Workouts Work Out In Down Markets - Part 3

By Joe Ponzio on January 21, 2008  |  15 comments

In Part 1, we looked at the various steps involved in a merger, acquisition, or going private transaction. As the transaction progresses along those steps, the spread between the market price and the closing price tends to close as the transaction becomes more finalized and less risky. In Part 2, we looked at a few deals and analyzed the risk vs. reward as well as the need to really dig in to the SEC filings.

Workouts are meant to be virtually "risk-less" transactions for idle cash in your portfolio. Let's dive in with that in mind.

I believe that it is human nature for people to want to profit on anything and everything and never lose money in the process. In practice, this is impossible. The number one strength you have is the ability to say "no" and pass on a deal. Buffett does it all the time; I do it all the time; you should do it all the time. Rather than trying to squeeze profits out of everything, wait for that great opportunity and then commit enough of your portfolio so that it has a meaningful impact.

When is a workout a phenomenal, virtually risk-less workout? Here's what I look for:

Regulatory Approval

First and foremost, I won't invest in a workout prior to Step 5. (For an explanation of the steps, see Part 1 here.) Keep in mind: risk-less. Investing in a workout before Step 5 is like buying any old stock and hoping that things turn out well. Though these companies have teams of smart people preliminarily looking into the regulatory aspects and pitfalls of the transaction, regulatory approval only comes from regulators.

Why would regulators kill a deal that the companies thought would go through? A quick look at the Bank of America/Countrywide deal says it all. In the U.S., no bank can control more than 10% of the nation's deposits. Bank of America already controls some 9.98%. Acquiring Countrywide — the mortgage house/bank — would push that control beyond 10%, and only a regulator can temporarily relieve BAC from that requirement.

Will the government allow BAC to control more than 10% of this country's deposits when there is clearly a law against it? If so, to what degree? Will the Countrywide deal put BAC at 10.2%? 13%? How much leeway will the regulators give, if any?

Prior to Step 5, there are a number of risks, hurdles, and obstacles that still need to be overcome. Investing at this point is more speculation than risk-less.

Shareholder Approval or "Pretty Much Guaranteed" Approval

You know what I don't want to see? A board that controls just 2% or 5% of the company's voting stock cutting deals that they can't close on. When management controls a small fraction of the voting control, they really need the shareholders — or a few large shareholders — to rally behind them to get the transaction done. This is the hurdle that BEA Systems must overcome (discussed in Part 2).

If a few major shareholders acquired stakes as a long-term investment, they may not welcome a merger, acquisition, or going private transaction — particularly if they were acquiring those stakes because they were ultimately planning on bringing in fresh management and masterminding a turnaround or control situation.

When management (and in the case of a merger or acquisition, the controlling company) controls 35% or more of the voting stock, there is rarely a question of shareholder approval. With 35% control of the deal, the company needs just 15% outside shareholder approval — hardly a lofty goal.

Of course, that assumes that the deal hangs on a majority vote, and not a supermajority (66%, 70% or 80% approval).

Financing

When there are no financing contingencies in an acquisition or going private transaction, I'm happy as pie. (I'm not so happy when a company dilutes existing stockholders' ownership by issuing new shares to complete a merger or acquisition.) When there are financing contingencies, you must decide how that will affect the deal, if at all. If financing is contingent on (a) the deal happening the way it was proposed, (b) there being no material changes in the business, and (c) there being no additional debt issuance, (along with other "general" loan terms and conditions) there usually isn't a cause for concern.

If, however, financing is contingent on a number of factors — especially the market prices of either or both of the companies — you might run into problems. You have to ask yourself: Is this a pretty straightforward deal or do the lenders have a zillion ways to back out.

The Risk Vs. The Payoff — Assessing The Odds

If all the ducks are in order, it is then time to analyze the potential risk versus reward. The risk: If the deal falls apart, the temporarily inflated stock price will likely drop. The Dow has been getting clobbered and yet Radiation Therapy Services (RTSX) has been holding steady around $30. They are set to go private (assuming shareholder approval and final signatures and financing) at $32.50 a share.

Why? Liquidity has pretty much dried up and few people are willing to buy or sell for much more (or less) than $30 a share because of the going private transaction. If, however, the deal falls through, you'll see a lot of workout investors and other shareholders getting out — with the stock price dropping in the process.

The RTSX deal is expected to close this quarter. A phone call to the company's proxy solicitation agent reinforced that (though no additional specifics were given). April 21, 2008 is the final date, after which either party can back out. Shareholder approval (of which management controls more than 40%) is expected at the special meeting of shareholders early next month. (If either party terminates prior to that, there is a $25 million penalty — somewhat hefty considering the size of both companies).

The potential payoff is about 8.8% (from $29.87 to $32.50) on an absolute basis. Assuming the deal goes through just before the April 21, 2008 deadline, that comes out to an annualized return of 28.8%, assuming you did this four times a year and reinvested the full proceeds each time. (Tip: You only need a few deals a year so don't jump into one today just because you are just learning about workouts and think they are a good idea.)

The downside? Assuming you could get out at $27 (a good-til-cancelled stop order is handy here), your risk is about 10%. Hmmm. 8.8% on the upside, 10% on the down. Doesn't sound like a good, risk-less transaction, does it?

Play The Odds

As you look at RTSX, or any other workout situation, you have to analyze the odds as well. You'll have a hard time finding post-Step 5 deals with 20% upside and 5% downside. It just doesn't happen. So, what are the odds?

What are the odds that this deal will go through? I can't say for certain, but I do believe that it is better than 50/50. This is nearly a "done deal" and the only things that can upset the applecart seem to be:

• virtually unanimous shareholder disapproval;
• a substantial change in RTSX's business;
• a major screw-up (and breach of duty) on the part of management or the acquirer.

So long as the odds are better than 54/46 for the deal going through, you'll make money in the long-term buying workouts like this. On any given workout, you may find yourself on the "46" side; still, in the long-run, you would be wise to put money in when the long-term odds are in your favor, and sit on the sidelines when they are not.

Some Final Questions On Workouts

On Wednesday, we'll answer some of those burning questions like:

• If workouts are so great, why don't I just do that?
• Should I consider using margin on my workout positions?
• Why do I keep missing out on workouts? The premium dries up the instant it is announced!
• What about class action lawsuits?
• Is this deal too good to be true?

And above all, remember: You have to read the reports, proxies, etc. on the SEC's EDGAR system! Know the deal, the companies, and the terms — not just the market price, closing price, and potential pay-off.

Also Filed Under "Workouts, Arbitrage, & Hedges"

• Just Sold Tribune
• When People Are Happy, Protect Your Portfolio
• Pre-Regulatory Workouts
• Workouts Work Out In Down Markets - Part 1