February 8, 2008

BCE: Special Situation Value Idea

The buyout of BCE present a risk arbitrage opportunity for the aggressive investor type. Private Equity has agreed to take BCE private for $42.75 per share in the summer of 2007.

I have spoken about it in the past, see post here. At that time I did not like the risk/ reward profile but since then the payoff profile changed significantly, as BCE shares declined due to skepticism that a deal that size can get done with the credit turmoil. The BCE opportunity promises a good return on investment compared to the risks involved. Let take a look, here are the facts:

  1. Current BCE price is $34.72.
  2. One additional dividend payment in April of $.365 per share.
  3. Take out price is $42.75 which is expected to be concluded in 2nd Qr 2008.
The payoff, if the deal is completed as announced, is 24% in 3 months, which is in excess of 100% annualized. However, such juicy opportunity would not last long. The market is voting that the deal won't get done at least at its current price.

The risks are two folds: financing and lawsuits from bondholders. There is a risk of a lawsuit from the bondholders to block the deal on the grounds that the deal will devalue their investment, as BCE take on more debt. Most legal opinion think this lawsuit will be dismissed and won't be an obstacle. The big obstacle, however, is the financing of the deal.

Most parties affirmed that they will go ahead, But will they get the needed financing. Big banks are sitting on $200 billion of backlog of LBO loans that they are trying to sell since mid of 2007 with no luck. Most LBO debt done in the summer of 2007 have gone down in price to the level of 75 cents on the dollar, see Businessweek table. Will banks extend credit with high probability of seeing losses to the tune of 25%? The smart money says no they won't.

Given this risk, lets take a look at the payoff in a probabilistic fashion. I will beg completing the deal at the proposed price at 40%. Moreover there is a possibility to getting the deal done at a revised price. The revised price can be anywhere from $35 to $42.75. Further more I will assign probabilities for each price point on an equal basis for all possible renegotiated prices in the mentioned range, then the expected payoff drops to 17.58% for 3 months. Not too bad.

But what happens if the deal gets dissolved. I expect the price of BCE shares to go to around $30 per share, its pre-buyout price, about 14% drop from its current levels. So an investor is faced with a 17.58% upside compared to 14% downside, these are good odds to work with. I think the risk reward profile of BCE arbitrage situation is well worth the risk now.

Off course if you want to protect your downside you can purchase at the money put which trade about $4 per share, therefore limiting any downside if the deal gets scrapped. However your expected payoff in this case decline to 5.5% or 22% on annualized basis; still not bad in such choppy market.

1 comment:

John said...
This comment has been removed by the author.