The state of M&A, Risk, and Risk-Arbitrage in Canada

With the markets bottoming on March 6th, money has finally started flowing away from treasuries and back into risky investments. Initially it was the primary markets in the form of new debt and preferred offerings from banks, insurance companies, and essentially every firm that could access the debt markets. It then cascaded into the secondary markets, as the TSX Composite is now up 33.8% since that day. Now, the M&A market is picking up steam as well, as evidenced by several deals hitting the tape in the last few days, specifically Pluspetrol Resources making a hostile Takeover Bid for Petro Andina Resources on June 18th, and Challenger Energy announcing a merger with Canadian Superior on June 19th. This presents a great opportunity to discuss the current state of M&A, risk, and risk-arbitrage (an investment strategy typically employed by hedge funds and investment bank proprietary trading desks) in Canada.

First off, sector wise, M&A is currently hot in the oil and gas arena, as these two deals comes on the back of CNPC / Verenex in February, Suncor / Petro-Canada and Paramount Energy Trust / Profound Energy in March, and Clean Harbours / Eveready in April. In addition, Canadian Superior and Challenger Energy just announced their intention to merge, literally the day after Pluspetrol's announcement. This recent activity in the O&G sector makes me think that risk is being viewed through a different lens than in 2007 / 2008, and that the O&G sector will be a hotbed of M&A activity in the coming months. CAPP recently issued a presentation that highlighted expectations of a decrease in drilling activity of 22.3% YoY in 2009, and actual YoY comparisons show the active rig count coming in at ~100 in April - much lower than in 2007 / 2008 (http://www.capp.ca/getdoc.aspx?dt=PDF&docID=151585). In fact, it has been significantly lower throughout 2009 relative to the past two years. With WTI and AECO still miles from their highs of ~$140 / bbl and ~$11 / mcf in 2008, the interpretation is that drilling simply does not make much sense in this environment, especially given the volatility in the commodities, and therefore the inability to plan for profitable production growth. With growth not emanating from the drill-bit, firms are being forced to find growth through other means - M&A. This makes sense, especially when one can purchase production (or potential production via exploration companies) on the open market for a song relative to a company's 2008 share prices. Consolidation is a major theme that will continue to play out in 2009, not only in the O&G sector, but throughout the capital markets.

Secondly, appetite for risk is definitely back, as PAR is primarily an oil and natural gas exploration company, which is a much riskier investment relative to a producing company. In addition, PAR is not a domestic play, but has operations located in such risky locales as Colombia, Argentina, and Trinidad and Tobago. Note that the return to foreign country risk is corroborated by the Challenger Energy deal, as it is also an O&G exploration company with operations based solely out of Trinidad and Tobago.

Thirdly, as risk is back, risk-arbitrage is finally making a comeback as well. There are two indicators for this. One, Pluspetrol's Takeover Bid for PAR is hostile, which is something that we have not seen in months. Secondly, the risk-arbitrage community is committing real capital to this deal, as the stock opened at $9.00, a full $0.90 or 11% above the $8.10 deal price. The day's low on PAR on the 18th was $8.75, and 6.3mm shares traded at or above that price - 24 times the 3 month average daily volume! Over one million shares traded the following day as well, and PAR has continued to tick upwards to a high of $9.47 / share on the 19th, settling in at $9.25 at the close of business. What this indicates is that risk-arb investors believe that PAR is cheap at $8.10 / share, and that either Pluspetrol will come in with a higher offer to appease investors or PAR will source a white-knight to save them. Either way, investors are willing to speculate on the prospects of a higher realizable valuation in the future, hence, risk and risk-arb are both back.

In the next blog, I will go through an analysis of the PAR deal, partially because I believe risk-arb is coming back, but also because PAR is a live, hostile risk-arb, and it is therefore potentially extremely lucrative and very exciting.

Thoughts on Pershing Square's Q1 Letter to Investors

On June 8th, Pershing Square (PS) issued its Q1 letter to clients (below).

http://www.scribd.com/doc/16261914/Pershing-Squares-Q1-Letter-to-Investors

After a thorough read, I felt it necessary to expand on some thoughts I had that underlie the essence of what it means it to be a value investor, and how PS seems to combine value investing, shareholder activism, and corporate governance.

First off, paradoxically, where PS failed in its proxy contest with the Target (TGT) Board of Directors, they actually succeeded in producing what matters - an increase in shareholder value. An increase in the stock price of TGT is not a long-term increase in the value of the company, however, the end result is desirable, as it shows that capitalism and the corporate governance process seem to work, albeit with their own set of issues. Specifically, the existence of a universal proxy card and non-anonymous voting in one of the largest corporations in America shows that corporate governance is still a major issue throughout the developed markets, however, this is getting better over time. It also represents opportunities for further value creation. Note that PS' methodology of "governing the corporation" is a massive change from the "wild west" days of the 80's and 90's where shareholder activism denoted hostile takeovers, 13-D's forcing the sale of the company, etc. In this day and age, shareholder activism has been transformed and refined. In form, PS is a hedge fund, however, its actions with McDonald's (MCD), TGT, and Border's Group (BGP), resemble tactics similar to those of a VC or private equity investor. Proxy contests, board / management changes, strategic planning proposals, capital allocation changes - these are but a handful of the methods that modern day shareholder activists now use to produce long-term increases in the value of a company. In the future, the TGT Board may or may not produce the desired economic results. However, the threat of loud, powerful, and credible investors with reasonable complaints and viable plans are enough to cause boards the grief necessary to make positive changes. This is the way forward, and I believe that with the recession still in full force, shareholder activism will come back with a vengeance once money managers recuperate and get over the market and business dislocations of the past year. These corporate governance issues existed before the credit crisis, and they represented an opportunity for an increase in shareholder value then. Now there are price-to-value gaps across countries, asset classes, and sectors, and this is just gravy for value investors that can spot opportunities, have the resources available to stake claims in companies, and eventually push for changes to close these gaps while increasing economic value - the holy grail of investing.

While the media has been focused on PS' proxy dance with TGT, the most interesting portion of the letter is actually in regards to PS' investment in General Growth Properties (GGP). It exhibits two interesting points about value investors. First off, true value investors do not define themselves by asset classes or sectors. They are agnostic in terms of the investment form, and only search for investments that exhibit two basic qualities 1) excellent probability of limited downside in a worst-case scenario, 2) excellent probability of material upside in the worst-case scenario. This is evident by PS' purchase of GGP unsecured debt and equity, while already expecting it to file for Chapter 11. Value investors are often viewed by the public to be invested solely in stocks, however, at the right price, anything can be a value play, and true value investors will ALWAYS seek legal and contractual protection (read: limitation of downside) by moving up the capital structure, provided risk-reward is to their liking. PS's purchase of unsecured debt exhibits this, however, it's investment in equity exhibits a search for what is essentially free (or low cost) optionality - another hallmark of value investors. Secondly, value investors routinely play in spaces where they have an edge and where there is limited competition. PS' edge is in real estate, as it had extensive real-estate experience from its dealings with MCD, TGT, and other portfolio companies. In reviewing PS's attempt to provide GGP with DIP financing at ludicrously attractive terms (to PS) when nobody else wanted to, it is apparent that a lack of competition confers the ability to earn above average returns. While PS' DIP financing proposal ultimately failed, GGP's board did what it was supposed to do and solicited more attractive DIP financing. In this scenario, PS earned $15mm without even putting up a dime of its proposed $375mm commitment. Should PS's proposal actually have gone through, it stood to make ~$110mm (assuming static LIBOR) on a $375mm investment (~29%) over an 18 month time frame, all while maintaining the most senior portion of the capital structure, which was backed by first-lien AND second-lien collateral. This does not even include the zero strike warrants for 4.9% of the post-bankruptcy entity (IE - free optionality), which could have been worth tens of millions upon exit. Although their proposal failed, this still benefitted PS, as the auction process for the financing increased the probability of GGP exiting chapter 11 in good financial shape, and thus allowing PS to make multiples on its unsecured debt and equity investments. A bitter-sweet end to the DIP financing process, but still much more sweet than bitter. This example demonstrates how value investors focus on limited downside and material upside in all investments.

A quick look at the statement by PS regarding the sale of stocks in its portfolio illuminates another principle. While value investors search for absolute value, at the end of the day, everything is relative. This is why value investors are agnostic, as Wendy's common at a 30% discount to intrinsic value is actually rich when compared to General Growth Properties senior unsecured debt at 50% to face value / post-bankruptcy value. Similarly, GGP senior unsecured debt at 50% to face value is rich relative to DIP financing at a 4% commitment fee, 3% exit fee, LIBOR + 12%, and free zero strike warrants for 4.9% of the post-bankruptcy common. It is all relative, and selling cheap investments to buy cheaper investments, while psychologically frightening, is actually the most rational thing one can do.

In PS' brief paragraph on "Equity Shorts", it is interesting to note that this hedge fund is actually doing what it promises it will do - hedge. Hedging is a rational action, as it theoretically allows for the "locking in" of a spread or profit. Although, I believe PS' walks a fine line with this as long / shorts are not perfect hedges and it risks being caught offside on its short position (see Greenlight Capital and the drubbing it took on its Volkswagen trade in October 2008). The only modicum of comfort comes from GGP and TGT having multiple differentials that allow for higher upside than their corresponding shorts, yet similar downside potential. In order for these hedges to work, correlation must initially be high, and must stay relatively static, if not improve. With no event (IE - closing of a deal as in risk arbitrage) forcing convergence of the multiple differential to zero, these are not true hedges, but simply fit the bill in eliminating some uncertainty. It should be noted that economic / sector risk is (almost) eliminated, while business-specific / event risk is added to the picture. This is why long / short investing does not represent true hedging, and is closer to the "art" side than the "science" side on the arbitrage scale.

Raison d'être

I have started this blog to help disseminate my views on the global capital markets, and in particular, value investing, risk arbitrage, shareholder activism, and corporate governance. I feel that writing is extremely helpful for every person, in the sense that it allows one to clarify their thoughts and feelings on a topic, while giving a medium to share their views with the world. This is especially important in investing, as this endeavor requires one to think about markets, business models, competitive advantage, psychology, and a whole host of other inter-related subjects. In today's world of complexity, clarity of thought is needed in helping to guide us safely through the global capital markets. I hope this blog helps satisfy some part of that need.