Monday, November 29, 2010

Risk Arbitrage: Update on Dynegy

The landscape for Dynegy Inc (DYN) has changed drastically since we last discussed the company. Blackstone Group (BX) increased its offer from $4.50 to $5/share on November 16. The 11% increase was given no justification by BX. Sure, Seneca Capital and Carl Icahn opposed the transaction, but recall that BX’s energy investment team head, David Foley, said in October that BX was willing to walk away even at $4.51/share. Also, BX re-confirmed $4.50/share the day before it increased the offer. While it lacks brevity, we include the statement in full, as it is indeed a gem.
Blackstone Capital Partners V L.P. today re-confirmed its affiliate’s $4.50 per share cash offer under the previously announced merger agreement with Dynegy Inc. (NYSE: DYN). This price represents a 62% premium to Dynegy’s closing share price on August 12th, the day prior to the announcement of the transaction.

The Blackstone transaction has been recommended by ISS, the leading independent proxy advisory firm. If the transaction does not occur, ISS has estimated that the value of Dynegy would be $2.66 per share. Blackstone’s offer represents a 69% premium to this ISS estimate.
Blackstone’s substantial cash premium offer to Dynegy’s shareholders is subject to the receipt of an affirmative vote of 50% of Dynegy’s total outstanding shares. The shareholder vote will occur at 10AM, Houston time, on Wednesday, November 17th.

Blackstone has not previously made any public communications to Dynegy shareholders, but believes investors must understand certain facts which, to date, have often been obscured by the large volume of erroneous information presented by other parties. In summary:
  • Seneca has no credibility in claiming that $4.50 per share is an inadequate price because it sold 700,000 Dynegy shares at $2.93 per share on the day before the proposed merger was announced. Blackstone’s offer represents a 54% premium to the price at which Seneca sold these shares. We fail to understand how any self-described successful investor in the power sector could have so significantly undervalued its investment.
  • Seneca’s past involvement as an activist investor with Reliant Energy and TransAlta was followed by significant losses in shareholder value.
  • Seneca’s only proposed Dynegy board nominee with power industry experience, Jeff Hunter, works for a competitor of Dynegy, and his election to the Dynegy board would raise serious antitrust issues. Further, Seneca misstated the ability of Mr. Hunter to serve “in an interim management role” in its SEC filings.
  • Carl Icahn’s incomplete and non-binding proposal to provide Dynegy with liquidity through 2012 does not fundamentally address the long-term liquidity challenges Dynegy currently faces. Moreover, access to liquidity, in and of itself, does not build value.
In evaluating Seneca’s campaign, Dynegy’s shareholders should be aware that Seneca Capital Investments, L.P. has experienced an 86% decline in its self-reported 13(f) securities under management (13F filings report more than $3.5 billion under management at June 30, 2007 versus $485 million as of June 30, 2010).

Seneca cites its successful track record as a long-term investor in the power and energy sector, but a closer look at the facts of their involvement in several prior power investments does not provide a basis for concluding that Seneca’s involvement with Dynegy will add value.

  • Texas Genco. Over the twelve month period from June 2003 to June 2004, Seneca reduced its stake in Texas Genco by 81%, from 987,400 to 183,000 shares, with most of such divested shares being sold during a period when the volume-weighted average price of Texas Genco was $23.45 per share. In July 2004, Texas Genco entered into a merger agreement to sell itself at $47.00 per share. After this transaction was announced, Seneca acquired 370,300 Texas Genco shares during a period when the volume-weighted average price was $46.41, but the deal was nonetheless consummated at the originally proposed share price.
  • Reliant Energy. Within a year after Seneca’s successful effort in August 2006 to add a nominee designated by institutional investors to Reliant’s Board, Seneca sold 86% of its Reliant stake. Following the addition of this director to the Board, long-term shareholders who continued to hold their shares suffered a loss of more than 71% of their equity value.
  • TransAlta. Seneca campaigned to block a July 2008 bid by Global Infrastructure Partners (GIP) and LS Power Equity Partners (LS Power) to acquire TransAlta. The GIP and LS Power offer was at C$39/share. Following opposition to the deal, including Seneca’s opposition, GIP and LS Power withdrew their offer. TransAlta shares subsequently fell and recently closed at C$20.41, a 48% decline from the GIP/LS Power offer price.
Three months have passed since the announcement of the Blackstone transaction, and Seneca has yet to advance a credible plan to create value above the $4.50 per share deal price. Their only specific proposal is to suggest that they would nominate two directors to Dynegy’s Board.
  • Seneca proclaimed that one of its prospective nominees, Jeff Hunter, would have the ability “to assist in an interim management role” with Dynegy. In response, Mr. Hunter’s current employer, US PowerGen, promptly issued a press release stating that Mr. Hunter did not have permission to serve in any management capacity at Dynegy.
  • Mr. Hunter, as Chief Financial Officer, was a key member of senior management that engineered US PowerGen’s 2007 acquisition of BostonGen for $3.2 billion. This acquisition ended unsuccessfully when BostonGen filed for Chapter 11 bankruptcy protection in August of this year. BostonGen is now in the process of being sold for $1.1 billion to Constellation Energy Group.
  • US PowerGen is a merchant power company that competes with Dynegy in the New York and New England markets. There will be a conflict of interest and potential antitrust issues if Mr. Hunter, an executive officer and equity owner of US PowerGen, also serves as a board member of Dynegy, with access to Dynegy’s confidential information relating to those competing markets.
  • The simple fact is that Seneca does not have a history of effecting positive change via board representation. Indeed, Seneca’s own Founder, Doug Hirsch, served as a board member at GMAC from 2006 until his departure in May 2009, when he left the board in the wake of approximately $12.5 billion of bailout assistance to GMAC.
Finally, Carl Icahn’s incomplete and non-binding proposal (submitted three business days prior to the shareholder vote) to replace Dynegy’s existing credit facility, even if it buys the Company some time, will present a day of reckoning at its initial maturity in 2012. If the company cannot repay or replace the Icahn credit facility upon maturity, Mr. Icahn would be in a commanding position to declare a default and force a bankruptcy filing in which he would rank ahead of existing bondholders and shareholders of Dynegy. Under those circumstances, Mr. Icahn, as Dynegy’s most senior creditor, would be in a privileged position to acquire the Company for the value of his debt. Even if asset sales were to occur (as would be permitted under his preliminary proposal), the consequence would simply make it more likely that his credit facility would be repaid at maturity. From the perspective of Dynegy shareholders, though, selling assets will exacerbate the $1.6 billion of negative free cash flow projected by the Company between now and 2015, making even more acute the continuing risks being borne by such shareholders.

While Mr. Icahn has implicitly suggested he could be a bidder for Dynegy if the Dynegy/Blackstone transaction is voted down, this interest at an unspecified valuation is inconsistent with Mr. Icahn’s failure to engage with the company during its two year “pre-shop” and the more recent, widely publicized, 40-day “go-shop” period. Indeed, unlike eight other parties, Mr. Icahn did not execute a non-disclosure agreement to receive confidential information during the go-shop period.

Blackstone believes that its offer of $4.50 per share, which represents a 62% premium to the unaffected share price and a 69% premium to the ISS estimate of Dynegy’s value if the Blackstone transaction is not consummated, remains a full and fair valuation and eliminates the substantial downside risk that will result from the failure of the merger to be approved by stockholders.
We agree with each argument BX makes. While it was refreshing to see BX finally come out in support of the original transaction, it was equally dismaying that the offer was increased the following day with no explanation. It’s things like this that make arbitrage frustrating at times. Even being the consummate skeptics that we are, if you can’t take BX at its word on the cogent argument included above then it makes investing in the space that much more difficult. And of course DYN traded through $5/share after the deal price was revised, because who is going to believe BX’s “best and final offer” language after how they have conducted themselves up until this point. One needs only to listen to Stephen Schwarzman on a conference call or any other public forum to know that he is two sandwiches shy of a picnic basket, but it is widely understood that Tony James has run the show at BX since his arrival in 2002, and we expected more from him than this.

Naturally, Seneca and Icahn continued to oppose the new price. The shareholder vote was postponed from November 17 to November 23. On the morning of the 23rd, DYN announced that it intends to immediately commence an open strategic alternatives process (thereby caving to Icahn). DYN said that it anticipates that the BX proposal will not receive the necessary votes to be adopted, and that while they intend to terminate the agreement, the shareholder vote will still be held. Admittedly, we are not M&A bankers in the Power sector, but the go-shop period that had 42 parties contacted and eight confidentiality agreements executed seems pretty thorough to us. DYN also adopted a shareholder rights plan which they state is not intended to prevent a sale of the company, but “to prevent any person from obtaining control or de facto control of Dynegy without offering a control premium”. The plan has a 10% threshold.

Sure enough, the necessary votes were not received and the merger was terminated. We wish them well, but DYN shareholders are likely to learn just like Dollar Thrifty Automotive Group (DTG) shareholders did that a bird in the hand is worth two in the bush.

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Monday, November 15, 2010

Risk Arb: Syniverse (SVR)

Merger arbitrage investing has long been likened to "picking up pennies in front of a steamroller". The idea behind that statement is that the strategy will not generate outsized returns (though some individual transaction can), and if you are not careful there can be significant downside. Done successfully, arbitrage provides steady, uncorrelated returns. A current transaction that can pay the bills is Syniverse Holdings Inc's (SVR) pending acquisition by the Carlyle Group.

SVR is a leading provider of technology and business solutions for the global telecommunications industry, providing a full portfolio of mobile roaming, messaging and network solutions. On October 28, SVR announced that it entered into a definitive agreement to be acquired by Carlyle for $31/share, or $2.6 billion. The deal price values SVR at 10.8x LTM EBITDA. SVR's five-year average multiple is 8.3x, with a high of 12.0x in December 2005 and a low of 5.3x in December 2008. SVR's peer's have traded at an average of 7.5x. Prior to the $31/share deal (which was a 30% premium to SVR's prior close), the stock traded over the previous five years at an average of ~$16/share, with a range of ~$7 to $24/share. We have discussed the importance of a control premium in earlier posts, and it is represented in this buyout. The transaction has fully committed financing, consisting of equity provided by Carlyle Partners V, a $13.7 billion buyout fund, and debt provided by Barclays Capital and Credit Suisse.

In late July, SVR terminated its shareholder rights plan (poison pill) "in light of the returned stability and orderly trading" of SVR shares. The plan was implemented in late 2008 with a 15% trigger. Removal of a pill implies a company is no longer concerned with a shareholder taking a large position. It would not be far-fetched to presume that CVR was considering its strategic options as far back as July. With further concatenation, one might believe that the company was well-shopped to other potential buyers, given the late July to late October time frame.

The preliminary proxy has not been released yet, so we do not know how negotiations proceeded, however a press report last week indicated that NeuStar Inc (NSR) was involved in the bidding process. It's encouraging to own a company that more than one suitor pursued. So, to run through a brief checklist, the valuation is fair (shareholder approval should not be an issue), financing is secured, and there is no regulatory risk (usually the case with a PE buyer). Not a bad risk arb situation for an allocation of capital with a 10% return annualized to a late January close.

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About the Authors

Hunter is the founder of the Distressed Debt Investing Blog and the Distressed Debt Investors Club. He has worked on the buy side for the past 7 years in high yield and distressed debt investing.

Edward has been a professional investor for four years, focusing mainly on the event-driven space. His investment philosophy is value-based, and he spends the majority of his time identifying near-term catalyst based opportunities.

Email

hunter [at] distressed-debt-investing [dot] com