I read John Paulson’s The “Risk” in Risk Arbitrage posted on gurufocus.com via Marketfolly. I filled it away and had the opportunity to use it recently in a merger arbitrage / risk arbitrage on iSOFT (ISF.AX). iSOFT is a medical software company based in Australia with substantial revenues from the UK. iSOFT are partners with Computer Sciences Corporation (CSC) in the NHS Program for IT (NHSPFIT) for the UK National Health Service. I used Paulson’s criteria to evaluate iSOFT and the results were quite positive. I was able to purchase iSOFT shares for 14.5c in mid-May which will be about 10 weeks before receiving the cash from the deal for a 17% return. This isn’t a perfect deal but it’s pretty close and provides a good demonstration of using Paulson’s criteria. Finally I will run his criteria over a couple of other transactions for comparison.
I came across iSOFT a few years ago as I was reviewing the companies created by or associated with Allco. Allco were a large, leveraged financial services company with interests in property trusts, leveraged buyouts and other primarily financial transactions. In 2008 they went into administration (the Australian equivalent of Chapter 7 bankruptcy). I purchased some bonds in one of their child vehicles called the Allco HIT trust (see a Hug for AHUG) where I nearly made many times my money but ended up making a small loss.
At times I also invested in Allco bonds and their Japanese property trust (RJT.ax). Another child company was Allco Equity Partners (AEP.AX) which changed their name to Oceanic Capital Partners (OCP.AX) after Allco went into administration. OCP owned publicly traded shares in iSOFT as well as convertible bonds. They also owned a security company and loan recovery company. They were selling for about half of their net asset value and I purchased a position in OCP. I intended to short the interest in iSOFT to substantially reduce the risk in m OCP holding.
However that side of the transaction proved to be too difficult — it’s hard to short Australian shares (a story for another day). OCP has executed a few returns of capital, and I’ve made a reasonable return in spite of iSOFT falling from around 90 cents to around 3 cents before the CSC takeover announcement. This is a good example of pulling the threads once you find an interesting opportunity and of investing in an opportunity with a wide margin of safety.
After the precipitous drop in iSOFT's performance and share price OCP took over chairmanship of the iSOFT board and were openly shopping it around. They made a deal with CSC for 17 cents per share. I rarely consider merger arbitrage opportunities because the margin of safety is often missing. In fact the opportunities often look more like picking up pennies in front of a steam roller. The last one I participated in was the Dow - Rohm and Haas opportunity in the midst's of the financial crisis (my error there was taking too small a position — though isn’t it always when the position works out!).
I took the opportunity with the announced iSOFT transaction to develop a merger arbitrage checklist and populated that list firstly with Paulson’s thoughts. He starts by dividing the risk to a merger arbitrage into Macro and Micro risks. For Macro risk you have little risk (risk of loss of capital) where the deal is cash, or stock where you can short the acquirer in proportion. Paulson then describes circumstances where the ratios are not fixed or are otherwise complicated.
I’ve nominated cash deals as the best kind followed by ones with a fixed ratio that can be shorted. Finally on Macro risk it is worth noting that extreme market moves up or down can decrease the likelihood of a deal completing (he notes the 1998 shutdown of the high yield market and the Internet bubble of examples each way. We all saw the recent financial crisis where the same occurred).
The impact of market dislocations, up or down, is largely about portfolio construction. If your portfolio is neutral then a little market risk from a merger arbitrage position might be fine. If, however, your portfolio is already bullish then you may want to better protect the macro risk downside of this transaction (and of your whole portfolio). If a merger arbitrage position was the only one in your portfolio then you may consider some type of long call/long put strangle that were both substantially out of the money. Other macro factors can impact a deal if it requires debt finance, or the value of the merger is tightly coupled to commodity risks.
Paulson then goes on to Micro risks starting with earnings. The major risk here is that the target has a negative earnings surprise during the announcement-to-closure period. This can lead to the cancellation or renegotiation of the deal (if the agreement allows).
Next is financing; cash transactions can come from cash already on the balance sheet of the acquirer or cash that they need to raise in capital markets. Once they need to go to capital markets you have all those macro risks come back into play. There is also a risk in a sudden decline in the earnings of the acquirer as their cost of capital would increase.
Paulson’s next discussion is around legal risks. You need to understand the specifics of the offer, if there are an corporate by-laws that impact the transaction and any litigation that either party is involved in. Another legal aspect is the merger agreement; it is a great representation of each parties’ commitment to the merger. Paulson describes the increasing degree of confidence that you draw from an agreement-in-principal all the way up to a definitive agreement.
The degree of due-diligence, performance tests, material adverse changes, drop-dead dates, walk away provisions and regulatory hurdles all impact the likelihood of completion. Regulatory hurdles include anti-trust or specialty government watchdogs such as those that exist for national security, banking, etc. can kill a deal. Due diligence allows the acquirer to look over the company in detail; if this occurs post-agreement then it allows the acquirer to exit the agreement if they find something they don’t like (or for practically any reason).
The acquirer is the party purchasing the target. The amount of cash on their balance sheet, their capital structure and their deal history is very important. Is it possible that the acquirer is going to in turn receive a buyout offer? Be especially careful if you’re short the acquirer in a stock transaction and consider put options to hedge that risk. Fraud is a consideration but no different to the considerations in being long any stock.
There is then a discussion of return and how premium, taxes, the consideration (cash, stock or other) and timing effect your return. The summary is to consider the after-tax return. In comparing multiple opportunities it’s also useful to calculate the annualized return by comparing the after-tax return to the period in which it is earned. Be careful though not to call a 10% return in one month a 120% annualized return (excluding compounding) because you need 12 of them back to back for you to actually realize that 120%.
Paulson then presents a list of the types of opportunities to focus on and those to avoid:
Let’s compare iSOFT to the list:
By way of comparison I invested in another Allco related entity which I wrote about in AHUG a good value investment. That deal met only six positives and had nine negatives. There were other potential upside surprises which made it more attractive. While it went ahead it was at a substantially reduced price leading to a loss. Running the “Dow – Rohm and Hass merger” over the list leads to 11 positives and 4 negatives (based on my recollection of the situation). That deal went through as originally envisioned.
With a limited sample, along with Paulson’s track record, it appears that this is a useful tool in analyzing merger arbitrage opportunities.
I came across iSOFT a few years ago as I was reviewing the companies created by or associated with Allco. Allco were a large, leveraged financial services company with interests in property trusts, leveraged buyouts and other primarily financial transactions. In 2008 they went into administration (the Australian equivalent of Chapter 7 bankruptcy). I purchased some bonds in one of their child vehicles called the Allco HIT trust (see a Hug for AHUG) where I nearly made many times my money but ended up making a small loss.
At times I also invested in Allco bonds and their Japanese property trust (RJT.ax). Another child company was Allco Equity Partners (AEP.AX) which changed their name to Oceanic Capital Partners (OCP.AX) after Allco went into administration. OCP owned publicly traded shares in iSOFT as well as convertible bonds. They also owned a security company and loan recovery company. They were selling for about half of their net asset value and I purchased a position in OCP. I intended to short the interest in iSOFT to substantially reduce the risk in m OCP holding.
However that side of the transaction proved to be too difficult — it’s hard to short Australian shares (a story for another day). OCP has executed a few returns of capital, and I’ve made a reasonable return in spite of iSOFT falling from around 90 cents to around 3 cents before the CSC takeover announcement. This is a good example of pulling the threads once you find an interesting opportunity and of investing in an opportunity with a wide margin of safety.
After the precipitous drop in iSOFT's performance and share price OCP took over chairmanship of the iSOFT board and were openly shopping it around. They made a deal with CSC for 17 cents per share. I rarely consider merger arbitrage opportunities because the margin of safety is often missing. In fact the opportunities often look more like picking up pennies in front of a steam roller. The last one I participated in was the Dow - Rohm and Haas opportunity in the midst's of the financial crisis (my error there was taking too small a position — though isn’t it always when the position works out!).
I took the opportunity with the announced iSOFT transaction to develop a merger arbitrage checklist and populated that list firstly with Paulson’s thoughts. He starts by dividing the risk to a merger arbitrage into Macro and Micro risks. For Macro risk you have little risk (risk of loss of capital) where the deal is cash, or stock where you can short the acquirer in proportion. Paulson then describes circumstances where the ratios are not fixed or are otherwise complicated.
I’ve nominated cash deals as the best kind followed by ones with a fixed ratio that can be shorted. Finally on Macro risk it is worth noting that extreme market moves up or down can decrease the likelihood of a deal completing (he notes the 1998 shutdown of the high yield market and the Internet bubble of examples each way. We all saw the recent financial crisis where the same occurred).
The impact of market dislocations, up or down, is largely about portfolio construction. If your portfolio is neutral then a little market risk from a merger arbitrage position might be fine. If, however, your portfolio is already bullish then you may want to better protect the macro risk downside of this transaction (and of your whole portfolio). If a merger arbitrage position was the only one in your portfolio then you may consider some type of long call/long put strangle that were both substantially out of the money. Other macro factors can impact a deal if it requires debt finance, or the value of the merger is tightly coupled to commodity risks.
Paulson then goes on to Micro risks starting with earnings. The major risk here is that the target has a negative earnings surprise during the announcement-to-closure period. This can lead to the cancellation or renegotiation of the deal (if the agreement allows).
Next is financing; cash transactions can come from cash already on the balance sheet of the acquirer or cash that they need to raise in capital markets. Once they need to go to capital markets you have all those macro risks come back into play. There is also a risk in a sudden decline in the earnings of the acquirer as their cost of capital would increase.
Paulson’s next discussion is around legal risks. You need to understand the specifics of the offer, if there are an corporate by-laws that impact the transaction and any litigation that either party is involved in. Another legal aspect is the merger agreement; it is a great representation of each parties’ commitment to the merger. Paulson describes the increasing degree of confidence that you draw from an agreement-in-principal all the way up to a definitive agreement.
The degree of due-diligence, performance tests, material adverse changes, drop-dead dates, walk away provisions and regulatory hurdles all impact the likelihood of completion. Regulatory hurdles include anti-trust or specialty government watchdogs such as those that exist for national security, banking, etc. can kill a deal. Due diligence allows the acquirer to look over the company in detail; if this occurs post-agreement then it allows the acquirer to exit the agreement if they find something they don’t like (or for practically any reason).
The acquirer is the party purchasing the target. The amount of cash on their balance sheet, their capital structure and their deal history is very important. Is it possible that the acquirer is going to in turn receive a buyout offer? Be especially careful if you’re short the acquirer in a stock transaction and consider put options to hedge that risk. Fraud is a consideration but no different to the considerations in being long any stock.
There is then a discussion of return and how premium, taxes, the consideration (cash, stock or other) and timing effect your return. The summary is to consider the after-tax return. In comparing multiple opportunities it’s also useful to calculate the annualized return by comparing the after-tax return to the period in which it is earned. Be careful though not to call a 10% return in one month a 120% annualized return (excluding compounding) because you need 12 of them back to back for you to actually realize that 120%.
Paulson then presents a list of the types of opportunities to focus on and those to avoid:
Focus | Avoid |
|
|
Let’s compare iSOFT to the list:
- Definitive Agreements – CSC and iSOFT have entered a definitive agreement that doesn’t have any clause allowing CSC to withdraw from the deal except in the most unlikely of circumstances (iSOFT default, iSOFT material litigation or iSOFT's customer contract termination and even then it has to have been omitted from the due diligence process) (+)
- Strategic rationale – iSOFT are the software provider under NHSPfIT but CSC do the implementations. It makes lots of strategic sense form CSC to own the software as well as deploy it. CSC are quoted saying "Our decision to acquire iSOFT is independent of any specific transaction, client or contact. It's a strategic acquisition that's in line with our global expansion plans." (+)
- Large acquirer – CSC are a USD 5.8Bn market cap company and this deal, including the assumption of debt and repayment of convertible securities, is worth around 500m. (+)
- No ï¬nancing condition – there are no financing conditions and CSC has 1.84Bn in cash on their balance sheet (gross, not net, of debt) (+)
- No due diligence condition – The due diligence was undertaken before the merger announcement (+)
- Solidly performing target – iSOFT's performance has been poor. Two years ago the shares were around 90c. Their cost structure is far too high for their revenue streams and they have costs in the ever increasing Australian Dollar whereas substantial revenue from the falling British Pound. (-)
- Reasonable valuation – iSOFT traded for 90c two years ago. It is a major player in clinical software and without CSC’s offer they may not have been able to pay off debt as it came due. It is likely that CSC have paid a distressed valuation for iSOFT. By the same token it was trading for 3.5c before the announcement so both sides are getting something of value. (+)
- Limited regulatory risk – Though this was unlikely to receive regulatory scrutiny it has already passed the foreign investment regulatory review. (+)
- Agreements in principle – No it’s definitive (+)
- Deals subject to ï¬nancing – No (+)
- Deals subject to due diligence – No, conducted before the agreement (+)
- Targets with poor earnings trends – Yes, see above (-)
- Targets with negative earnings – Yes, see above (-)
- Deals in cyclical industries – No (+)
- Deals in highly regulated industries – No (+)
By way of comparison I invested in another Allco related entity which I wrote about in AHUG a good value investment. That deal met only six positives and had nine negatives. There were other potential upside surprises which made it more attractive. While it went ahead it was at a substantially reduced price leading to a loss. Running the “Dow – Rohm and Hass merger” over the list leads to 11 positives and 4 negatives (based on my recollection of the situation). That deal went through as originally envisioned.
With a limited sample, along with Paulson’s track record, it appears that this is a useful tool in analyzing merger arbitrage opportunities.
