Ellington Financial LLC — FY 2013 Form 10-K
Business context and reporting period. This annual report covers the year ended December 31, 2013; quarterly figures below include the three months ended December 31, 2013. The registrant is Ellington Financial LLC, a specialty finance company externally managed by an Ellington affiliate. It invests opportunistically in mortgage-related securities and loans, including non-Agency and Agency RMBS, CMBS, distressed loans, and related derivatives. It reports as a partnership for U.S. federal tax purposes and seeks to maintain exclusions from Investment Company Act registration.
Financial performance and position
| Metric | FY / year-end 2013 | FY / year-end 2012 |
|---|---|---|
| Interest income | $85.7 million | $63.9 million |
| Net investment income | $49.7 million | $24.2 million |
| Net realized and unrealized gains | $29.7 million | $73.0 million |
| Net increase in shareholders’ equity from operations | $78.5 million; $3.28 per share | $97.1 million; $5.31 per share |
| Net asset value total return, including reinvested distributions | 14.2% | 22.2% |
| Net interest margin, including swap payments | 4.19% | 4.34% |
| Cash and cash equivalents | $183.5 million | $59.1 million |
| Total assets | $3.0 billion | $2.2 billion |
| Total equity | $626.0 million | $506.4 million |
| Reverse-repo borrowings | $1.236 billion | $905.7 million |
| Diluted equity per share | $23.99 | $24.38 |
FY 2013 interest income rose with larger Agency and non-Agency portfolios. The non-Agency portfolio earned $54.7 million of interest income, at an average yield of 8.88%; Agency RMBS earned $31.0 million, at 3.40%. Average repo borrowing cost was 0.89%; including interest-rate swap payments, average cost of funds was 1.42%. The filing does not present a conventional operating margin measure.
Cash flow from operating activities was negative $244.4 million. Financing activities provided $368.8 million, including $330.4 million of net reverse-repo financing and $125.6 million of share-issuance proceeds; after dividends and other items, cash increased by $124.4 million. Management stated that available cash, portfolio cash flows, and financing were expected to meet anticipated liquidity needs.
At year-end, the company had $1.730 billion of long investments at fair value, alongside $845.6 million of investments sold short and $14.9 million of net derivative assets. Agency RMBS and TBAs were substantially hedged with short positions and derivatives. Debt-to-equity was 1.98:1; this ratio excludes liabilities other than debt financings. Reverse repos were short-term, with an average remaining maturity of 56 days, and were subject to collateral and margin requirements.
For Q4 2013, net investment income was $12.5 million and net increase in shareholders’ equity from operations was $14.9 million, or $0.58 per share. Q4 2012 comparatives were $3.7 million and $24.8 million, or $1.19 per share.
Material changes versus the prior year
- Annual operating results declined: shareholder-equity growth from operations fell to $78.5 million from $97.1 million, chiefly because realized and unrealized gains were lower, partly offset by stronger net investment income.
- The 2013 return on net asset value was 14.2%, down from 22.2%. Diluted equity per share fell from $24.38 to $23.99.
- The May 2013 share offering raised $125.3 million net. The company deployed proceeds into investments and increased portfolio size, cash holdings, and borrowing.
- Reverse-repo debt increased by about $330 million; cash rose by $124.4 million. The number of repo counterparties increased from 10 to 14.
- The company bought its first pool of non-performing residential loans in December 2013: about 200 loans, $36.2 million unpaid principal balance, purchased for approximately $24.1 million. It also expanded distressed commercial-loan and CLO activity and began buying European non-dollar RMBS.
- Interest rates rose sharply during 2013, pressuring Agency RMBS prices; non-Agency MBS generally rallied. The 10-year Treasury yield ended 2013 at 3.03%, versus 1.76% a year earlier.
Outlook, management commentary, risks and unusual items
Management expressed a positive outlook for non-Agency MBS, citing housing-market improvement and investor demand, while expecting 2014 home-price gains to moderate from 2013. It anticipated further opportunities in distressed residential loans, European non-dollar RMBS, CMBS, CLOs, and distressed commercial loans. For Agency RMBS, management expected continued volatility and saw opportunities in selected specified pools and active hedging. No numerical earnings, return, or dividend guidance was provided.
- Rates, prepayments and valuation: Changes in interest rates, mortgage prepayments, credit losses, and collateral assumptions can materially affect portfolio values, interest income, hedging results, and liquidity. Significant holdings are valued using estimates and, in many cases, Level 3 inputs.
- Leverage and liquidity: Short-term repo financing exposes the company to renewal risk, higher borrowing costs, margin calls, collateral haircuts, and forced asset sales. A large portion of repo maturities fell within 90 days.
- Credit and servicing: Non-Agency RMBS, whole loans, subordinate securities, and distressed commercial assets carry default, loss-severity, foreclosure-delay, and servicer-performance risks.
- Counterparties and hedges: Derivatives and financing depend on counterparties and clearing access. Hedges may be costly, imperfect, or ineffective and can generate losses.
- Regulatory and tax structure: Investment Company Act asset tests constrain portfolio choices. The filing also flags uncertainty around partnership tax qualification; a February 2014 tax-reform discussion draft proposed changes that, if enacted as described, could affect qualification after 2016. It was a proposal, not enacted law.
- Manager alignment and governance: The company is externally managed, pays a 1.50% annual base fee and an incentive fee of 25% above a defined hurdle, and faces conflicts involving the manager’s other accounts and allocation of investment opportunities. The management agreement was amended and restated on March 13, 2014.
- Distributions: The board approved a $0.77-per-share Q4 2013 distribution, payable March 17, 2014. Dividends are discretionary and may be reduced or suspended. As a partnership, shareholders may owe tax on allocated income even if cash distributions are insufficient to cover that tax.
- Other items: No material legal proceedings were reported. The auditor issued an unqualified opinion and reported effective internal control over financial reporting. The company reported no off-balance-sheet arrangements of the described kind.
Important facts for investors to verify
- Reconcile reported earnings, per-share results, and distributions: the filing reports $3.08 per share for 2013 quarterly dividends, while cash dividends paid during calendar 2013 also included prior-period distributions.
- Review repo maturity, haircut, collateral, and counterparty exposure, and the company’s ability to roll short-term financing during market stress.
- Assess the sensitivity of book value and income to interest-rate, prepayment, credit-loss, and fair-value assumptions, including Level 3 valuation inputs.
- Track the performance, resolution timeline, and financing of the new non-performing residential-loan pool and expanded distressed-asset investments.
- Monitor partnership tax qualification and Investment Company Act asset-test compliance, especially as the portfolio mix changes.
- Review the amended management agreement, incentive-fee calculations, termination provisions, and allocation/conflict safeguards.