Monday, March 15, 2010
As an arbitrageur, I’m often asked what companies I expect to be taken over soon. Most people do not realize that this is not what arbs do. It’s the job of bankers and the corporate development folk to determine which companies to buy. Arbs evaluate and take positions in situations that have already been announced, whether friendly or hostile. Friendly transactions are simpler to handle, since the terms, conditions, and timeline are all known. Unsolicited offers are a bit more complex. Let’s walk through a current example merger arbitrage example of the latter.
On March 2, Elliott Associates (a hedge fund concern with a smattering of private equity totaling over $16 billion in AUM) proposed to acquire Novell Inc (NOVL) for $5.75/share, 21% above its last closing price. Elliott currently holds 8.5% of NOVL. The proposal is subject to confirmatory due diligence, and obtaining financing is not a condition to deal completion. Elliott noted that they “intend to work with financing sources”, so it would be no surprise that, in its response, NOVL says that the lack of committed financing makes the proposal highly conditional. Elliott noted that NOVL’s cash balance represents almost 60% of its market cap, though a significant portion of that cash is overseas, and may not be realized in a tax-efficient manner.
The offer price values NOVL at 1.24x its 2010 consensus revenue. We need to determine if this is a fair price, so let’s first look to NOVL’s closest comps. They appear to be trading at a multiple of 1.55x. Admittedly, there is no perfect comp, but, all things equal, an agreement is unlikely to be reached at a 25% valuation discount to its peers. For a transaction multiple, Elliott tried to acquire Epicor Software Corp (EPIC) back in October 2008 for 1.5x forward revenues estimate. The EPIC valuation is on the low end, as other deals in the space have been executed as high as 6x.
An important aspect of any transaction, specifically in an unsolicited situation, is the bidder. How credible are they? How is their access to financing? Have they done deals in the past? Now, Elliott is a firm I respect. Paul Singer has been in the business for over three decades, first as an attorney for Donaldson Lufkin & Jenrette, and then founding Elliott as a convertible arbitrage shop. The firm eventually branched into the multi-strategy fund that it is today. Looking at the NOVL press release, Elliott’s history immediately came to mind.
Elliott made an offer to acquire EPIC in late 2008 for $9.50/share, a 20% premium to the prior closing price, and said that it would potentially offer a higher price if allowed access to due diligence. At the time of the proposal, Elliott owned 10% of EPIC, and increased its holdings to 12% two weeks later. After no negotiations with EPIC management, Elliott commenced a tender offer, which EPIC recommended that shareholders reject. A month after the proposal, the offer was lowered to $7.50/share, as Elliott stated that it was not granted due diligence. Elliott terminated the tender offer in late November, citing the recommendation from EPIC’s management that shareholders reject the offer.
Two things are key in the EPIC offer, and deciding which one to weigh more heavily could justify how one views the offer for NOVL. First, this is late 2008. Lehman had already failed, and all markets were in a tailspin. It’s very easy to believe that Elliott saw the environment as an inopportune time to pursue EPIC, and therefore it did not put up any fight to management’s rejection. The second route is to take Elliott literally, and believe that the any exogenous influence (the market) was not outcome determinative. This implies that Elliott merely did not want to continue without management support, and without such, it discontinued the offer. However, I’m more of a believer in the former theory. Elliott initially stated that its $9.50/share offer could be increased if due diligence merits a higher price. So, Elliott saw at least $9.50/share of value just from public information. To this, I ask, why did they lower the offer to $7.50/share after they were not granted the access? What information changed to warrant a material decrease in the offer price? Did they really expect any shareholders to tender to the lower offer? I would argue no, and that the overall markets were really a factor. Therefore, this makes me skeptical of Elliott’s stated intentions. Why didn’t they just cite the deteriorating condition of the financial markets, as companies have done in the past?
It is from this thinking that I question the commitment Elliott has to taking NOVL private. Remember, Elliott has an 8.5% position, so it could be drumming up interest from another bidder. Putting the firm in play could be its true intention. Indeed, NOVL’s under-utilized assets and bloated compensation structure could be remedied by a strategic acquirer.
I’m still on the sidelines with this risk arb transaction, but it is something to watch closely.