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.

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!