Following the management externalization transaction (the “Externalization”), which was approved by holders of approximately 83% of the Company’s stock on May 23, 2013, the Company became externally-managed by the Manager. Pursuant to the terms of the Management Agreement, the Company pays the Manager a management fee and the Manager pays all of the compensation to Annaly’s management personnel (including the NEOs). The Compensation Committee annually reviews the management fee and the performance of the Manager, including the achievements discussed beginning on page 7. The Independent Directors then consider the Compensation Committee’s recommendations when determining whether to renew or amend the terms of the Management Agreement. Based on the review and factors described in more detail below, the Independent Directors have determined that the Management Agreement continues to be in the best interests of the Company and its stockholders. For additional information, see “Certain Relationships and Related Party Transactions”, “Compensation Paid by the Manager to the Named Executive Officers” and “Compensation Discussion and Analysis.”
Management Agreement Terms
The Compensation Committee believes that the terms and conditions of the Management Agreement compare favorably to the terms and conditions that exist between Annaly’s externally-managed mREIT peers and their respective managers. In particular, as illustrated by the table below, when compared to the median for the peer comparison, (i) the management fee paid to the Manager is lower as a percentage of stockholders’ equity, (ii) the term of the Management Agreement was of a shorter duration, and (iii) the Management Agreement has no termination fee, which is expressed in the table below as a multiple of trailing average annual management fees.
|Agency Residential REITs|
|Base management fee(1)||1.29%||1.29%||1.20%||1.37%||1.05%|
|Initial term in years||6.0||6.0||2.0||10.0||2.0|
|Termination fee multiple(2)||4.2x||4.2x||3.0x||5.3x||None|
|Base management fee||1.50%||1.50%||1.50%||1.50%||1.05%|
|Initial term in years||2.8||3.0||2.0||3.0||2.0|
|Termination fee multiple||3.2x||3.0x||3.0x||4.0x||None|
|Incentive fee(3)||20% above||20% above||None||25% above|
|8% hurdle||8% hurdle||8% hurdle||None|
|Non-Agency Residential/Hybrid REITs|
|Base management fee(4)||1.49%||1.50%||1.41%||1.50%||1.05%|
|Initial term in years||4.0||3.0||1.0||15.0||2.0|
|Termination fee multiple(5)||2.9x||3.0x||1.0x||5.0x||None|
|Incentive fee(6)||N/A||N/A||~15% above||35% above||None|
|~12% hurdle||12.5% hurdle|
Source: Public filings as of year ended December 31, 2017. All base management fees are calculated as a percentage of stockholders’ equity and all termination fees are calculated as a multiple of the average annual base management fee during the prior 24-month period, except as otherwise specified below. Agency Residential REITs represent the externally-managed agency mortgage REITs included in the BBREMTG Index as of December 31, 2017 and includes Anworth Mortgage Asset Corporation (“ANH”) and ARMOUR Residential REIT, Inc. (“ARR”). Commercial REITs represent the externally-managed commercial mortgage REITs included in the BBREMTG Index as of December 31, 2017 and includes Blackstone Mortgage Trust, Inc. (“BXMT”), Ares Commercial Real Estate Corp. (“ACRE”), Resource Capital Corp. (“RSO”), Apollo Commercial Real Estate Finance, Inc. (“ARI”), Starwood Property Trust (“STWD”) and Sutherland Asset Management (“SLD”). Non-Agency Residential / Hybrid REITs represents the externally-managed non-agency residential and hybrid mortgage REITs included in the BBREMTG Index as of December 31, 2017 and includes New Residential Investment Corp. (“NRZ”), Two Harbors Investment Corp. (“TWO”), Invesco Mortgage Capital, Inc. (“IVR”), PennyMac Mortgage Investment Trust (“PMT”), MTGE Investment Corp. (“MTGE”), New York Mortgage Trust Inc. (“NYMT”), AG Mortgage Investment Trust, Inc. (“MITT”), Orchid Island Capital, Inc. (“ORC”), Western Asset Mortgage (“WMC”), Great Ajax Corp (“AJX”), Cherry Hill Mortgage Investment Corp. (“CHMI”), Ellington Residential Mortgage REIT (“EARN”), and Five Oaks Investment Corp. (“OAKS”).
For ARR, base management fee is calculated as 1.50% of gross equity raised up to $1.0 billion plus 0.75% of gross equity raised in excess of $1.0 billion.
ARR’s termination fee is calculated as the greater of (a) the base management fee calculated prior to the effective date of agreement termination for the remainder of the term or (b) 3x the base management fee during the preceding full 12 months.
Of the six Commercial REITs, five have incentive fees in addition to their base management fees. STWD and RSO have incentive fees of 20% above an 8% hurdle. BXMT has an incentive fee of 20% above a 7% hurdle. RSO has an incentive fee of 25% above an 8% hurdle. SLD has an incentive fee of 15% above an 8% hurdle. For purposes of this table, the calculation of the mean includes only the five Commercial REITs that have incentive fees.
NYMT only pays base management and incentive fees with respect to its distressed residential loan strategy. NYMT’s base management fee is calculated as 1.50% of invested capital in distressed residential mortgage loans.
NRZ’s termination fee is calculated using the prior 12-month period. Pursuant to the terms of its management agreement, PMT’s termination fee is calculated as a multiple of the base management fee and a performance incentive fee. For purposes of this table, any impact from this performance incentive fee on PMT’s termination fee multiple has been disregarded.
Of the 13 Non-Agency Residential/Hybrid REITs, four have incentive fees in addition to their base management fees. NRZ has an incentive fee of 25% above a 10% hurdle. PMT has an incentive fee with a sliding scale beginning above 8%. NYMT has an incentive fee of 35% above a 12.5% hurdle. AJX has an incentive fee of 20% above an 8% hurdle. For purposes of this table, the calculation of the mean includes only the four Non-Agency Residential/Hybrid REITs that have incentive fees.
Structure and Amount of the Management Fee
The Compensation Committee annually reviews both the structure of the management fee as well as the amount of such fee to determine whether they incentivize the Manager to work towards the Company’s desired goals to the benefit of long-term stockholder interests. The Compensation Committee has determined that the use of a management fee formulated as a percentage of stockholders’ equity (as defined in the Management Agreement) represents a responsible and prudent method of compensating the Manager. In particular, in the context of an mREIT that uses leverage as a key component of its business strategy, the Compensation Committee believes that providing for a contractually required payment structured as an “incentive fee” may misalign the goals of the Manager from those of the stockholders.
Moreover, the Compensation Committee believes that a management fee that is based upon stockholders’ equity (along with the stock ownership guidelines discussed on page 47) aligns the management team to the goals of the Company, and that focusing the management fee on the preservation and growth of the Company’s book value incentivizes the Manager to achieve long-term performance that protects stockholders’ equity as realized losses decrease such equity and, ultimately, the management fee.
Additionally, for the Manager to earn a larger management fee, the stockholders’ equity of the Company would need to increase. As a result, the growth of the stockholders’ equity is an alignment between the interests of stockholders and the Manager. Further, this alignment is stronger in the REIT industry than in other businesses. REIT regulations require the Company to pay at least 90% of its earnings to stockholders as dividends. As a result, unlike most companies, Annaly cannot grow its business and book value by reinvesting its earnings. This places a unique market discipline on the Company.
The Compensation Committee also believes that the structure of the management fee is more favorable to the Company’s stockholders than if the fee was based on total assets under management, which could potentially incentivize an external manager to excessively leverage assets under management in an attempt to increase short-term incentive payouts.
Clawback for the Management Fee
Pursuant to the 2016 amendment and restatement of the Management Agreement, the Company is entitled to receive reimbursement from the Manager if the Board determines that a computation error (regardless of the reason for or amount of such error) resulted in the overpayment of a management fee to the Manager.
CONTINUED COST SAVINGS RELATED TO THE EXTERNALIZATION
The Compensation Committee believes that the Externalization has materially reduced the Company’s compensation-related costs. When comparing the management fees the Company paid for the fiscal years ended December 31, 2013, 2014, 2015, 2016 and 2017 against the estimated compensation costs (including tax costs) the Company would have paid for the same period if those costs remained what they were in 2012, management estimates that the Externalization has resulted in total compensation savings, including tax savings, (calculated in accordance with GAAP) of approximately $276 million.
As illustrated by the table below, the management fee for each of 2013(1), 2014, 2015, 2016 and 2017 is significantly lower than the Company’s 2012 compensation expenses (which is represented by the dark gray line):
Management Fee/Compensation Expense(2),(3)
Although the Manager commenced management of Annaly on July 1, 2013, the Company’s stockholders received the benefit of the compensation savings created by the Externalization for the entire 2013 calendar year pursuant to a pro forma adjustment to the 2013 management fee. The Manager calculated a pro forma management fee, which was the management fee as if the Company was managed by the Manager from January 1, 2013 until July 1, 2013, and the actual amount of cash compensation paid to all of Annaly’s employees from January 1, 2013 until July 1, 2013 reduced the amount of the management fee owed to the Manager.
Assumes compensation costs for each of 2013, 2014, 2015, 2016 and 2017 would have remained what they were in 2012 (the last full year prior to the Externalization).
Gray shaded area represents compensations savings (exclusive of tax savings).
ANNUAL REVIEW OF MANAGER PERFORMANCE AND MANAGEMENT FEE CONSIDERATIONS
The Compensation Committee annually reviews the Manager’s performance and management fee against both historical results and the Company’s mREIT peers, based on a number of metrics, including those discussed above in the “Proxy Summary” and the expense ratios discussed below.
Peer Comparison of Operating Expenses as a Percentage of Average Assets and Average Stockholders’ Equity
The Compensation Committee reviews the Company’s total operating expenses (including the management fee), as a percentage of both average assets and average stockholders’ equity, among other metrics. The Compensation Committee believes these ratios, which allow comparison of the Manager’s performance against the Company’s internally- and externally-managed mREIT peers, measure the extent to which the Manager operates in an economically efficient manner.
Operating Expense as a Percentage of Average Assets
Operating Expense as a Percentage of Average Equity
Source: Company Filings, SNL and Bloomberg. Averages are market weighted based on market capitalization as of Dec. 31st of each respective year. Note: Internally-Managed Peers and Externally-Managed Peers represent the respective internally- and externally-managed members of the BBREMTG Index as of December 31st of each respective year. The average for each excludes Annaly and companies during years in which they became public or first listed. Operating Expense is defined as: (i) for Internally-Managed Peers, the sum of compensation & benefits, general & administrative expenses and other operating expenses, and (ii) for Externally-Managed Peers and Annaly, the sum of net management fees, compensation & benefits (if any), general & administrative expenses and other operating expenses. Annaly’s 2016 operating expenses exclude costs of $49 million related to the Company’s acquisition of Hatteras Financial Corp.
In its review of these operating expense ratios, the Compensation Committee noted that the Company has outperformed both its internally- and externally-managed mREIT peers over the last six fiscal years. In this regard, the Compensation Committee has viewed the Company’s performance as an indicator that, among other things, the Manager has managed the Company in an efficient manner with appropriately scaled operating costs (including the management fee).