What happens when the following get together?

Hubris

Easy Capital

Ego

Peaking Fundamentals

Peaking Stock Prices

Big Deal Fees

Deal Background

David (FINL) vs. Goliath (GCO)

In a David vs. Goliath scenario, FINL won the bidding contest in June 2007 against FL (a much larger competitor) to purchase GCO (a much larger company by market cap).

The terms were for $1.5b in cash, or $54.50 per share, with funding provided by UBS. A very overvalued deal.

Tail end of the LBO mania.

By September 2007, in combination with the news and the consumer and retail sector being hit hard, FINL traded down from $11 – $15 per share to about $5 per share. GCO was trading at $45 per share.

Possible Outcomes

Outcome Band includes:

The deal closes (FINL buys GCO)

The deal breaks (FINL does not buy GCO)

Something in between…

Embedded legal uncertainty (MAC, solvency certificate, judge, jurisdiction)…

ays to Place an Investment

Common approaches…

Long/Short FINL, or

Long/Short GCO

What is the risk*/reward?

FINL: appr. 1/5 to 1/10

GCO: appr. 1/1 to1/2

*Risk = permanent loss of capital, not beta

Ways to Place an Investment #1

A better approach #1…

Long both FINL and GCO

Why both? Counterintuitive…

Standard merger arb analysis on GCO alone is limited Insurance/hedge “cost”

Transfer of value concept Combination increases safety

“The Ratio” – 1/5 risk/reward ratio or 0/4.5?

Ways to Place an Investment #2

A better approach #2…

Just Wait

Why?

Mr. Market gives little credit these days – time to act Always be able to walk away

All said, the thesis boils down to…

Heads I Win, Tails I Don’t Lose

By going long both FINL and GCO:

Investment boils down to – heads I win (likely a lot), tails I break even (pretty much).

There is a near-term catalyst that creates value – the M&A deal between FINL and GCO will either close or break.

The outcome does not matter: in the former, we lose nothing; in the latter, potential for 100% to 400% upside.

Waiting for a possibly unencumbered FINL is just as valid.

Denali

Denali Investors – Columbia Business School Presentation 2008 Fall v3 (1)