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Mortgage REIT's odyssey continues with M&A deal

The unusualhistory of Sutherland Asset ManagementCorp. took another turn on April 7 with the announcement of the proposed combination of the externally managed mortgageREIT with ZAIS Financial Corp

The dealrepresents the latest example of consolidation in a mortgage REIT sector in whichmany stocks, including that of ZAIS Financial, continue to sell at significant discountsto their year-end 2015 book values per share.

SutherlandAsset Management expects the proposed transaction will allow it deploy an expandedcapital base in support of its current strategy of investing in small-balance commercialmortgage market — an area that the mortgage REIT continues to view as . It alsoprovides a path to a broader public currency with an NYSE-listed stock that twiceeluded mortgage REITs operating under the Sutherland Asset Management name throughproposed initial publicofferings that were later postponed: first in July 2009 and then in January 2015.

The mortgage REIT planned to initially invest in nonagency RMBSat the time of its first attempt at an IPO, a period in which its management viewedthat market as facing "extreme" distress. The current iteration of SutherlandAsset Management, with its small-balance commercial focus, traces its roots to August2007. Its business had been operated as part of Waterfall AssetManagement LLC's Victoria series of funds. The Victoria funds latercontributed its small-balance commercial loans to Sutherland Asset Management'soperating partnership in 2011 and Sutherland Asset Management formed small-balancecommercial originator ReadyCap CommercialLLC in 2012, setting the stage for the mortgage REIT to raise $226 millionof equity capital in a 2013 private placement and engage in a series of formativetransactions.

The mortgageREIT's success in the small-business commercial space preceded its October 2014filing of an IPO registration statement with the SEC on Form S-11 — a document itmost recently amendedin December 2015. That filing indicated that Waterfall Asset Management had identifiedloans with unpaid principal balance of approximately $2.3 billion for acquisitionas of Sept. 30, 2015. No subsequent filings containing proposed terms of a prospectiveIPO had been submitted through April 6.

Two mortgageREITs under current SNL coverage completed IPOs during 2015, but both of those deals,offerings by Great Ajax Corp.and Jernigan Capital,closed in the first quarter of that year as market conditions became increasingmore challenging thereafter. And the sector has been consolidating rather than expandingof late, with the announcement of the proposedcombination of Apollo Commercial RealEstate Finance Inc. and ApolloResidential Mortgage Inc. as well as the recently closed dealinvolving ARMOUR Residential REITInc. and JAVELIN MortgageInvestment Corp.

Of the41 mortgage REITs with total market capitalization of more than $10 million underSNL coverage as of the April 6 market close, only four closed at a premium to theirDec. 31, 2015, book values per share: StarwoodProperty Trust Inc., RAITFinancial Trust, HannonArmstrong Sustainable Infrastructure Capital Inc. and The median price-to-bookratio among the group was 80.1%.

ZAISFinancial's stock closed April 6 at 73.8% of its Dec. 31, 2015, book value. Theshares had been under significant selling pressure earlier in 2016, closing in earlyFebruary generally at price-to-book ratios in the low-60% range. The pro forma exchangeratio provided in theApril 7 announcement would value the shares at 91.6% of adjusted Dec. 31, 2015,book value. The cash tender offer of up to $64.3 million in proceeds would be madeat a price said to be equal to 95% of ZAIS Financial's adjusted book value per share.The final exchange ratio and cash tender offer price are subject to adjustment underterms of the merger agreement.

ZAISFinancial completed its IPO, which raised gross proceeds of $120.1 million includingthe underwriters' overallotment option in February 2013. The mortgage REIT's shareswere priced at $21.25 in that deal. Within the past 12 months, ZAIS Financial'sshares have traded no higher than $19, apiece, and they topped out at $16 on anintraday basis on April 7 following the release of the merger news, before retreatingto a close at $14.91.

The dealcalls for Sutherland Asset Management to merge into a subsidiary to be formed byZAIS Financial. The subsidiary will be the surviving entity of that transaction.ZAIS Financial will be renamed Sutherland Asset Management. It will terminate itsexisting management agreement with ZAISGroup LLC, an affiliate of ZAISGroup Holdings Inc., and enter a new one with Sutherland Asset Management'sexisting external manager.

Upon completion of the merger, the surviving company will continueto focus on small-balance commercial lending with a targeted equity allocation ofabout 10% to residential mortgages, which has served as ZAIS Financial's area ofemphasis. The mortgage REIT originates, acquires, finances, sells andservices residential mortgage assets, including loans, nonagency RMBS and mortgageservicing rights.

Sutherland Asset Management said the combined entity would havea stockholders' equity base in excess of $550 million, assuming that the tenderoffer is fully subscribed. The deal also provides a public equity currency thatthe mortgage REIT said would enhance its access to the capital markets. Shares ofSutherland Asset Management, which would be approximately 84% owned by its existingshareholders and 16% owned by ZAIS Financial shareholders, would be publicly tradedon the NYSE under the symbol "SLD."

For ZAIS Financial, the announcement marks the beginning of theend of a strategic review process management revealed in November 2015. The mortgage REIT said at thetime it would consider a sale, combination or liquidation of the company or otherpossible transactions. It announcedon March 9 in conjunction with its fourth-quarter 2015 earnings release that itwas in preliminary discussions regarding a merger or sale transaction. Concurrentwith that news, the mortgage REIT said it had stopped purchasing newly originatedresidential mortgage loans in its conduit business, planned to unwind the conduitbusiness and expected to begin selling whole-loan assets from its mortgage investmentsegment.