Article #1
Tribune Co. Case Study (http://www.futureblind.com/2008/01/tribune-co-case-study/)
by Max Olson | Tuesday, January 22nd, 2008 at 9:50 am
The following is a section from my 2007 letter to partners. It examines the buyout of the Tribune Company, an arbitrage situation we took part in last year. Tomorrow I will post another section that discusses risk arbitrage. (Please note that I have removed some of the non-public information that was included the actual letter). Enjoy!
On April 2, 2007 Tribune Co. announced that Sam Zell prevailed in his bid for the struggling newspaper company. The final $34 per share offer was chosen over another eleventh-hour bid from Los Angeles billionaires Eli Broad and Ron Burkle. Sam “The Grave Dancer” Zell—contrarian real estate magnate—had just completed the sale of Equity Office Properties, his real estate holding company. With the cash he received from the sale (the largest leveraged buyout in history), Zell jumped back into business with his offer for Tribune. The company owns coveted newspapers such as the Chicago Tribune and the Los Angeles Times. Other assets include a string of TV stations and the Chicago Cubs baseball team.
Under the terms of the agreement, each share of Tribune would eventually be exchanged for $34 in cash. The deal would be subject to shareholder approval and regulatory clearance from the FCC. Sounds simple, right? The end result of the transaction was easy to understand, but the mechanics of the deal were anything but. It was especially unique because the shares would initially be owned not by Zell, but by an Employee Stock Ownership Plan (ESOP) where Tribune employees would share in the company’s upside.
Immediately after the announcement, the ESOP would purchase $250 million of newly issued stock for $28 a share. Zell’s initial investment consisted of a $200 million promissory note and $50 million in new stock. In May, Tribune would borrow $4.2 billion to finance the purchase of about half of the company from public shareholders.
After shareholder approval and FCC clearance, the ESOP would buy out all remaining holders and become a Subchapter S corporation (which passes all taxable income to its owners). Since Tribune’s sole owner would be the ESOP—another tax-free vehicle—the company would essentially pay no taxes. This plan would free up cash flow to pay down debt and reinvest in operations. When the deal closed, Zell’s initial $250 million investment would be redeemed. He’d then make a new investment, consisting of a $225 million eleven-year loan and a $90 million warrant. The warrant will give Zell the right to purchase 40 percent of the company for $500 million in the next fifteen years. For a total outlay of $315 million, Zell has a lot of upside and little downside—an excellent situation to be in, if I may say so myself.
And one more thing—if the deal didn’t close by the end of the year, starting January 1, 2008 the $34 price would raise by 8 percent annually. An important aspect for arbitrageurs, especially if the deal was delayed.
Everything went as planned through the May share repurchase. At this stage, Tribune was half its prior size and the ESOP owned about 7% of the company. Up until June, Tribune’s stock traded around $33 per share (a $1 spread), a more normal price for a deal only a few months from completion. Near the end of summer, the market started heading south. The credit crunch had investors worried that lenders would back out of commitments and tighten credit standards. Tribune shares fell to under $26 just before the August 21 shareholder vote.
On the day of the vote, I purchased Tribune stock for about $28 per share. It had shot back up from $26 as investors realized the vote was in the bag, with a 97 percent approval rate. As sentiment improved over the next few months, the price started moving back up. I sold our stake for $30 per share, a quick 7% gain (53% annualized). A good return by arbitrage standards, but I have no clue what I was thinking in hindsight. At this point there were very high odds the deal would go through, and I left a lot of gains on the table.
Thankfully, the share price went nowhere over the next six weeks, and I had the chance to redeem myself. At the end of November, the FCC finally approved the deal—putting it off until the last possible second. Four days later, I pulled the trigger again, buying back our stake for $30 a share.
At this point, there was only one thing that could possibly get in the way: the banks pulling their financing arrangements. But in my view, that was highly unlikely. A consortium of banks had already lent over $7 billion to Tribune, and they’d be shooting themselves in the foot by holding up the deal. Every player had huge incentives to complete the transaction before year end. After December, not only would the buyout price go up (more money from the banks), but Tribune would lose their preferential tax treatment for 2008. In the months preceding our purchase, Tribune stated on multiple occasions that the deal was still on track. Despite every step of it being followed by The Wall Street Journal, few investors took advantage of this underpriced opportunity.
So how did it all turn out? Sixteen days after our second purchase, the buyout was finally complete. Thirty-four dollars per share in cash was distributed to each remaining shareholder on December 20. For us, this worked out to a 12% total return, or 1,257% annualized (that is, if I got the same return every sixteen days for the next year).
Below are a few lessons you can take away from this investment. I’ll elaborate on some of them in my post title Risk Arbitrage 101 tomorrow.
1. In any special situation investment, it always pays to look at incentives.
2. Always know who’s involved—on both sides of the transaction.
3. The market hates complexity, so that’s usually a good place to find bargains.
4. Don’t listen to the market—especially when they’re thinking as a crowd.
I’ll finish the story with a quote from Sam Zell, at a press conference on December 20:
“I’m Sam Zell. I’m here to tell you that the transaction from hell is done. It’s also the transaction that nobody in the world except us collectively believed was going to happen, but it did.”
Article #2
Risk Arbitrage 101 (http://www.futureblind.com/2008/01/risk-arbitrage-101/)
by Max Olson | Wednesday, January 23rd, 2008 at 9:32 am
Below is the second clip from my 2007 letter to partners. The first post was a case study of Tribune Co., an arbitrage situation we participated in last year.
“Give a man a fish and he eats for a day. Teach him to arbitrage, and he will eat for a lifetime.” —Warren Buffett
Risk arbitrage (also called merger arbitrage) is where an investor buys stock in a company that’s expecting to be taken over. The investor’s goal is to profit from the difference in current market price and eventual buyout price. Here’s a simple example: Company A announces that it will acquire Company B for $20 per share. Immediately after the announcement, the share price moves from $15 to $19 per share. The arbitrageur then purchases the stock, hoping to make a $1 profit once the deal is complete.
Why doesn’t Company B just move straight to $20 after the announcement? Why the $1 difference? There are a number of reasons. First, since the merger usually takes some time to complete, part of the $1 represents the “time value” of not receiving the $20 right away. But most of the discrepancy usually represents the market’s uncertainty about the final outcome. The deal may fall through for multiple reasons, such as financing problems, regulatory roadblocks, or the acquirer simply changing their mind. So the risk arbitrageur has two questions to answer: will the deal go through – and if so, how long will it take?
Merger arbitrage is like a simpler, time-constrained version of value investing. When screening for candidates, there’s no need to do valuation work because the value of the company has already been announced. Both arbitrage and value investing involve handicapping the odds and buying assets for less than they are worth. With that in mind, below are some important things to consider when making any arbitrage investment.
•
Figure out the odds. Before serving as the Secretary of the Treasury under Bill Clinton, Robert Rubin worked in the risk arbitrage department at Goldman Sachs. I highly recommend his autobiography In an Uncertain World, where he writes not only about his life but about the specifics of his job at Goldman.
To engage in arbitrage, you must estimate the odds of the merger going through, and what the possible outcomes will be if it does not. Once a deal was announced, Rubin would undergo rapid, intensive research, examining all available public information. He would weigh each factor, and create an expected value table for the deal.
An expected value table works like this. Take the example of Company A and B from above. If the deal goes through, there is $1 in potential profit, and maybe we think there’s a 90% chance this will happen. In the 10% chance the merger falls apart, it will probably decline $4 to its price before the announcement. The final equation is: 90% x $1 - 10% x $4 = $0.50. So our expected return is fifty cents on a $19 investment, or 2.6%. If the deal took two months to close, the actual annualized return would be 36%. But using our expected profit, annualized return is only 17%. Rubin normally accepted deals only if expected annualized return was 20% or more.
Bob Rubin’s most important lesson was this: you should use probabilistic decision making when confronting any problem. Success comes by evaluating all the information available to judge the odds of various outcomes and the possible gains or losses for each.
•
Look at incentives. Incentives aren’t given enough credit in most arbitrage situations. Yet they are very powerful motivators and can have a huge impact on the final outcome. Look for monetary incentives on both sides of the transaction. Usually there will be a “break-up” fee to discourage the buyer from walking away. What do executives in both companies get out of the deal? Will there be synergies or huge cost savings that make the merger beneficial? Do major shareholders have enough incentive to approve the deal?
•
Know who’s involved. In May of last year, Rupert Murdoch made a surprise bid for Dow Jones & Co., publisher of The Wall Street Journal. The $60 per share offer was a huge 67% premium to Dow Jones’ prior closing price. In the weeks after the bid, hostility from the Bancroft family (the controlling shareholders) caused the market to price Dow at a 10% discount to the offer. It seemed reasonable, considering the amount that Dow would drop if the deal fell through (30 to 40%).
Warren Buffett knows Rupert Murdoch. Not as in “he knows him as a friend,” but as in he knows who he is, as a businessman. The market was weary, but Buffett knew there was a very good chance the deal would get done. Between the announcement and the end of June, Buffett purchased 2.8 million shares of Dow Jones—another one of his classic arbitrage investments.
Knowing the background and personalities of those involved can help immensely. The Tribune takeover was a prime example of this. No matter what happened in the final stages, Sam Zell was the kind of guy who wouldn’t have let Tribune slip past him. He had the intelligence, resources, and determination to see the deal through to the very end. This aspect isn’t always present in every arbitrage situation, but when it is, it’s often overlooked by the market.
•
Look for a margin of safety. What will happen if the deal gets cancelled? You don’t want to end up holding an overvalued or distressed security. Look for any “back-doors” if the initial thesis doesn’t play out. If the Tribune deal fell through, there were multiple bidders who may have stepped in to buy the company or its assets.
Find out if it’s a good deal in the first place. When you think the takeover target is more valuable than the price being offered, it’s beneficial for a few reasons. First, if the deal falls through, you’ll still end up holding an undervalued security. Second, there’s a better chance of someone coming in with a higher bid. Either way, your possible losses are minimal.
•
Wait for the no-brainers. Most funds and institutions that are dedicated to arbitrage treat it like an actuarial business. They participate in dozens of investments at a time, hoping any losses in one will be made up for with gains in the others. With the risk that merger arbitrage imposes, this isn’t a terrible way of thinking. But it ensures only mediocre performance. Warren Buffett’s strategy in his partnership and early Berkshire days was a more concentrated approach. He would be in at most a handful of situations at any one time.
The advantage Buffett had (and we have) is that he wasn’t constantly forced to make new arbitrage investments. If the buyout market cooled off, he could wait on the sidelines for better opportunities. This is in contrast to the dedicated arbitrage funds who are forced to remain active and analyze every possible deal. The best thing to do is wait for the no-brainer buyouts where (forgetting the market) the target company is obviously mispriced. That was the case with our investment in Tribune Company.