June 4, 2012
On May 21, 2012 Prem Watsa, who is also known as the ‘Warren Buffett of Canada’ bought a 76.81% stake in Thomas Cook India for INR 50 per share. Admittedly he got a good deal by purchasing the shares at an 18% discount to the closing price on the last trading day before the deal was announced. Although pure value investors don’t try to time the market, I do think it was a brave decision to purchase a travel company during the onset of a renewed global recession. Furthermore, India’s 5.3% 1st quarter GDP print, the lowest in the past nine years, makes me even more cautious about the current fragile state of the market. Regardless, a true value investor is buying when others are selling. I just think that there is a lot more selling to come. But I digress. Getting back to the point, there is still an opportunity for you make money from this deal even though it’s already been announced through merger arbitrage.
If you’re unfamiliar with the strategy of merger arbitrage, you can sign up for our paid subscription service, which is officially launching on July 1, 2012. In our inaugural report, I’ll be going into significant detail how you can use merger arbitrage and special situation investments to enhance returns in the Indian market. If you’re thinking that you don’t need to learn about special situations investing to outperform the market, you might not know that arbitrage deals have been a primary driver of Warren Buffett’s investment success.
In professors Gerald Martin and John Puthenpurackal’s study of Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s stock portfolio’s performance from 1980 to 2003, they discovered that the portfolio’s 261 investments had an average annualized rate of return of 39.3%. Even more amazing was that out of those 261 investments, 59 of them were identified as arbitrage deals. And those 59 arbitrage deals produced an average annualized rate of return of 81.28%! Warren’s arbitrage performance not only beat his regular portfolio’s performance, it also stomped the average annualized performance of every investment operation in America by a mile.
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Interestingly, Prem Watsa’s acquisition of Thomas Cook India has the potential to be an interesting merger arbitrage play. However, there is a major caveat, which is correctly interpreting the complicated morass that is SEBI’s SAST (Substantial Acquisition of Shares and Takovers) regulations. The takeover regulations in India are, in the words of Winston Churchill, “a riddle wrapped in a mystery inside an enigma”. Before I can explain how to actually make money off the Thomas Cook deal, I have to provide you with a little background information.
Back in October, 2011 SEBI (Securities and Exchange Board of India) issued new takeover rules that were widely viewed as being minority shareholder friendly. SEBI created a 12 member committee called TRAC (Takeover Regulations Advisory Committee) to advise on the new regulations. As can happen with any government regulations, unintended consequences can actually negate the original intent of the law. Basically the new regulations specify that any company that acquires a 25% stake or greater in a target company, would be required to make a mandatory offer for an additional 26% of the outstanding voting capital. Thus, any acquirer that purchases up to 25% of a company would be forced to acquire a majority 51% (25% + 26%) stake. The rules were put in place to allow minority shareholders to benefit from any potential takeovers. Unfortunately, there is no guarantee that a shareholder will be able to sell their stake in a company even if they tender their shares since an acquirer is not obligated to purchase more than 26% of the voting capital. TRAC actually suggested a 100% open offer to address the concerns of minority shareholders, but SEBI didn’t end up implementing their suggestion.
Although the lack of a 100% open offer rule isn’t really a deal breaker, the bigger issue is that the new rules prevent a de-listing from occurring for at least 12 months. When you combine this rule with the minimum public shareholding requirement of 25% for a listed company, the result is truly astounding in its implications for acquirers. Somasekhar Sundaresan, one of only two lawyers on the TRAC, succinctly explains the problem with the new ruling in an op-ed piece in the business Standard. He states the following:
Under the new Takeover Regulations, the right to delist otherwise available under the Delisting Regulations, has been taken away. An express prohibition on attempting to delist has been imposed for such period of twelve months. In short, during such period, he would have to dilute his holding back to 75%. After an expiry of twelve months from completing the open offer, he may attempt delisting of the company afresh. In other words, there would have to be a yo-yo of securities offerings by the acquirer – first, to acquire shares under the Takeover Regulations; second, to sell shares so acquired in order to achieve minimum public shareholding; and third, yet another offer to acquire shares, this time under the Delisting Regulations.
Basically, Prem Watsa is forced to make an open offer for the remaining shares he doesn’t own. After he’s acquired full control of the company he will be forced to sell down his stake to 75% due to the new regulations. If he ultimately wants to take over the whole company he’ll have to make a de-listing offer after 12 months. Clearly, the new rules are not only illogical but punitive towards acquirers.
With an open offer at INR 65.48 currently outstanding, the question for investors remains whether they should tender their shares or wait for an eventual de-listing. The key risk due to the new takeover regulations is that Mr. Watsa will be forced to sell down his stake back to 75% within a 12 month period. This will cause a significant overhang on the stock and downside pricing pressure. Finally, there is no guarantee that the company follows through with the de-listing after 12 months. The other side of the argument is that historically de-listings have occurred at significant premiums. A de-listing offer would more than likely occur at a premium to the current open offer price. SEBI also requires acquirers to have funding in place for the transaction. Prem Watsa’s company Fairfax Holdings is reported to have USD 30 billions in assets so financing shouldn’t be an issue. In my view, there is a clear way to play this deal for a reasonable return with zero market risk and limited corporate action risk. Fortunately, for my subscribers I’m going to provide my detailed game plan in the July launch issue.
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