Monday, March 29, 2010
To successfully follow risk arbitrage, one must have a solid understanding of the legal process. We do not have a JDs (it is in no way required, though it makes the learning curve less daunting), but both of us spend many hours a week analyzing legal documents. I also attend any court hearings or trials relevant to the deals I’m following. Long ago I stopped trusting live webcasts of proceedings, as my luck would have the feed cut out right before an important announcement. We will discuss at length the legal aspects of investing in the event-driven space over the life of this blog.
A trial I am currently following involves Novell Inc (NOVL), a target we reviewed earlier. The case involves the ownership of the copyrights to Unix, and is set to conclude a three week jury trial this week in Utah District Court. NOVL bought Unix in 1993 for $300 million, and then sold Unix to the Santa Cruz Operation of California in 1995. Since Santa Cruz could not pay cash for Unix, NOVL retained royalties from the pre-1995 versions, and also shares of Santa Cruz stock. To hedge against a substantial decline in Santa Cruz stock, NOVL also kept the copyrights to Unix. In 1996, the sale agreement was amended to include the transfer of the copyrights. Caldera International (later named The SCO Group) bought Unix from Santa Cruz a few years later. SCO filed suit against IBM Corp in 2003, accusing IBM of using Unix to make significant changes to the Linux operating systems, which made Linux a SCO competitor and forced SCO’s revenues to decline. After SCO sued IBM, NOVL claimed that it owned the copyrights to Unix, and that SCO’s suit against IBM was invalid.
The trial appears to be favoring SCO. Testimony from the Robert Frankenberg, the CEO of NOVL during the sale of Unix, reveals that it was his intention to sell the copyrights in 1995. Even the two top NOVL negotiators of the Unix sale said that the transaction included the copyrights, while one added that it “would not make any sense” to exclude them.
What does the agreement say? The amendment is obviously the relevant document, and it does not support SCO as heavily as the executives do. The wording is amazingly convoluted, but the amendment is essentially a promise to assign the copyrights to Santa Cruz, and therefore it is not evidence of a valid transfer of ownership. To throw more of a twist, the Utah Appeals Court has ruled that intentions matter in contracts, so the jury could rule in favor of SCO.
If SCO wins this case, then it will pursue its lawsuit against IBM. SCO is on the ropes, and it would be unwise for NOVL to look beyond this case. SCO was sent into bankruptcy court in 2007, and it remains under control of a trustee. SCO is in dire need of a financial settlement. NOVL could be on the hook for about $25mn, which would help SCO more than it would hurt NOVL (NOVL has $607 million in cash).
As for an update on the unsolicited offer from Elliott Associates, the board rejected the $5.75/share proposal on March 20, arguing that it undervalues the company’s franchise and growth prospects. Additionally, the board authorized a review of strategic alternatives, including, a share repurchase program, a cash dividend, joint ventures, a recapitalization, and a sale of the company. The last one is crucial, as it shows the company is a willing seller, at the right price. Some management teams are unwilling to let go of their company for any monetary figure. With management on board for a potential sale, a financial sponsor’s lurking, and assets ripe for revitalization by a strategic acquirer, NOVL is likely to be sold.
Sunday, March 21, 2010
Carl Icahn is a respected, and often feared, investor with an enviable long-term track record. His successes and failures have attracted attention throughout his high-profile career. I believe his current strategy with LGF is bound to end with a resounding thud. A bidder’s credibility and intentions are important aspects in the deal process, and while no one will doubt Icahn’s credibility, I’m not sure even he knows his intentions for LGF.
First, a little background will bring us nicely up to speed. Over the course of 2008, Icahn more than doubled his holdings in LGF to a stake of 14%. People were thinking that he would dust off his poison pen, rattle the cages, and encourage a sale of the company. Icahn said in February of 2009 that he is evaluating increasing the size of the board and adding his own directors. In March, he terminated his talks with LGF, citing the failure to reach a sufficient standstill agreement. Icahn’s next move was to make a tender offer for $325 million of LGF’s senior subordinated notes at 73% of par.
At this point, we know Icahn has a problem. LGF has a very concentrated shareholder base, and the top three holders (nearly 50% combined stake) are supportive of management. Interestingly, the top holder (20%) is Mark Rachesky, who was a senior investment officer for Icahn Holdings from 1990 to 1996. Rachesky left to launch MHR Fund Management and has created his own impressive legacy. He, too, is an influential investor, and it is inauspicious for Icahn that his protégé is not siding with him on LGF.
LGF struck a deal with convertible debt holders to keep $316mn of the securities out of Icahn’s hands, by restructuring the strike price from $14.28 to $8.25, and also extending the put date from 2012 to 2015. Investors showed their lack of support for Icahn’s offer when 5% tendered their notes.
In September, Rachesky was nominated to the board. Meanwhile, Icahn quietly grew his holdings to 19%. In mid-February, with LGF trading at $5.23/share, Icahn announced a $6/share partial tender offer to increase his holdings to 29.9%. Here is why I don’t think Icahn knows his intentions for LGF: After he announced the partial tender, he went on CNBC and said that he is not seeking control of LGF, and that he wants to increase his holdings so he can have more say in potential acquisitions the company makes. (In the past, he had criticized LGF’s acquisition of the TV Guide Channel.)
On March 12, LGF recommended that shareholders not tender to Icahn’s partial offer. Management argued that the offer is inadequate, and noted that $6/share is a 30% discount to the average analyst price target. They said that, with 29.9% of the shares, Icahn could effectively veto certain transactions and would have power over fundamental decisions. LGF pointed out that the Icahn Group lacks industry experience. The company noted that a successful partial tender would constitute an event of default under its credit facilities, which would permit the lenders to accelerate the maturities of outstanding borrowings ($516 million of such notes). The board also authorized a shareholder rights plan (poison pill) to “limit the potential adverse impact…of an accumulation of a significant interest in the shares”. The plan has a threshold of 20% (note that Icahn is holding 18.9%).
On March 19, Icahn amended his offer to buy 29.9% of LGF, and is now seeking to purchase all of the common shares outstanding for $6/share. He did not change the offer price, which was previously rejected. Icahn said that he intends to pursue legal proceedings to set aside the poison pill, and that it restricts the rights of LGF shareholders to accept the offer. If more than 50.1% tender to the offer, Icahn intends to replace the board with his own nominees. Icahn went on to address the change of control provisions in the debt, and said that his group is prepared to provide a bridge facility if the provisions are triggered.
His offer is not competitive. He said one month ago that he is not seeking control of the company – now he is. The $6/share offer was rejected in the partial tender, now he wants to make it for the whole company? Curious at best. We will be sure to follow this possible merger arbitrage investing opportunity in the future.
Wednesday, March 17, 2010
We detailed the Cedar Fair (FUN) risk arbitrage situation earlier, and it is worth the time to provide a follow-up. Shareholders were scheduled to vote on the $11.50/share buyout by Apollo on March 16. Recall that a significant number (at least 18%) of shareholders opposed the transaction, and the two-thirds vote requirement was looking uncertain. Let’s look at what has happened, and then at the role of proxy advisors.
On March 15th, the day before the vote was to occur, a certain M&A focused publication said that Apollo was considering raising its offer from $11.50 to $13.50/share. As is not infrequently common, Mr. Market took the report more seriously than perhaps it should have. The spread reacted violently, moving from 3.2% to -6.0%. It’s a bit worrisome to me that people so quickly believe this source, considering how wrong it consistently is. Nevertheless, the stock remained expensive. Later that evening (with the vote scheduled the next day), FUN announced that it will postpone the shareholder vote until April 8. The purpose of the postponement was to solicit additional votes and give shareholders more time to review the proposed acquisition.
FUN’s largest shareholder, Q Investments (18% stake opposing the deal), said today that it is concerned over reports that FUN is continuing price discussions with Apollo. Q Investments believes that it is not a matter of price, and therefore they are not supportive of any such effort. Instead, they are believers in the long-term potential of FUN, and will not support any transaction that forces them to surrender their shares. Furthermore, Q Investments recommended that the board request that Apollo allow FUN to commence discussions about various alternatives with its bank group to avoid covenant violations and a potential default.
My belief is that Apollo will not raise its offer. FUN can postpone the vote, but it will not secure a successful tally at the original terms. It was made public on March 9th that RiskMetrics Group, Proxy Governance, and Glass Lewis & Co all recommend that shareholders vote against the acquisition, while Egan-Jones was the lone dissenter. Of the four advisors, I consider RiskMetrics to be the most respected and analytical. The common basis for the recommended rejection was the low takeout valuation. This is a good time to discuss the role of proxy advisory firms.
Proxy advisors make recommendations to shareholders on issues that require a vote. Situations like mergers and board nominees commonly have one or all of these firms weigh in to advise shareholders. Take a merger, for instance. Institutional investors will do their own research and reach a conclusion whether or not to approve a transaction. However, individual investors like to hear from a source other than management (which will inevitably recommend shareholders approve a deal, or vote its nominees to the board). Another key audience for the proxy advisors is the index crowd. Many index funds are mandated to vote their holdings to the recommendation of the proxy advisors, and these shares can be pivotal in a close vote.
A recent deal in which proxy advisors had an important role was Alpha Natural Resources’ (ANR) acquisition of Foundation Coal Holdings, announced in May of 2009. On June 24, Stanley Druckenmiller’s Duquesne Capital filed as a passive holder of 7.7% of ANR. Since the merger was structured as a stock exchange, ANR shareholders had to approve the issuance of ANR shares for currency. (Technically, per NYSE Rule 312, a company requires a shareholder vote if it is seeking to issue a number of shares in excess of 20% of the number of common shares outstanding before the issuance. In this case, ANR was above 20%.) On July 16, Duquesne switched its filing from a 13-G to a 13-D, becoming active, and increased its holdings to 8.3%. At this point the fund indicated concern over the acquisition and said it will evaluate the benefits of the deal. A few days later, Duquesne said it will vote against the merger on July 31, arguing that the dilution to ANR shareholders will be irreversible. By this time, all four proxy advisors had recommended approval of the merger. The spread was widening on rumors that RiskMetrics was planning to reverse its recommendation. To my knowledge, they have never done such a thing, so the vote (and ultimately, the merger) would have been in serious jeopardy had this happened. Days before the vote, RiskMetrics and Glass Lewis reaffirmed their support for the deal, and Proxy Governance changed its recommendation to being against the deal. The spread was enormously wide for a merger with a few days to close, and after a narrow vote on the ANR side, the transaction was complete.
The lesson here is that proxy advisors can affect the trading of a deal, and also its outcome. A good lesson in real time for merger arbitrage.
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.
Monday, March 8, 2010
Let’s take a moment and enjoy the recent upsurge in announced M&A activity. Risk arbitrageurs love a plethora of deals, as the opportunity set for potential portfolio positions increases. While we are still not back to the deal volume of 2006-2007, when just about anyone could muster up the financing for a multi-billion dollar bid, no one in the space is complaining about the recent trend.
M&A activity is certainly on the rise from last year’s poor showing. Dealogic data indicates that there have been 1,579 deals in the U.S. in 2010 (up 13%) for a total value of $144 billion (up 46%).
The Wall Street Journal highlighted Thomson Reuters data on Thursday, saying that 55% of the deals so far this year have been cash considerations, up from 40% in 2009. The highest cash figure in the last decade was 2007’s 57%.
In the last few weeks, we’ve seen definitive agreements or unsolicited offers involving OSI Pharmaceuticals (OSIP), RiskMetrics Group (RISK), Millipore Corp (MIL), Zenith National Insurance (ZNT), and Bowne & Co (BNE).
Financial buyers (as opposed to strategic) have also been active, targeting RCN Corp (RCNI), Southwest Water Co (SWWC), Novell Inc (NOVL), and CKE Restaurants (CKR).
Some of these events (OSIP, RCNI, and NOVL) have the potential for increases to their current offer prices. OSIP and NOVL are in receipt of unsolicited bids, and agreements are never reached at the initial offer price. RCNI has a 40 day go-shop period to sift through the marketplace for other interested parties.
Time will tell if this upswing in merger and acquisitions and the profit opportunities it may produce in merger arbitrage has any legs.
Posted by Hunter at 6:26 PM
Thursday, March 4, 2010
This post will highlight a current transaction with a large shareholder who opposes a deal. Since mergers either have to be approved by a target company’s shareholders by vote or by tender, consent by the owners is required. While a rare occurrence, shareholders can block a deal from consummating. A current situation in merger arbitrage that is at risk of being voted down is Cedar Fair LP (FUN). We will detail a lot of minor events in this deal, but it is worth the read to understand how an event trades.
On December 16, 2009, Apollo Global Management announced a definitive agreement to acquire FUN. The $11.50/share purchase price represented a 27% premium to the previous closing price. The agreement requires approval from two-thirds of FUN’s shareholders, and carried a 40-day go-shop period (a go-shop period allows FUN to solicit alternative proposals, with the intention of receiving a superior offer).
The spread first went negative (traded above $11.50/share) on January 6, closing at $11.63/share. On January 19, Q Investments disclosed ownership of 9.8% of FUN (which, oddly, was done in a 13G filing, indicating a passive holder). This brought FUN’s share price to $12.19, a spread of -5.6%. On January 22, Q Investments announced (while still a passive holder) that it will vote its shares against Apollo’s buyout, and argued that FUN has numerous options to deliver more value than the $11.50/share bid. FUN responded to this by saying that the acquisition is in the best interest of shareholders. Q Investments increased its ownership to 12% on January 25, driving the spread to -10%. On February 1, Neuberger Berman (correctly, in a 13D) said that it opposes the buyout with its 9.6% ownership. Q Investments (still in a 13G) bumped its stake to 17% on February 4, and then to 18% on February 12 (finally, in a 13D). Maintaining the quirkiness of this deal, the spread was then at 0.5% (yes, now positive). I found this unusual, because at this point, you have at least 27% of shareholders who publicly oppose a merger that requires two-thirds approval. On February 16, Neuberger Berman hinted at a change of heart when it switched to a passive holder and decreased its holdings to 7.7%, with no mention of opposition to the merger.
What about another bidder, you might be asking? Well, the go shop period expired, and in late January, FUN disclosed that it contacted 32 interested parties, though no party expressed any interest in making a proposal.
In early March, FUN released presentations which detail the rationale for the merger. FUN believes that $11.50/share is the highest and best value for shareholders, and reiterated that all available strategic alternatives were considered before they entered the agreement. Additionally, FUN explains nicely how challenging the environment would be in the absence of a transaction. High unemployment, low discretionary spending, and suffering sales are all cited as risks to FUN’s business if the deal is not executed. FUN says that its debt load (5.14x Total Debt/EBITDA) is unsustainable, and highlights that the covenants on its debt step down to more restrictive levels at the end of 2010.
Where does this deal stand now? The shareholder vote is scheduled for March 16. The spread is 4%, starting to price in the risk of an unsuccessful vote. You have at least 18% of shares being voted against the current offer (excluding Neuberger, since they switched to passive, but their current intentions are unknown). Again, a two-thirds vote is required for approval, and a failure to vote (think retail investors) has the same effect as voting against the merger. FUN clearly states that the company will face a tough time as a standalone, so if it is voted down, then the share price will really be hammered. Interesting risk arbitrage situation.