Monday, October 25, 2010

Risk Arbitrage: Dynegy (DYN)

An ongoing transaction that is attracting attention is Blackstone Group's (BX) acquisition of Dynegy Inc (DYN). Announced on August 13, the $4.7 billion deal is facing investor opposition, and DYN has been forced to argue the merits of the transaction. The $4.50/share deal price represents a 62% premium to DYN's August 12 close. DYN was permitted to solicit alternative proposals for 40 days. In a separate deal, NRG Energy (NRG) signed an agreement with BX to purchase natural gas-fired DYN assets in California and Maine for $1.36 billion. It is the NRG agreement with BX that has caused the uproar. Here's the math: At $4.50/share, DYN's equity value is $540 million. Selling $1.36 billion of DYN assets (after the buyout) nets BX an $820 million profit at day one. Speculation was that BX would then just issued itself a dividend with these funds, and if that is the case, why wouldn't DYN just sell the assets to NRG independently and keep the gains to itself? Let's take a closer look at this risk arb situation.

DYN stands to lose a $1.9 billion credit facility after the takeover. DYN is a highly leveraged company (levered ~10x, compared to its peer group of 3.5x to 6.5x, by the company's own account) and it needs that facility. The $1.9 billion is subject to redemption upon a change of control, so the proceeds from the NRG sale are needed to replace this credit line. Let's suppose for a second that BX wanted to employ the "scorched earth" tactic, and buy DYN, sell the assets to NRG, pocket the proceeds, and just let DYN fall into bankruptcy. Well, even that cannot happen, since DYN's credit agreements do not permit any meaningful dividend to be paid. Additionally, Delaware law would not permit a public company to issue dividends with financial forecasts like DYN's (negative cash flow projected through 2015).

On September 23, DYN announced the expiration of the go-shop period, during which Goldman and Greenhill contacted 42 parties, executed eight confidentiality agreements, and did not receive any acquisition proposals. That's a pretty thorough process, so the attention is now on the November 17 shareholder vote. A press report on October 7 indicated that hedge funds would soon be disclosing positions in DYN to band together and vote against the BX deal. Also in the press was an interview with the BX professional who headed up the DYN deal team where he said that he was willing to walk away even at $4.51/share. Not really sure what the dissident shareholders want, but it would be unwise to assign a high probability to an increased offer from BX.

Sure enough, Seneca Capital disclosed a 9.3% active position in DYN on October 7. Not to be outdone, Carl Icahn followed suit with a 9.9% active position five days later, and stated that he does not "believe that the consideration agreed to in the proposed merger is adequate".

DYN has stated its case in presentations to shareholders. It argues that the BX transaction is the best alternative, and highlighted the extensive strategic review that was conducted. DYN believes that "unrealistic and unsubstantiated market speculation will significantly harm stockholder value if the Blackstone transaction is not completed". DYN said that its board had previously considered various asset sales, but any proceeds would be needed to support existing collateral needs and help fund ~$1.5 billion of currently projected negative cash flow over the next five years. Also, any asset sales would increase DYN's leverage and further limit future access to the capital markets.

Icahn is supposed to meet with DYN executives the week of October 18. It's unclear what he seeks to discuss. Some say he wants to take BX's spot and acquire DYN himself (highly unlikely). If that is the case, then he will certainly wait until after an unsuccessful shareholder vote, since the termination fee will change from $50 million to just covering $10 million of expenses. The spread has been negative since the deal's announcement and DYN closed as high as $5.10/share on September 2. Taking a position on this event is a tough call. You can't expect a white knight, and BX is disinclined to increase its offer, so going long is a risk. Also, the vote will surely be contested. As for going short, remember what happened with Cedar Fair LP (FUN)? That was a similar situation, and being short was the wrong play. If we had more clarity on the vote (i.e. conviction it would be successful) then short would be the way to go. As for now, we are merely spectators.


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.


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