Wednesday, June 30, 2010

Merger Arbitrage: SonicWALL Inc (SNWL)

On June 2, SonicWALL Inc (SNWL) announced a definitive agreement to be acquired by an investor group led by Thoma Bravo, LLC and including Ontario Teachers' Pension Plan for $11.50/share, or about $720 million. SNWL is a leading provider of IT security and data backup and recovery solutions. The offer price represented a 28% premium to SNWL's previous closing price. SNWL expects the transaction to close in the fiscal quarter ending September 30 or early in the fiscal quarter ending December 31. The press release did not contain any more information, nor was there a conference call. Let's dig into this merger arbitrage situation.

Some people might be thinking, "great, a 28% premium from legitimate buyers", however there are warning signs that should be evident after reading the 8:30pm announcement. We have mentioned the first two issues several times on this blog. The first is that there is no go-shop period, which would allow SNWL to solicit bids from third parties for a specified time period, typically 30 days. These provisions are typical with private equity buyers. The second issue is that there is no voting agreement with shareholders. Or, shall we say, there was no announcement of any go-shop period or voting agreement. Since these are viewed favorably to shareholders of target companies, and management will go out of its way to display any shareholder friendly actions performed, we assume that lack of disclosure means that these items do not exist. We learn at 6am the following morning in a filing that there is a voting agreement, albeit for the 1% of shares that management and the board own. This is unconvincing, given that page one holders represent 64% of the shares outstanding.

These are nice ancillary points, one could say, but how about something more substantive? Okay, let's look at valuation. At $11.50/share, SNWL is valued at about 2.0x LTM revenues. SNWL's comps trade at a multiple of about 2.2x. All things being equal, which they admittedly never are, the takeout multiple should be higher than where the peers trade. The main reason is that shareholders must be enticed with a control premium.

For some background on Thoma Bravo, the private equity firm agreed to acquire Entrust Inc on April 13, 2009 for $1.85/share, or $114 million. The transaction contained a 30-day go-shop provision. Thoma Bravo was able to secure a voting agreement with 19% of Entrust shares. When the go-shop period expired on May 13, Entrust provided an update on what transpired in the process. After speaking with 35 separate parties, Entrust received written, non-binding indications of interest from three parties, each of which contemplated a price higher than the $1.85/share deal with Thoma Bravo. As a result, Entrust intended to provide additional due diligence and continue discussions and negotiations with these parties. Notwithstanding the foregoing, Entrust reiterated that its board determined that the merger with Thoma Bravo is fair and that they still recommend shareholder approval of the deal. On June 11, Entrust director Douglas Schloss (who runs the risk arb fund Rexford Management) publicly stated how the timing is poor to be selling the firm and that the offer price should be increased. Schloss was one of the two directors out of the nine-person board who voted against the $1.85/share deal. On July 10, Thoma Bravo amended its merger agreement with Entrust for an acquisition price of $2/share, or $124 million. The deal closed on July 28.

Now let’s return to the SNWL deal. On June 11, we learn from the preliminary proxy that three parties outside of the buying consortium entered confidentiality agreements with SNWL, though no offers were made. This does not support management's decision not to negotiate a go-shop provision, since clearly there were other interested parties. Surprisingly, this did not tighten the spread, as it remained at 2.4% after this news. The release of the definitive proxy on June 22 set the shareholder vote for July 23. It also disclosed that regulatory clearance from the FTC had been granted. The most important piece of information in the filing was added to the end of the background section, acting as the latest update. This is the section where one can learn about other conversations the company had about a transaction. Often there is nothing material (no big change in the background section from the preliminary to the definitive), though in this case, there is an important addendum:
On June 16, 2010, the board of directors of SonicWALL, Inc. received an unsolicited non-binding proposal from Strategic Party D, a privately held competitor, in which such party proposed, subject to completion of due diligence and finalization of definitive documentation, to acquire the outstanding shares of common stock of SonicWALL for $12.00 per share in cash. Strategic Party D’s offer identifies Financial Sponsor C and Financial Sponsor D as expected equity financing sources for its proposal and states that it is in discussions with debt financing sources.

On June 18, 2010, the board of directors of SonicWALL, after consultation with its financial and legal advisors, determined that the unsolicited non-binding proposal from Strategic Party D meets the criteria required by Section 5.6(b) of the Merger Agreement to permit the Company to provide information to, and negotiate with, Strategic Party D in accordance with its terms. Based on this determination and as permitted by the Merger Agreement, SonicWALL delivered a confidentiality agreement with a standstill provision to Strategic Party D and its proposed equity financing sources as provided for in the Merger Agreement and, upon its execution, will furnish information to Strategic Party D and enter into discussions with it regarding its proposal.

The board of directors of SonicWALL has not approved, adopted or recommended the acquisition proposal from Strategic Party D or declared it superior to the Merger Agreement and the merger. Moreover, SonicWALL’s board of directors has not withdrawn, qualified, or modified its recommendation that SonicWALL shareholders approve the principal terms of the Merger Agreement, the merger and the Agreement of Merger. Our board of directors continues to recommend that you vote “FOR” the proposal to approve the principal terms of the Merger Agreement, the merger and the Agreement of Merger. There is no assurance that negotiations with Strategic Party D will ultimately lead to a superior proposal, that SonicWALL and Strategic Party D will reach final agreement on terms regarding the acquisition of SonicWALL by Strategic Party D or that, if the parties do enter into such an agreement, regulatory approvals and other conditions to completing such a transaction will be obtained.
Knowing about Entrust, we are aware that Thoma Bravo has been in a similar situation. We also know that the result was an increase in the purchase price. The spread closed on June 22 at -3.0% after disclosure of this bidder. As of June 29, it is -1.5%, as investors are still very interested in the potential spoiler bid.

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Sunday, June 27, 2010

Risk Arbitrage - An Investor's Guide: Chapter 3

A few months ago, we began to summarize Keith Moore's fantastic book: Risk Arbitrage - An Investor's Guide. We continue this series here at Merger Arbitrage Investing with chapters 3 and 4.


In Chapter 3, Moore talks about the risk arbitrage industry. He points out that in the 1970s, only 10 or 15 firms were involved in risk arbitrage. These organizations were generally arb departments in sell side firms. With the growth in hedge funds, via limited partnerships, the growth of merger arb participants exploded. Moore also points out that pension funds have become larger players in the past decade.

In spite of this, Moore points out that returns in the risk arbitrage business remain attractive. Supporting this - MERFX, the Merger Fund, has had a 5 year return of 4.15% versus the S&P which has been essentially flat over the same period. In addition, using the MARB function on Bloomberg, one can see over 100 deals in the merger arbitrage universe.

Later in the week, we will review Risk Arbitrage's chapter 4, which I think is the most important chapter in the book.

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Tuesday, June 22, 2010

Risk Arbitrage: Charles River’s Acquisition of WuXi PharmaTech

This post will review a merger arbitrage situation with an extremely wide spread. For the same reasons stock prices fall, spreads widen on an increase in the perceived risk of a transaction, or investors simply don’t believe that management’s original plan for the deal will actually be realized. Charles River Laboratories’ (CRL) acquisition of WuXi PharmaTech Inc (WX) is currently facing opposition from CRL shareholders, which has forced the spread to 31.3% as of June 17.

WX is a drug research and development outsourcing company with expertise in discovery chemistry and with operations in China and the US. CRL is a global provider of research models and associated services and of preclinical drug development services.

On April 26, WX announced a definitive agreement to be acquired by CRL for $1.6 billion, consisting of $11.25/share in cash and $10/share in CRL common stock (to be determined by an exchange ratio with a collar). The ratio will be determined by dividing $10.00 by the weighted average of CRL’s closing price for the 20-day period ending the second business day prior to the closing. (For those new to arb, these “pricing periods” are standard for undetermined exchange ratios.) If CRL’s average price is greater than or equal to $43.17/share, then the exchange ratio will be fixed at 0.2316, and if CRL’s average price is less than or equal to $37.15/share, then the exchange ratio will be fixed at 0.2692. The companies anticipate closing the merger by the fourth quarter. CRL intends to finance the cash portion of the transaction through balance sheet cash on hand and its $1.25 billion financing commitment from JP Morgan and Bank of America Merrill Lynch.

During the conference call that CRL hosted later that morning, management stated that they were the only party which conducted discussions with WX about a merger. This can have both positive and negative implications, though mostly the latter. Shareholders of the target like to hear this because it could mean that the absence of a competitive bidding process equates to a lower purchase price. The flip side of that could be that they offered so high a price that the board of the target did not deem a market check for outside interest necessary. Conversely, when shareholders of the target hear that the acquirer was the only party with whom the board negotiated then they are want to cry foul. Indeed, it is the board’s fiduciary responsibility to extract the greatest value for shareholders in a sale process. The gross spread was 9.5% the day of announcement.

The merger agreement was released the evening of the deal announcement and it provided a glimpse into the confidence that CRL had in securing approval from its shareholders. The termination fee is $50 million, the reverse termination fee is $50 million (payable if CRL decides to terminate), and there is a $25 million fee if CRL shareholders fail to approve the acquisition. It’s the last fee that grabs our attention. This tells us that not only was CRL concerned with whether its shareholders would approve the acquisition, but it went so far as to include an out (at half the price) in the agreement if they do not. Logically, this is because they either ran the purchase by their top shareholders before the announcement and were unsure of their support, or they did not survey the top holders (perhaps because they knew it would be unwelcome) and were just hedging themselves.

Sure enough, on June 7, Barry Rosenstein’s JANA Partners (an investor we respect, and CRL’s largest shareholder at 7.0%) sent a letter to CRL’s chairman and CEO, James Foster. JANA said that they “have serious doubts about the wisdom of pursuing this transaction at this time. Even if the contemplated benefits can ultimately be realized, we believe that the high cost, significant integration risks and inopportune timing simply make the proposed acquisition the wrong path for Charles River shareholders. For these reasons, we intend to vote against the issuance of Company stock required to complete the proposed acquisition, and we believe based on shareholder sentiment it is likely that a majority of the Company's shareholders will do the same.” JANA cited that the 16x consensus 2010 EBITDA estimate valuation assigned to WX compared to 8x for CRL at the time of the announcement cannot be justified with WX’s declining margins and falling growth rates. JANA’s letter widened the spread to 28.1%.

On June 14, Foster responded to JANA’s letter and said he is “convinced that this combination will create meaningful additional value” for CRL shareholders. Foster believes that applying pre-tax EBITDA multiples is misleading given WX’s significantly lower effective tax rate than CRL. He further recommends that investors consider (when factoring in WX’s significantly higher expected EPS growth rate) the purchase price representing a 1.4x PEG, in-line with CRL’s own valuation. Foster said on June 15 that he has met with all of his largest shareholders and that the majority of them are agreeable to the acquisition of WX.

JANA fired off another letter to CRL on June 16 and cited one analyst who said that 35% of CRL shareholders already oppose the acquisition of WX. On June 17, Neuberger Berman, a 6.3% holder of CRL, joined in on the fun and said that acquisition is not in the best interests of shareholders. Neuberger correctly pointed out that CRL “needs to demonstrate that the current assets can generate returns well in excess of its cost of capital before being allowed to spend $1.6 billion of capital”.

The increasing shareholder opposition on CRL’s side is a severe hurdle to deal completion. Much of the criticism of the merger is well-founded. CRL has two choices: Press ahead with the deal or terminate before shareholders vote down the agreement. Terminating before the vote would save face, and show that the board is receptive to the concerns of a sophisticated shareholder base. However, they would save $25 million if they let the vote take place even while knowing it will be unsuccessful. This is the more likely route they will take.

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Monday, June 14, 2010

Merger Arbitrage: Javelin Pharmaceuticals

Similar to other areas of investing, following arbitrage deals helps you construct a historical framework from which to build your analysis. For instance, some deals are beneficial from an antitrust perspective. Some provide insight into M&A law. Other deals are good references for analyzing deals with multiple bidders. For Javelin Pharmaceuticals Inc (JAV), we have the latter two aspects. Using Bloomberg’s description, JAV is a specialty pharmaceutical company that develops drugs to treat intense moderate-to-sever pain.

On December 18, 2009, JAV agreed to be acquired by Myriad Pharmaceuticals Inc (MYRX) for a stock exchange of 0.282 MYRX shares per JAV share. The ratio valued JAV at $1.50/share, a 22% premium to its previous close. MYRX agreed to place 4% of shares in the combined company in escrow to be delivered to the pre-merger shareholders of JAV, depending on the timing of FDA approval of JAV’s Dyloject, a post-operative pain management drug. If approved by June 30, 2010 the ratio would be 0.3311, if by January 31, 2011 the ratio would be 0.3066, and 0.2943 if approved by June 30, 2011. MYRX also agreed to provide up to $6 million of interim financing to fund JAV’s operating activities prior to closing, which was expected to occur during the first quarter of 2010.

The preliminary proxy’s background section revealed on February 12 that there was outside interest in JAV. An unnamed European pharmaceutical company gave a preliminary indication of interest on August 6, 2009 of a stock exchange worth $2.20/share. A separate company offered a stock exchange work $2/share on August 7, which was revised to a $2.47/share value on August 30. Another company sent a letter of interest for $1.85 to $2/share in cash on December 10. JAV rejected this offer due to its lack of a working capital facility and because it was subject to further due diligence.

Millennium Management, a 7% JAV holder, disclosed in a 13D on March 3 that the proposed merger with MYRX does not maximize shareholder value, and cited the higher valuations from other parties in the sale process. The spread went from -4% to -7% on Millennium’s opposition.

On April 12, JAV announced that it had received a binding offer from Hospira Inc (HSP) to be acquired in a cash tender offer for $2.20/share. In addition, HSP would provide JAV a working capital facility under which JAV may borrow up to $4.5 million to fund operating activities prior to closing a merger, $8.3 million for JAV’s repayment of the principal and accrued interest incurred under a similar arrangement entered into with MYRX, and $4.4 million for payment of the termination fee to MYRX. JAV’s board said that if MYRX does not favorably adjust the terms of its offer within a five business day good faith negotiating period, then they expect to enter the merger and loan agreements with HSP. JAV closed at $2.15/share the day of this announcement, a 60% increase from the previous close. MYRX also rose 10%.

On April 19, JAV terminated the merger with MYRX, and later that day signed an agreement with HSP for $2.20/share, or $145 million. HSP said it pursued the deal to take advantage of synergies between JAV’s main product candidate, Dyloject.

As a side note, we see two similarities with the offers. One is that both provide short-term financing. This tells us that JAV is in a bit of a cash crunch. The second thing we notice is that both deals rely on Dyloject, so it is clearly important to JAV.

On May 19, HSP extended its tender offer to June 2, after 79% of shares were tendered. HSP extended the offer “based on its determination that all of the conditions to the offer had not been satisfied”. Normally one would think that the condition not satisfied is the minimum number of shares required, but four minutes later JAV released the following:

Javelin believes that, in asserting the failure to satisfy in full any such conditions, Hospira is purporting to rely on information regarding a supply chain issue in the United Kingdom described below.

Javelin was notified, on May 14, 2010 by a licensee of commercial rights to Dyloject in the European Union, that an issue has arisen in the UK Dyloject supply chain. Javelin notified Hospira of this matter promptly after being informed. Javelin is not aware of any issue in its supply chain for Dyloject in the United States.

Javelin disagrees with Hospira's position under the merger agreement that the conditions to the tender offer have not been fully satisfied and believes that all of the conditions of the tender offer have been satisfied. Javelin continues to honor its obligations under the terms of the merger agreement.

Wait a minute. That changes things. Remember how we mentioned Dyloject, and how both bidders found it to be an integral part of their strategy to acquire JAV? It’s certainly not a good thing when “an issue has arisen” with this product. JAV closed down 17% for the day.

On May 24, JAV finally clarified the European “issue”.

Therabel Pharma UK Limited ("Therabel"), a subsidiary of Therabel Pharma N.V. and Javelin's licensee of commercial rights to Dyloject™ (diclofenac sodium) in the European Union recently informed Javelin and publicly announced that it is withdrawing all batches of Dyloject (diclofenac 75mg/2ml) from the UK market with a Drug Alert Class 2 Medicines Recall.

Therabel reported that it became aware of the presence of a white particulate matter in some vials of Dyloject in its supply chain. These findings were promptly reported to The Defective Medicines Reporting Centre (DMRC) of The Medicines and Healthcare Products Regulatory Agency (MHRA) in accordance with standard procedures.

Therabel further reported that its review of pharmacovigilance information does not appear to indicate any detected patient safety concerns linked to the particulate matter found in some vials. Dyloject has been marketed in the UK since December of 2007.

Therabel has indicated that it is cooperating fully with the MHRA and is active in an investigation to resolve this matter and to restore the supply of Dyloject to the UK market as soon as possible. Javelin is providing assistance to Therabel with its investigation.

JAV closed down another 30% at $1.26/share on May 24, leaving the gross spread at 74%. The spread remained wide as investors were seeking to determine what HSP would do next. Would it continue with the transaction? Would it attempt to invoke a MAC?

The next move was made by JAV, when on June 3 it filed suit against HSP in the Delaware Court of Chancery. The suit seeks to compel HSP to complete the merger and also asks for expedited proceedings to allow for an early trial. The complaint contends that HSP breached the merger agreement by failing to accept and pay for the 79% of shares that were tendered through May 18 and by failing to complete the merger. Additionally, the complaint asserts that HSP breached the terms of the loan agreement under which HSP was obligated to $2 million on June 1.

HSP extended the tender offer on June 3 to June 16. The acquirer was careful to add that it “intends to continue to work with Javelin to confirm the satisfaction of the conditions to the offer as promptly as practicable”. In a letter to JAV’s CEO, HSP’s general counsel said that HSP “believes that the occurrence of the particulate issue, which directly affects the Company’s sole viable drug product, would reasonably be expected to result in a Material Adverse Effect, as defined in the Merger Agreement”.

The Court granted the motion to expedite on June 4. Later that day, JAV received notice from the NYSE staff that it is not in compliance with the NYSE Company Guide. Specifically, the staff indicated that JAV has “sustained losses which are so substantial in relation to its overall operation or its existing financial resources, or its financial condition has become so impaired that it appears questionable, in the opinion of the Exchange, as to whether Javelin will be able to continue operations and/or meet its obligations as they mature”. JAV announced on June 11 that HSP funded at $2 million loan under the existing loan agreement.

This is a very risky transaction to play right now, though the monster spread might be attractive to some people. The most likely outcome is this deal is terminated. Invoking a MAC in Delaware has proven to be a difficult task. It’s obvious why JAV wants an expedited trial – it is running out of money. The timeframe provided by the courts might not be fast enough for the company.

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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