Macquarie's take on risk arb deals
For everyone who thinks that the job of a hedge fund manager is a piece of cake (I’m not one of those people), here is a neat research note from Macquarie Capital Markets that provides a route map to try your hand at the risk arb game. But beware, the upside is modest and the downside can be meaningful:
“Buy a deal basket
(All figures in CAD unless otherwise noted)
Event
Risk arbitrage (arb) strategies historically outperform traditional investment styles in flat-to-down markets given a low correlation to overall equity returns.
Our analysis of material open deals on the TSX uncovered attractive increments of return (spread) with varying degrees of certainty.
Impact
Market turmoil has widened spreads on several deals, providing attractive upside for event-driven accounts or fundamental investors looking for shelter. Average annualized returns of 17.2% are compelling given market conditions. Looking back to 1985, risk arb strategies have only suffered in two down years: during the tech bubble of 2002 and the market crash of 1987.
Last year, risk arb strategies returned +10.55% versus 6.85% for the S&P 500. Year-to-date through May, it is +1.22% vs. -3.80%.
Analysis
We analysed 14 deals in Canada across sectors, valued at $250m or greater. In this market, we prefer cash deals for large liquid companies, with certain timelines to close, strong strategic rationale, potential for multiple bidders, support from board members and management and no financing issues.
Catalysts
Despite poor credit markets, rising inflation and weak economic growth, M&A activity has picked up. Unlike in 2006, when credit was readily available, current deals are being driven by a select group of companies with solid balance sheets and a distinct advantage to consolidate companies hit by rising costs and debt markets.
Risks for investors
Market volatility and deteriorating credit conditions could cause some deals to fall apart. Downside to pre-deal price levels is, in most cases, significant.
Action and recommendation
Our top-picks are BCE, FDG-U (non-taxable), TA, FLY/A, CDS and PTC. For low risk deals, we recommend entry points providing 10% annualized returns, 15% for medium risk deals and 20% for high risk deals.
Top risk arbitrage deals (acquirer/target)
Multiple Acquirers / BCE Inc (Deal size: approximately $34,800m)
BCE stock price as of 18 Aug 08: $40.19
(Low risk)The spread closed at $2.56, representing an annualized return of 20.2%. On 4 July 2008, financing risk was removed as fully negotiated and executed credit agreements were delivered. All final conditions, regulatory and court approvals have been received and fundamentals of the stock are strong, with recent 2Q results in line with analyst expectations. The offer is all cash and the stock is liquid.
Action: We would accumulate shares up to $41.40 to earn a 10% annualized return or better.
LS Power and GIP / TransAlta (Deal size: approximately $8,000m)
TransAlta stock price as of 18 Aug 08: $36.23
(High risk)The spread for the proposed bid by LS Power and GIP closed at $3.58, representing an annualized return of 12.6%. On 6 August, TransAlta’s BOD concluded that the offer was too low. This is a higher risk situation as no formal bid has been submitted. However, upside remains in owning TransAlta stock as shareholder activism will continue to pressure management to address shareholder value. Additionally, long term fundamentals (eg, gas price) supports strong upside as power price contracts roll over. On 15 August, it was disclosed that Children’s Investment Fund owns a 6.1% stake in TransAlta and has urged management to seek strategic alternatives. In its letter, Children’s indicated it believed the LS Power offer undervalued the company. The deal is not BOD-supported; regulatory risk exists based on past sales of Alberta Transmission Assets (2001) and a definitive agreement is not in place. The unsolicited offer is all cash and we are attracted by liquidity and the possibility of increased
bids or a more formal offer.Action: We would prefer to accumulate below $33.57 to earn a 20% annualized return or better.
First Reserve Corp / CHC Helicopter Corp (Deal size: approximately $1,600m)
CHC Helicopter stock price as of 18 Aug 08: $30.80
(High risk)The spread closed at $1.88, representing an annualized return of 51.8%. As of 29 July, CHC extended the outside completion date until 15 September, pending regulatory approvals in Europe. The deal is all cash and shareholders approved the deal on 29 April 2008. Approval has been received by the BC Supreme Court on 1 May and by Investment Canada on 8 July. However, certain regulatory approvals remain outstanding. These largely relate to the transfer of flying licenses in Europe. The transaction will be financed with a $1.6bn equity infusion from First Reserve and US$850m in debt financing committed by Morgan Stanley. The agreement includes a $61.4m reverse break-fee payment to CHC if, in certain circumstances, the purchaser fails to complete the transaction.
Action: We would accumulate shares up to $32.18 to earn a 20% annualized return or better.
Barrick Gold / Cadence Energy (Deal size: approximately $440m)
Cadence Energy stock price as of 18 Aug 08: $6.72
(Low risk)The spread closed at $0.03, representing an annualized return of 5.8%. On 21 July, Cadence
terminated its agreement with Daylight Resources Trust, thus eliminating the possibility of a rival
bid from Daylight. On 6 August, Barrick purchased Daylight’s Sturgeon Lake assets, which are adjacent to Cadence’s Sturgeon Lake assets. Operationally, the deal makes sense as Barrick would consolidate 100% of Sturgeon Lake’s South Leduc pool and would allow Barrick to hedge energy costs. The deal is all cash and has been unanimously approved by the board of directors of Cadence. All of the board members of Cadence and all of the officers of Cadence, who own approximately 7% of the outstanding Cadence shares, have agreed to tender their Cadence Shares into the Barrick offer. The offer is open until 4 September 2008Action: We would prefer to accumulate below $6.70 to earn a 10% annualized return or better.
Inmet Mining Corp / Petaquilla Copper Ltd (Deal size: approximately $350m)
Petaquilla Copper stock price as of 18 Aug 08: $1.89
(Medium risk)The spread closed at $0.11, representing an annualized return of 27.6%. On 12 August 2008, the Board of Directors of Petaquilla concluded that it needs further time to consider the Inmet Offer and determined to make no recommendation to shareholders at this time. Petaquilla is in the process of pursuing strategic alternatives in response to the offer.
Action: We assess a strong possibility of a sweetened bid from Inmet and would accumulate
shares up to $1.91 to earn a 15% annualized return or better.Special cases
Teck Cominco / Fording Canadian Coal (Deal size: approximately $14,100m)
Fording Canadian stock price as of 18 Aug 08: $92.50
(Medium risk)The spread closed at $4.34, representing an annualized return of 23.1%. The deal was structured as an asset sale to allow US$33.3 m (US$22.00/share) of total tax savings to Teck. Given the tax consequences of the purchase of Fording assets by Teck, shareholders will receive a distribution at tender that is taxable as income, not a capital gain. Thus, a limited market exists for the Fording units today, with the current spread likely only of interest to non-taxable Canadian accounts (pension funds). In addition, Teck announced its plans to sell its approximate 20% interest in Fording during a 20-day period following all approvals for the same tax reasons, thus creating an overhang on Fording shares today. The deal is conditional on US$9.8bn in financing being arranged. We note that, while credit markets remain challenging, Teck is already highly under levered, and with tax savings, should be able to maintain investment grade ratings post deal (net debt to EBITDA < 1.0x). The deal is roughly 90% cash and The Independent Committees of the Trustees of Fording have unanimously recommended that Fording Trustees and the Fording Directors support the transaction. While another bid is possible, the current deal is a win-win given Teck’s 40% interest (operator) in Elk Valley, and 20% interest in Fording. A shareholder meeting will be held in late September, and the company expects that the transaction will be completed in late October 2008. Action: We would accumulate shares up to $93.87 to earn a 15% annualized return or better"
MRM
Recent Comments