Wednesday, March 4, 2009

A look at Western's purchase of Mustang Capital

Western agreed to purchase a 51% interest in Mustang Capital Advisors in the first quarter of 2008. Here are the numbers for Mustang from 2006 through 2008. All amounts are in dollars.

Year 2008(9 months)2007 2006
Operating income (Management fee income less operating expenses) 282,524 (376,698 annualized) 234,070 148,346
Net portfolio income - 3,006,532 1,541,847
Portfolio income, net of minority interests - 613,063 374,591
Assets in portfolio @ end of year - 13,629,075 10,824,470
Minority interest in assets - 12,672,954 10,279,485

Source for numbers above and calculations below:
There are 2 sources of income for Mustang:
a. The management fee income that accrues from providing investment advice to third parties.
b. The performance incentive (20% allocation) for beating a hurdle rate of 4% on the actively managed funds, the size of which is reflected by the row titled ‘Minority interest in assets’ in the table above. The estimated returns for 2006 and 2007(assuming no deposits/withdrawals during the year) look pretty good at 16.6% and 27.78%. 2008 has been difficult, with the equity portfolio down $347,132 on a cost basis of $6,348,528 as of Sept 30, 2008. I'd expect that the decline has continued through the rest of the year.

The segment that provides the management fee income has been growing nicely, as can be seen from the numbers above. The portfolio income, dependent as it is on market values for the securities held, is a little harder to evaluate. Let’s assume that John Linnartz, the fund manager at Mustang, and the managers that will succeed him, are able to invest the assets at 6% in perpetuity. We’ll also make the assumption that the capital invested in the funds remains the same i.e. all returns are distributed to the investors in the funds. The portfolio income is therefore 20% of the excess spread (6%-4% = 2%) on a capital of approximately $12.6 million (the incentive allocation is only on the minority interest in the funds). This works out to $50,400 annually. The value of this income stream in perpetuity, discounted at an opportunity cost of 15%, is $336,000.

There is also about $1 million in capital in the funds that belongs to the general/limited partners in the funds (essentially John). Let’s say that this was worth “book” value at the end of 2007 i.e. 1 million.

So, at the end of 2007:
Mustang’s value = Book value of capital of general/limited partners + Value of the actively managed funds + Value of the management fee income stream
= $ 1 million + $336,000 + Value of the management fee income stream

Western’s purchase price, for a 51% interest in Mustang = $ 1.173 million ($300, 000 in cash + rest in Western stock)
Implied value of Mustang based on Western’s purchase price = $2.3 million

Value of the management fee income stream (inferred from value of Mustang above) = $2.3 million - $1.336 million = .96 million
Implied multiple on 2006 operating earnings (lowest of the 3 years) = 6.5
Implied multiple on estimated 2008 operating earnings (highest of the 3 years) = 3.4

For a business with little on-going capital expenditure requirements, these are great multiples on what can reasonably be expected to be recurrent earnings, if you are the buyer. When you factor in the conservativeness of the assumptions (6% returns on managed funds, payout of all returns), this seems like a steal for Western. A few possibilities that lend themselves as possible explanations are:
1. I am missing something in my valuation (always possible).
2. The assumptions underlying the valuation of the managed funds are not as conservative as I think they are.
3. John’s estimate of the value of Western’s stock was higher than it was trading for at the time of purchase ($16/share). In fact, I’d go as far as to speculate that without Western’s stock comprising a majority of the purchase price that this deal wouldn’t have gone through for the price that it apparently did.

Often wrong but seldom in doubt,

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