Unexpected drama is unfolding with one of Canada’s leading mortgage brokerages.
Back in September we reported how DLC was making a play to retake control of itself from Founders Advantage Capital Corp (FA). The deal was to lead to increased investments in broker technology and new acquisitions of brokerages and complimentary financial services companies, among other positives.
The slump in the stock essentially reflected a “loss of excitement for the deal,” said James Bell, COO of FA.
“DLC is a great business….All you have to do is look at our financials to see that,” he said. But there were going to be “a lot of shares going out…Massive dilution…The market spoke after the announcement and it didn’t like the deal.”
With the stock price waning, and the daunting prospect of running a public company and managing all of its assets, DLC co-founders Gary Mauris and Chris Kayat felt it necessary to renegotiate the deal, Mauris said. They simply didn’t feel comfortable paying more than market price.
But FA didn’t agree to the new proposed terms.
M3’s Rumoured Interest
In the last week, multiple lenders have been telling us that they’re hearing M3 Mortgage Group is considering a bid for FA. M3 is DLC’s arch rival.
I reached out yesterday to M3’s Chairman and CEO, Luc Bernard, to verify it. He said he was unable to provide a comment on M3’s interest in FA “at this time.”
Such a deal would seemingly fit right into Bernard’s growth plans. He has stated on numerous occasions his desire to consolidate and control the mortgage broker market, and from past discussions with him, he absolutely has access to the capital needed to do a deal this size.
But it wouldn’t be easy. While FA has no poison pill to block a takeover, insiders own about 70% of the 38.2 million shares outstanding. Moreover, both FA’s board and the DLC founders must agree to any sale.
Moreover, any buyer would have to eat FA’s credit facility. That amounts to paying off about $55 million of debt principal plus $17 million in guaranteed interest.
Mauris called the prospect of an M3 takeover “very, very unlikely at any point in the future.” Perhaps when DLC’s no-sale provision expires, however, that could change.
“We’re not ready yet to leave the industry,” Mauris said. “With Eddy Cocciollo as president [of DLC], we can be more focused than ever before.”
There’s also a question of how an M3 buyout would hurt competition in the mortgage broker space. DLC Group and M3 Group have virtually formed a duopoly in the industry. Each call itself the leading non-bank mortgage originator—claims that have never been publicly confirmed. (This could be settled easily if DLC and M3 publicized their lender volume reports. That way we could see who the true leader is, because one of them is not telling the full truth.)
We asked the Competition Bureau how it would look at this kind of transaction, in which one entity controlled 4 out of 5 brokered mortgages. It told us:
“Under the Competition Act, mergers of all sizes and in all sectors of the economy are subject to review by the Commissioner of Competition to determine whether they will likely result in a substantial lessening or prevention of competition in any market in Canada.
“…It is not appropriate for the Bureau to speculate on whether a transaction would raise concerns under the Competition Act, as this can only be determined following a complete and thorough review.
“In reviewing mergers, the Bureau considers many different elements, including the level of economic concentration in the relevant markets and the merging parties’ market shares. As part of our normal approach in examining a merger, the Bureau consults with a wide range of industry participants, such as suppliers, competitors, industry associations, customers, buying groups, and industry experts.
“If the Bureau determines that a merger is likely to substantially lessen or prevent competition, it may apply to the Competition Tribunal for an order to prevent, dissolve or alter the merger.”
But loss of competition may be less of a factor in the mortgage space, since consumers have plenty of other options. Brokers control just one in three mortgages and consumers have numerous banks and credit unions they could turn to as well. It’s highly unlikely there would be any negative price impact on borrowers.
In fact, one impetus for such a merger would be for the new mega-brokerage to squeeze lenders and suppliers further. That’s a serious concern for lenders who rely on the broker channel for distribution. In fact, it could conceivably scare at least a few lenders out of the channel altogether. And God forbid if our industry loses another major bank lender.
Looking ahead, 2019 will be must-watch TV in the broker space, with this saga being a top-rated show.
On paper, FA seems undervalued, with a liquidation value that Mauris estimates near $2.50 a share (about double its current price). He adds that DLC is a cash machine. As the crown jewel in FA’s portfolio, it grew 22% year-over-year, despite a less hospitable mortgage market.
It appears the stock is caught up in a cycle of negative market sentiment, a cycle that preceded this most recent drama. For one thing, smallcap stocks have lost favour as people rotate into large caps. Small companies like this don’t have as much institutional support to begin with, reducing retail investor demand.
More than that, Mauris acknowledged that investors are “temporarily concerned about the Canadian housing market and rate risk.” That and general economic concerns are weighing on the entire sector. Look no further than the bank stocks for evidence of that.
S&P TSX Banks Index (Source: TMX)
On top of it all, we’re looking at oncoming digital competition from major lenders (which could create a speed of approval advantage for banks versus brokers), greater influence of rate comparison websites (which weighs on interest margins) and a push by lenders—including broker-channel lenders—to sell mortgages direct-to-consumer (online with discounted rates).
How it Could All Shake Out
“We may get another partner at Founders,” Mauris said, while allowing for the possibility that someone comes in and makes a bid for FA’s shares.
“We’ll [only] approve a partner that we think is a good fit,” he added, but “Nobody’s buying [DLC] unless we run it…A takeover doesn’t give you management control, only share control.”
Another possibility is that Mauris & Co. renegotiate to buy the company back from FA. “Our relationship with Founders is not broken. I like the guys at Founders,” says Mauris.
Mind you, it’s hard to envision FA doing another similar deal with DLC management. Anything’s possible, Bell said, but “Cancelling a deal like this [was] a big step.” We get the sense that it’s unlikely FA would revisit another deal with DLC’s founders unless (perhaps) the stock price rebounded above $1.75-ish.
One thing we do know is that betting against Mauris and Kayat has been a bad bet. When they launched DLC in 2006, few gave them a chance to unseat the superbrokers of the day. They did. Few outsiders thought brokers would re-sign DLC’s long-term contracts when they came up for renewal. They did (well over 90% have, Mauris said). And fewer yet believed that DLC could post strong growth in an incredibly difficult regulatory environment. They did.
Regardless of how this unfolds, DLC Group brokers clearly have some of the industry’s most proven leadership behind them, leaders who are acutely aware of how the market is changing, and how they need to adapt to succeed.
For now, DLC Group’s management will remain patient and try to use market weakness to the company’s advantage. “I wouldn’t have pulled out of the deal if I didn’t think there’d be a better outcome,” says Mauris.