putting together contracts they never want cancelled. The contracts pay both management and incentive fees, and like the truck stop contracts from years ago, are favorable to the Portnoys/RMR Group at every turn. Lastly, the tax asset created by the Up-C transaction is such that it increases in value as the shares of RMR Group increase in value. The Portnoys should care about RMR share price because they own half of the company and because it increases the value of their tax asset. In the Portnoy universe of the REITs they manage through RMR and the operating companies, RMR Group is the crown jewel; it is how they get paid, and we get to sit alongside the Portnoys.

This is a wonderful business with incredible contracts and a history of growth and aligned interests between the Portnoys and RMR holders. In essence, our investment came down to basic math and three numbers. The first is the length of the contracts – 20 years self-renewing is virtually unheard of. The second was the valuation of approximately 4X EBITDA for a high quality money management business with strong contracts. Lastly, the ratio of approximately $1 of RMR stock for every $100 of REIT stock owned creates conditions for indiscriminate sellers. More complicated math is required to understand the true tax benefits that accrue to the Portnoys because of RMR share price increases, but their 50% ownership combined with the tax benefits portend well for our investment. I believe that the conventional wisdom that Portnoy = greedy is now actually Portnoy = greedy for RMR shareholders. Given their history of entrepreneurship and creating value over time, we should have the opportunity to make money alongside them.

Scott Miller is an instructor at Wide-Moat Investing Summit 2016.

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This post has been excerpted from the Greenhaven Road Capital Q1 2016 Letter.

Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Greenhaven Road Capital Fund 1 LP and MVM Funds makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors, appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Greenhaven Road Capital Fund 1 LP and MVM Funds. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Greenhaven Road Capital Fund 1 LP and MVM Funds, which are subject to change and which Greenhaven Road Capital Fund 1 LP and MVM Funds do not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption thereunder. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.