Monday, April 19, 2010

Risk Arbitrage and Tender Offers: Lions Gate (LGF)

New events have unfolded since we last discussed risk arbitrage situation Lions Gate Entertainment Corp (LGF). Recall that Carl Icahn announced a $6/share tender offer for LGF on March 19, which we said is far from competitive and will not be well-received by shareholders. On April 15, Icahn increased his offer to $7/share. While the 17% increase in his offer is a start, we believe that investors will still demand more. Icahn went to great lengths to explain why $6/share represents substantial value to LGF shareholders, so if we’re an LP of Icahn Partners, we would be asking why he is overpaying (by his own determination of LGF’s intrinsic value).

So why is Icahn raising his offer? “We decided to raise our offer price not because we believed $6.00 per share to be inadequate but rather because we felt it necessary to make every effort to protect the investment we currently have in Lions Gate.” Wait, what? If Icahn wants to protect his investment, but thinks $6/share is a premium valuation, then he should have sold his position when it traded at a premium to his offer.

The board has certainly stood behind management so far. However, they are said to be nearing the end of their support for the current strategy. If true, this would obviously benefit Icahn since he wants to replace management.

LGF pointed out on April 12 that the average sell-side analyst price target is $8.70/share. Indeed, friendly transactions are nearly always struck at a price above this figure. It’s hard to determine a fair takeout price, but shareholders will be very hesitant to sell to Icahn before he announces who will run the company under his control.

The shareholder vote to implement the LGF poison pill is scheduled for May 4th. Letters from both sides have been sent to shareholders encouraging them to vote for/against implementation of the pill. LGF wants to ensure that Icahn does not gain coercive control of the company with a position over 20%, and Icahn thinks pills are poor corporate governance.

We pointed out that MHR Fund Management and Capital Research (combined 37% position) oppose Icahn’s control of LGF. Icahn noted in his April 15th letter that MHR’s Mark Rachesky, his former co-worker, “has pledged his support for management and its policies and has received a special deal from the company as to certain registration rights, ‘most favored nation’ rights and other rights”. Well, now we know those two aren’t the best of friends since their split.

A separate announcement on April 15th was that Mark Cuban, of Dallas Mavericks and Broadcast.com fame, disclosed that he is an active holder of 5.4% of LGF. Cuban actively owned 14% of Register.com’s stock in 2005 and was vocal about his opposition to the acquisition by Vector Capital. He did not drum up enough support in this effort, and that deal closed four months after he announced his views. We don’t know what Cuban’s view is on the Icahn offer, but he is certainly capable of increasing his position and becoming vocal.

Does Icahn have another bid increase left in him? It’s difficult to tell, since he says one thing and does another (recall that he said he does not want to acquire LGF then weeks later announced his offer for the whole company). What we do know is that he sought to acquire Morton’s Restaurant Group (MRT) in 2002, and his bidding went from $13.50 to $15, and finally to $17/share. MRT was in a definitive agreement with Castle Harlan, and since Icahn’s offer merely matched the agreement, it was not deemed superior. As for the next important date in the LGF situation, it will be the May 4th shareholder vote

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Tuesday, April 13, 2010

Risk Arbitrage and Acquisition Rumors: Palm

When most people think of a handheld PDA, the PalmPilot is the earliest memory of such a device. Most busy people (or those wishing to appear so) had one of these units back in the day. Look around now, and it seems that people either have a BlackBerry or an iPhone. What happened to the PalmPilot? On April 7, speculation began circulating that Palm Inc (PALM) was nearing an announcement that it will be acquired. This news sent the stock up 20% for the day. It was disclosed on April 11 that PALM had retained Goldman Sachs and Frank Quattrone’s Qatalyst Partners to solicit parties’ interest in an acquisition of the handset maker. As we’ve said before, our main focus in risk arbitrage is to evaluate a transaction after its announcement. Though, given the interest that PALM has received, we thought it would be useful to determine who would potentially buy PALM, and to look into credibility of the market chatter. Let’s address each potential bidder.

Lenovo Group of China was the initial rumored bidder. Sure, Lenovo had zero success when it acquired IBM’s PC business in 2004 for $1.75 billion, but that might be far enough in the past for them to have forgotten about the difficulties of integrating an acquisition. Beyond this, however, Lenovo acquired its handset maker, after divesting the division two years ago, a few months ago. Hardly the move one makes when considering buying PALM. Lastly, CEO Yang Yuanqing said in March that the focus for their acquisition targets will be the emerging markets. Less than 5% of PALM’s latest quarterly earnings came from international markets.

China's Huawei Technologies is said to have been approached by PALM in mid-February about preliminary acquisition talks, though no progress has been made in the discussions. It's worth noting that PALM's reaching out came a month before it announced dismal earnings on March 18 (maybe the company foresees dwindling demand for its products). Also, Huawei might be reluctant to make another effort in the United States after its failed attempt to acquire 3Com in 2008.

HTC Corp of Taiwan is also making the rounds as the acquirer. The company is studying having its own operating system, which would enable it to reduce its dependence on outside developers. Going this route would preclude a PALM bid. It’s CFO, Cheng Huiming, pointed out this week that, while it requires many reasons to justify having its own system, the current business model is working nicely.

Dell Inc is said to have taken a look but will not make a proposal. Nokia has Symbian, and doesn’t need PALM. Hewlett-Packard just completed the 3Com deal on Monday, so it is likely in no rush to open its checkbook again.

PALM's Chairman and CEO, Jon Rubinstein, is a prized asset. Before joining PALM in 2007 to direct the company's return to innovation, Rubinstein was at Apple and led the rollout of both the iMac and the iPod. PALM also has a bevy of talented engineers. I believe there are plenty of competitors near PALM’s Sunnyvale, California, campus who are waiting to pick off the most skilled employees. That’s always a work-around to an acquisition.

PALM is covered by 30 sell-side analysts, two of whom have a price target of $0. PALM could very well be taken out in the near future. Its performance is deteriorating, and it would surely like to enter an agreement before it is desperate to do so. We don’t have a firm opinion on who the buyer would be, but if we had to guess, it will be a foreign company. If a risk arbitrage opportunity presents itself, we will be sure to report it here.

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Sunday, April 11, 2010

Merger Arbitrage: Update on Recent Deals

We recently reviewed the Cedar Fair (FUN) and 3Com Corp (COMS) deals, and updates on both are necessary. As transactions have been closing or terminating recently, merger arb money is going to the sidelines to wait for the next opportunities. Fortunately, there are some situations that could provide attractive entry points in the near future, and we will be covering some on this blog.

For FUN, recall that its largest shareholder, Q Investments, opposed the $11.50/share buyout from Apollo, and vowed to vote it 18% position against the deal, which required two-thirds approval. We said that Apollo is unlikely to raise its offer, and that the vote would be unsuccessful on the original terms. We also said that the downside valuation for FUN would be severe. Two for three is not the end of the world.

On April 6, two days before the rescheduled shareholder vote was supposed to be held, FUN and Apollo announced that they have mutually terminated their merger agreement. The termination occurred after FUN determined that it lacked the required level of investor support. FUN agreed to pay Apollo $6.5 million for expense reimbursement, and both parties agreed to release each other from all obligations with respect to the merger, as well as from any claims arising from the merger. Additionally, FUN adopted a poison pill with a 20% threshold.

On our scorecard, we correctly determined that Apollo would not raise its bid and that the shareholder vote would be unsuccessful, but we badly misjudged how FUN’s share price would react to deal termination. FUN closed on Friday at $14.11/share, well above the $11.50/share deal price. The exact reasons for this are still unknown to us (if any of you, dear readers, care to elaborate, we’d love to know your thoughts), but we have a few ideas. While technically a “deal stock” FUN was never sufficiently owned by arbs. Viewing the HDS function on the Bloomberg terminal reveals very little event ownership. That would explain why FUN has moved on a fundamental basis (as opposed to being event-driven) when the merger broke. Clearly, people side more with Q’s view of the company’s future than they do with FUN’s own assessment. But what that doesn’t explain is why, when the shareholder vote was largely up in the air, the spread widened. Perhaps we’ll never know, but at least we were not short. To “Chinese” a deal (put on the trade in the opposite manner, i.e. shorting a cash deal instead of going long the target) is often very risky, and we stress capital preservation.

To tie-off thoughts on FUN, the timing of the shareholder rights plan is interesting. It’s very likely that, regardless of the higher current share price, FUN does not want to have a shareholder with more of a say than what Q currently has. Those with egg on their faces include management and FUN’s financial advisors, who recommended a deal which was summarily rejected by shareholders.

For COMS, we stressed the uncertainty and lack of transparency involved with China’s Ministry of Commerce. We said that that the acquisition by Hewlett-Packard should gain approval on pure antirust grounds, but noted that the China discount was a threat. On April 7, COMS announced that China, the remaining regulatory approval needed, cleared the transaction. The merger is scheduled to close on April 12. For those playing in risk arb, it will be bittersweet to watch this name disappear. We wish we could provide more color on the reasoning for approval, but again, given the black hole of information that is the People’s Republic, any explication would be a conjecture on our part.

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Saturday, April 10, 2010

Merger Arbitrage: SkillSoft (SKIL)

On February 12, SkillSoft PLC (SKIL) agreed to be acquired by a consortium of Berkshire Partners, Advent International Corp, and Bain Capital for $10.80/share, an 11% premium to SKIL’s prior close. The transaction requires approval from a majority of SKIL shareholders, assuming at least 75% of them vote. A go-shop provision allowed SKIL to solicit alternative proposals until March 6. SKIL hosted a conference call to discuss the $1.1 billion deal, which set the tone for a trade that caught investors by surprise. Let us take a look at this risk arbitrage example.

As with most deal calls, the interesting part began with the Q&A. Of course management is in favor of the deal, or else there would be no agreement. We obviously have our own opinions on deals, but it is imperative to know how others perceive a transaction, and the Q&A portion is the first chance to discern their thoughts. Right off the bat, the questions force management to take a defensive stance. How well was the company shopped to other bidders? How did you arrive at the low takeout valuation? Why are you selling now, instead of a year down the road, when the sales that you said would pick up will be higher? Did you discuss the deal with any of your largest shareholders before signing? (The answer was no.) Even the largest shareholder chimed in, which rarely happens on deal calls. “Just out of curiosity, why weren’t the larger shareholders consulted?” After an unsatisfactory answer, the 22% holder said to the CEO “would you mind coming to see me?”

You understand the general tone. Investors are displeased, and the largest shareholder is unimpressed and surprised. So now, all eyes are on the go-shop period. The day the deal was announced, SKIL closed at $11.03/share, a spread of -2%. The spread was negative for the entire go-shop period, and SKIL peaked at $11.29/share (-4.3%) on March 9, as the market knew the go-shop expired, and announcement of a superior proposal was anticipated. The following day, SKIL provided an update on the process and said that Credit Suisse contacted 45 parties on SKIL’s behalf, entered 10 confidentiality agreements, and received one conditional preliminary proposal for an offer above $10.80/share, but no formal offer was made. So there it is. The company was shopped to third parties and no one took the bait, and SKIL immediately fell to $10.71/share.

On March 12, SKIL held its earnings call, and during the Q&A, the issue of shareholder approval arose again. Management said they had spoken with shareholders “both large and small”, and they are “feeling very good” about the April 6 shareholder vote. So with a 22% holder who sounded unimpressed by the deal initially, one would think that said holder’s blessing was secured in order for management to have such optimism. The spread should be tight, right? Wrong. As late March 29 SKIL was trading at $10.18/share, a 6% spread, for a deal that should close in two months. That is too wide, so we must be missing something. Reviewing the conference call transcript, we can determine one of two things. By saying that they are comfortable with the shareholder vote, management is either lying, or they are not disclosing all of the information they have. With a 6% spread, arbs were pricing in a low probability that the deal closes. It would be much tighter if there were any confidence in the vote. It’s tough to be a buyer (will the vote be successful?) or a seller at this point (SKIL’s downside valuation is attractive).

On April 1, with arbs’ hands behind their backs, and the vote a few days away, SKIL announced that the offer price was revised from $10.80 to $11.25/share. The vote was rescheduled from April 6 to April 29. Columbia Wanger Asset Management, the largest holder, entered a voting agreement in favor of the new terms. The offer was increased because SKIL thought the likelihood of success with the original deal was insufficient. SKIL closed that day at $11.10/share, for a spread of 1.3%. Not only did the market not expect a higher offer, which the 6% spread indicated, but you have to give credit to Columbia Wanger and the other parties involved for not showing their hand. The event-driven space is so used to having leaks that it is a shock when people don’t have an idea of what is going on behind the scenes.

The lesson here is that shareholders matter. If deal parties do not consult with, and receive voting agreements from, shareholders before a transaction is announced, then they better be sure that the valuation is attractive enough for the holders to agree with ex post.

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Sunday, April 4, 2010

Merger Arbitrage: Takeover Defenses

Not all acquisitions are negotiated in a friendly manner. Companies often become targets when they are weak, be it a depressed share price, or a troubling business environment. Management is always reluctant to relinquish control during these times. We all want to leave while on top, right? When a company receives an unsolicited takeover offer, it has several possible defense mechanisms. Defensive by-law provisions are designed to create structural impediments for acquirers, thereby allowing the incumbents to maintain control. We will highlight various takeover defenses companies use to thwart interested parties.

If a hostile offer is rejected by a target company’s board, the bidder will often seek to replace said board with its own nominees. To do this, the bidder will have to gain majority representation and vote to accept the proposal. To prevent this, the target can adopt a classified board, also called a staggered board. Assume a board is composed of nine directors, each serving three year terms. Further imagine that a takeover proposal is initially rejected in unanimous fashion (maybe the valuation is unacceptable, or perhaps the board is replete with friends of the CEO who don’t want to see their buddy out of a job when the new sheriff arrives). In a standard board, the bidder can elect its nominees, and if the sufficient number of shareholder votes is secured, then board control is realized. In a staggered board, a nine-member board will likely have three directors up for election each year. So, to gain control, it will take a minimum of two shareholder votes (often annual meetings) to hold the required number of board votes. This can be a lengthy and expensive process. What can also happen is that the target’s share price can drift to the offer price on a fundamental basis, which diminishes the bidder’s argument that it is offering a substantial premium.

Another tool commonly used is the shareholder rights plan, which is also called a poison pill. Recall that Carl Icahn is seeking legal proceedings to remove Lions Gate’s poison pill. The idea of a rights plan is that the board adopts a threshold above which the people who do not cross are allowed to purchase shares at a discount to dilute the triggering party. The longer-term trend shows that poison pills have been on the decline. In 2001, 60% of S&P 500 companies had pills in place, sharply higher than the 21% in 2009.

Let’s look at an example of how a pill has a dilutive effect. A company with a $10 stable stock price has a shareholder rights plan with a 20% threshold and a $40 exercise price. An investor hits the 20% mark, thereby triggering the “flip-in” feature of the plan. Each shareholder, except the triggering party, has the right to buy eight shares for $5 each (the right is to buy, for the exercise price, the number of shares equal to the exercise price divided by 50% of the 30-day average price). Let’s say there are 100 shares total, so the non-triggering parties own 80 shares, and have the right to buy 640 shares for $3,200. The triggering party would see his or her position go from 20% of a $1,000 company, a $200 interest, to owning 2.7% of a company worth $4,200, a $113 interest. The math goes from 20/100 to 20/740. This is assuming maximum dilution, and that each non-triggering shareholder exercises all the available rights.

The vast majority of companies are incorporated in Delaware. Since a board of directors must approve a merger, Delaware has the “just say no” defense, meaning that the board can reject an offer indefinitely. The remedy to this is to replace the board, and the aforementioned staggered board can prolong this process. Of course, if a compelling enough offer is continually ignored, then the directors will ensure their own ouster.

These are strategies that merger arbitrage investors keep in mind in unfriendly transactions. They will undoubtedly come up in future situations we will analyze

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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