November 20, 2007

Cerberus deals come undone

The death of private equity deals has lead to some interesting events. Cerberus Capital is failing the pain of the fallout in a big way. The private equity firm is headlined in all sort of tangled mess from the its buyout deals:
  • It is being sued by United rentals for failing to complete their buyout.
  • GMAC the financial arm of GM lost $2.3 billion last quarter
  • Sale of its $4 billion debt for the Chrysler deal is postponed and may face price drop.

The firm is also a part of group to buy BCE Inc, a Canadian telecom provider, in one of the largest buyouts this summer. The BCE buyout is expected to close late in the first quarter of 2008. Earlier this year Cerberus along with the Ontario teachers fund offered C$34.8billion to BCE shareholders to take the company private; it offered C$42.75 per share. The firm has been definitely busy this summer. Can the BCE deal go in the way of United rentals? Will Cerberus Capital walk away here also?

maybe the best way is to look at what the price of BCE is telling us.

An arbitrage opportunity exist in the buyout but the professional arbitrageurs have not exploited it yet due to the inherent risk of financing such a huge deal. Can the investor group raise that enormous debt levels to complete the deal? Is the arbitrage opportunity worth the risk? Lets look at the probabilities:

  1. Complete deal @ $42.75 (Probability 85% ) give an expected payoff 9.19% (42.75 less 39.82 (current price) + Dividends: 2 payouts@ $.365)
  2. Abandon deal (probability 15%) give an expected loss of -22.8% (share will fall to its pre offer price level of $30+ Dividends)
  3. The expected payoff is 4.38% expected pay off

I am assigning a 15% that this deal will not go forward and here is my rationale: The probability of completing the buyouts stand better chance than the United rental deal. Cerberus have the deep pocketed teachers fund on its side as well as host of other institutional investors like Merill Lynch. The deal cleared all regulatory hurdles and shareholders approved the merger. But there the pesky bond holders who do not like the deal as their bonds have fallen off from grace (they can hold to maturity!). Those will not pose any material challenge to the deal going forward. What will pose a challenge is the credit market and that is where arbitrageurs have not piled into this opportunity.

This is a very optimistic scenario given the problems in the credit market and the troubles Cerberus is having floating its Chrysler deal. many would have assigned a much higher probability for the deal to fall apart, which is plausible. since the credit crunch many deals have came undone and this will persist with the worsen credit market. But I am an optimistic kind of person.

With a payoff of the BCE arbitrage play at 4.3%, I would rather buy a 90 day TB thank you very much!


John said...

Great analysis

That said, I risked a big margin play on BCE. (i.e. 23% of my non RRSP portfolio is now BCE on the margin)

Borrowing on the margin is at 6.5% vs the difference to the close price(fingers crossed for a Q2 deal close)

Downside is definitely in the 30% range (i.e. 10$ loss and 25% chance)

I do not understand enough about the rules on the buyers these. Why do the buyers (if they are really serious) just not start buying at the 39$ price now and save themselves the difference to 42.75?

Sami said...

it used to be like what you say, buyers will float a public offer at lets say $40 per share and buy on the open market at may be 37-whatever less than the offer. This was very popular technique in 70s and 80s but regulators stepped in and outlawed these tactics and created some unfavorable tax consequences for any firm doing this.

As for BCE the decline in the price from the $40 range is the market voting that the probability of the deal getting done is decreasing. However, this not an entirely a private equity deal. Ontario teachers is the big boy in this battle and it carries a heavy weight with the Canadian banks so they may advance the necessary loans to get this thing done.

Once it gets done you are looking at nice gain so good luck.

John said...

Thank you for the answer. I did not realize the buyers could not simply purchase shares until the transaction closes. It seemed so illogical.

On another topic, it appears to me that you really have a handle on investment and risk analysis (much more then most blogs that are just struggling to understand the basics of investing and value)

I want to follow your picks closer. I think I will just buy along with you for a while. Risk is not much problem for me since I have about 40 plus long term positions in the market now and I am always looking for new buy and hold concepts to deal with the dividends the portfolio throws off.

My question – Is the “my value Ideal investment performance” sheet on your blog home page a list of your current picks and the date price you picked them at?

PS – If your start up concept is half a good as your investment analyses you will be a massive success. You have a great step by step approach to risk and a deep understanding of business. (Not at all like the typical accounting type))))

Sami said...

hi John,

Thanks for the complement. The blog's goal is to force me to write down my analysis on my investment. I think going through the process of a write up crystallizes my thinking.

I just try to think independently from all the CNBC and media hype and try to formulate an opinion for myself. but I urge you to study and analyse for yourself and have an opinion on the business independent from any

Yes my investment performance is the business I picked and the date I got into them.

my start up is now in the product development stage sometimes it is frustrating as things move slower than what I like, but it is great fun.

Thanks again John for the kind words!!

John said...

I do enjoy the study and analysis part of investing.

I read the Wall Street Journal each day as my base information. (cost a fortune but I have it delivered to the house since the “paper feel” is so much better then the online for an experience with coffee)

I read all the usual National Post and Globe articles also.

You could say my life long hobby had been investment analysis.

I have access t the globe Investor and all of the TD research reports online.

So I know a fresh view when I see it. Your analyses are about half way between the pro (sometimes mindless) approach you see from the stock analysts and the fluff pieces (which I enjoy) that are in Fortune.

You have at least one reader (me) and for fun I am going to just invest along with you for a while.


Sami said...

Thanks John. You are putting a lot pressure on me to only bring good analysis, which is what i want :)

I too like the analysis aspect of the investment process. And I want to improve my analysis even more. i want it to be airtight. currently i feel I still have some holes. the one thing I want to improve is risk assessment of companies.

i think writing about it and interacting with readers like you will help me.

So thanks for reading!

Anonymous said...

Hi Sam,

Stumbled upon your blog.

Had a question regarding the risk assessment, specifically the BCE arbitrage play:

How did you arrive at 4.3% expected pay off?

BTW: awesome blog

Sami said...

hi anon,

thanks for the complement.

basically the 4.3% is the expected pay off of buying BCE shares. there are two scenarios, given the current credit market conditions:
1. the deal get done at $42.75 so the return will be the difference between the buyout price and the purchase price plus the two dividends:
(($42.75-$39.82)+ (2*$.365))/$39.82= 9.19%

2. the second alternative: the deal fall apart and bce shares go to their pre buyout price of $30 plus two dividend payments, assuming you will sell at that point:
((30-39.82)+(2*.365))/ 39.82=-22.8%

I assigned a probability of 85% for the deal to get done and 15% to fall apart, a judgement call.

Typically a deal like that will have a higher probability in normal market conditions. But with credit market not working well and invesors being careful, who knows?

knowing the payoffs in the two scenarios, then you multiply the probability by the payoff to get the overall expected payoff:


In case of BCE there are two alternatives and assigning probabilities to them is completely arbitrary, so you may disagree with me and say the probability of it getting done is higher therefore increasing the payoff for the investment.

Hope that helps.

John said...

Now the following comment is real nit picking.

The numbers in the method above are not “annualized”

On an annualized basis the deal done scenario is worth closer 20% plus.

I compare that to my 6.5% margin costs and I take the risk.

That said the risks are real and this is not something for people who are not comfortable with risk arbitrage.

The faster the deal gets done (or undone) the better for me since I have a god size bet and the margin aspect blocks me from perusing other opportunities until I get this one off my books)))

My own views were 75% deal will be done, 25% something will change and screw it up.

Sami said...

hi John

yes the numbers are not annualized, so it may make the expected returns look better. but the point there is some risk with buying bce stock.