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.