Special Situations

Network 18 PCCPS
1 pccps = 1 stock + 1 warrant + 1 preferred
1/2 stock

Buy Spot

Sell in Futures

Create cheaply!

Market neutral returns of 23% in 3 months

News story of 3 Jan 2012

Bha

vook

The Rocket!

Buffetts Case on Arcata Corporation

28 Sept, 1981: KKR agrees to buy Arcata printing and forest products business and a contingent claim. 10,700 acres of Arcata timberland acquired by govt. in 1978.

Arcata Timberland

$97.9 mil compensation over many installments deemed inadequate; plus co got 6% simple interest- claimed more, compounded Value of the stock = value of the business (less debt) + the value of contingent claim

KKR offered Arcatas shareholders $37 plus twothirds of contingent claim if materialized.

How did HE Analyse this situation

How likely is it that KKR will go through with this transaction? Deal subject to satisfactory nancing Given KKRs credentials, low probability of deal failure

What will happen if the deal with KKR fell through? Other buyer likely to emerge

What is the Redwood Claim worth? Somewhere between zero and a whole lot. Why did Mr. Buffett not value this claim?

Started buying at $33.50. offer price was $37 plus two-thirds of the claim. Started buying on 30 September. Payment expected by next January. Heads I win a little, tails I win a lot Not counting the value of contingent claim, expected return = 40% p.a. annualized.

Financing glitches appear. (Shit Happens) The stockholders meeting was postponed again, to April. Such news usually treated by the arbitrageur community as bad bad news.

Stock declines, Mr. Buffett buys more. On March 12 KKR revises offer, rst cutting it to $33.50, then two days later raising it to $35.00.

March 15: Arcata Board Rejects KKR bid and accepts rival bid of $37.50 plus 50% of contingent claim. Stockholders approved deal, $37.50 paid on June 4.

BRK received $24.6 mil versus its cost of $229 mil. average holding period close to 6 months. Annualized return came to 15% return excluding any value for the redwood claim.

What about the contingent claim? The trial judge appointed two commissions: One to look at the timbers value

The other to consider the interest rate question. January 1987: Timber valued at $275.7 mil compound interest @14% p.a. awarded! Wow!

August 1987 the judge upheld these awards Total value of claim = $600 mil. Government appealed. In 1988, claim settled for $519 million. BRK received an additional $29.48 per share, or about $19.3 million.

Risk Arbitrage Teaches Probabilistic Thinking

Risk Arb: Pursuit of prots from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc.

In most cases the arbitrageur expects to prot regardless of the behavior of the stock market. The major risk he usually faces instead is that the announced event wont happen.

To evaluate arbitrage situations you must answer four questions: 1. How likely is it that the promised event will indeed occur?

2. How long will your money be tied up?

3. What chance is there that something still better will transpire - a competing takeover bid, for example?

4.

What will happen if the event does not take place because of anti-trust action, nancing glitches, etc.?

Annexure to 3rd Edition of Security Analysis

Probabilistic Thinking works in Straight Equities too

Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display.

He Listed Three Risks 1. Earthquake 2. Systemic 3. Real estate exposure

None of these eventualities can be ruled out. The probability of the rst two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions.

Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.

A year like that - which we consider only a low-level possibility, not a likelihood would not distress us.

In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity.

Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990.

Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
Fear is a Foe of the Faddist,but a Friend of the Fundamentalist.

In my view nothing is certain; nothing is absolute. And that is the view, I might add, of modern science.

So it seems to me with respect to any decision that you're going to make, what you have to try to gure out is what are the odds, what is the likelihood of something happening, and if it does happen, what benet do you get?

And if it doesn't happen, what do you lose? Then you make your decision by looking at the likelihood of different possibilities, and the gains if they happen, and the losses if they don't happen.

You try to get the best possible likelihood-adjusted result, of the best average result, if you want to put it that way. And then you might adjust that, because you might say, Well, that's the best average result, but in fact I'm more risk-averse, so I'm not going to take that much risk.

Or you might say, "That's the best average result, but I'm willing to take more risk, so I'll shoot for the moon.

Arbitrage is an actuarial business, just like so much of life. Each judgment was probabilistic. What you needed to do was make sure you didn't get so big in one position, even if the odds were very good, that if it went bad it wiped out everything else. You had to maintain your balance.

It's very simple algebra. And it was all worked out in the course of about one year in correspondence between Pascal and Fermat. They worked it out casually in a series of letters. Your brain isn't designed to gure it out spontaneously.

It's not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique. Fermat/pascal Letters: http:/ /www.york.ac.uk/depts/maths/histstat/pascal.pdf

Fermat/pascal Letters: http:/ /www.york.ac.uk/depts/ maths/histstat/pascal.pdf

The only certainty is that there is no certainty. No such thing as a sure thing Shit Happens

Every decision, as a consequence, is a matter of weighing probabilities. Despite uncertainty we must decide and we must act.

Deciding and Acting are different things. Deciding to not decide is also a decision. Sometimes the best decision is to not make a decision - preserving optionality

Sometimes we have to choose the least worst option. E.g. War on drugs or Bank bailouts

We need to judge decisions not only on the results, but on how they were made. Process vs. Outcomes

Probabilistic Thinking

Process/Outcome

Why am I telling you so much about Risk Arb?

Risk Arb forces you to think rationally using an expected value framework

And BFBV is about rationality

The lessons learn from Risk Arb can be applied in other elds

Risk Arb requires constant reevaluation of odds, and relative attractiveness e.g. Milestones e.g. Opportunity cost Mistakes costly, but non-correction of mistakes even more costly

The

in Risk Arb

1. Deal Risk
Risk Arbitrage is like picking up pennies in front of a steamroller

2. Reinvestment Risk

3. Focus Risk

19 December 2008 Case: Eicher Motors

Is there a place for Special Situations in a portfolio?

Alternative to cash

Eicher Motors Case

http://tacticacapital.com/Cases/Entries/ 2008/10/10_Eicher_Motors.html

Key Data

How attractive is this stock at its current price?

JV with Volvo

The commercial vehicle business of Eicher Motors Limited along with the related components and design services businesses will be transferred to the joint venture company which is a step-down unlisted subsidiary of EML on slump sale going concern basis at a value of Rs202 crores

Volvo will contribute Rs 1,082 crores in cash and will also transfer its Indian truck distribution and service network to the joint venture. In lieu of cash and the service and distribution network, Volvo will be allotted 45.6% equity shares in the joint venture. EML will consequently hold the balance 54.4% equity and thus the joint venture will be a subsidiary of EML and its nancials will be consolidated with the nancials of Eicher Motors.

Volvo will also buy 8.1% equity stake in Eicher Motors Limited from the promoters of Eicher Motors Limited at a consideration of 157 crores which equates to Rs.691 per share. Now taking into account its direct and indirect holding, Volvos economic ownership of the joint venture will be 50%.

Why did Volvo buy from promoters?

The joint venture will have exclusive distribution rights in India for all present and future Volvo truck products. All future Volvo group truck projects in India will be routed through this joint venture subject of course to agreement on the terms and conditions.

Option value 4% of sales at sub level- with growth Why high quality earnings stream? Marty Whitmans SOTT Look-through earnings for Eicher Motors

Is this good news or bad news?

Quality of earning stream Capital Intensive business out Volvo keeping manufacturing Potential for dispute?

EML and promoters have also entered into a separate non-compete agreement with the joint venture for not getting into trucks and buses business in India. Volvo shall pay a non-compete consideration of Rs.39.4 crores each to Eicher Motors and to the promoters.

Post-closing Eicher Motors will receive a consideration of 202 crores from the joint venture and it will be debt-free. In addition there will be the 39.4 crores of non-compete fees which will come in. So both put together this will be around 240 crores.

Eicher Goodearth (promoter of EML) intends to propose to the EML board to consider a buyback of shares from the public shareholders in the same proportion as the promoters have sold to Volvo. So the promoters have sold 8.1% out of 58.2% stake and that equates to around 13% of the promoter holding. So we are recommending to the EML Board to do the same to the public shareholders and at the same price of Rs.691.

14,08,969/1,07,43,018 = 13.11%. Can it get better?

Now what do you think about the buyback proposal?

Investment Operation

Buy 100 shares at 225 Tender 13 shares at 691 Effective cost of 87 shares = 13,517 or Rs 155 per share. Accounting vs. Economics Think cash ow! Your cost of remaining 87 shares is simply the net cash outow from the investment operation.

With 2.43 cr shares post buyback, you will pay Rs 378 cr for this debt-free company. What do you get in return for this payment?

Cash of Rs 360 cr. 54% stake in JV

What can go wrong?

Recent change - sebi has relaxed the rules

What else can go wrong?

Peer valuation Holding company What will happen when buyback is announced?

What will the reported earnings of JV look like?

What should happen when buyback commences?

Why is this stock a screaming buy at Rs 90 per share? Because 13 shares sold at 691 will deliver cash of about Rs 9,000, which was the cost of acquiring 100 shares! Rest 87 shares would be free!

What Happened Afterwards

Market Cap 3 Years Ago: Rs 621 cr. Market Cap Now: Rs 4,248 Cr.

How do THEY create their own SPECIAL SITUATIONS?

Thats why it makes sense to ride along in a sidecar with people who have complimentary skills of getting such lucrative deals which are not available to others. Refer to uU document by Zeckhauser

Capital Structure Arbitrage Exploiting relative valuation gaps between different securities which form part of the same capital structure.

In Pure Capital Structure Arb, you have long and short positions. In Capital Structure Risk Arbitrage, you may be long only

Capital Structure Arbitrage Example Network 18 PCCPS

=
1 pccps = 1 stock + 1 warrant + 1 preferred
1/2 stock

Buy Spot

Sell in Futures

Create cheaply!

Market neutral returns of 23% in 3 months

A convertible bond is convertible into 2 shares. The bond on a stand-alone basis is a safe investment worthy of selling at 100 without any conversion option. The current stock price = Rs 55 per share. The current bond price may be Rs 115. (Premium of Rs 5) The investor believes that the stock as well as the market is overpriced and due for a fall. Shorting the stock against a long position in the convertible will be a protable trade

Grahams Rules on Converting and Switching

Example: An investor holds a convertible bond which was originally issued at Rs 100. Interest rate is 10% p.a. The bond can be converted into 1 equity share of the company at any time during the next ten years at the option of the holder. The price of the stock is Rs 200. The price of the bond may be Rs 210 The investor bought this bond primarily as a commitment in the stock.

The stock pays a dividend of Rs 5 per share. Current dividend yield is 2.5%. The bondholder should not convert the bond into stock. If he did so, he will not only give up his senior claim but will also suffer from a loss of current income.

Moreover, he will surrender an instrument which has a current market price of Rs 210 in exchange of another instrument which has a current market price of Rs 200, with no additional benets accruing to him due to the exchange. By holding the bond, he has nothing to lose and everything to gain. Principle Derived: Never Convert a Convertible

Parity, Premium, and Discount. When the price of a convertible bond or preferred is exactly equivalent, on an exchange basis, to the current price of the equity shares, the two issues are said to be selling at a parity.

When the price of the senior issue is above parity, it is said to be selling at a premium and the difference between its price and the conversion parity is called the amount of the premium, or the spread. If the price of a convertible is below parity, the difference is discount.

A convertible issue selling on a parity with the equity is preferable thereto, except when its price is so far above an investment level that it has become merely a form of commitment in the equity share.

Rule on Switching - Holders of equity shares who wish to retain their interest in the company should always exchange into a convertible issue whenever it sells at both an investment level on its own account and also close to parity on a conversion basis.

Notice this is the reverse of the rule, never convert a convertible.

EXAMPLE CONVERTIBLES ARB TATA STEEL

CCPS

26.8 x 6 = 160.80 which is 12% cheaper than Tisco Stock

Current Discount is 12%

Rs 2 per share dividend on Rs 26 dividend yield (tax free) = 7.7%

EXAMPLE CONVERTIBLES ARB TATA MOTORS DVR

Slides from a presentation made on 13 october, 2011

DVR enjoys 1/10th the voting right of Equity but gets 5% extra dividend rights. Discount of 46%

Post Split Equity shares = 269 cr shares @ 186 Rs 50,000 cr. Post Split DVR = 48 cr DVRs @ Rs 101 Rs 4,800 cr. (Almost $1 billion) Discount of Rs 85 per DVR x 48 cr DVRs = Rs 4,100 cr.

http://breport.myiris.com/ICICISL/TATENGLC_20110530.pdf

Why No Mention of DVR?

Why dont they switch?

Why the discount?

Is corporate governance at Pantaloons better than at the house of Tatas?

28% discount

Month Jun 2011 Mar 2011 Dec 2010 Sept 2010 Jun 2010 Mar 2010 Dec 2009 Sep 2009 Jun 2009 Mar 2009 Dec 2008

Promoter Stake in DVR 9% 19% 19% 36% 36% 53% 57% 80% 84% 84% 84%

Is there a technical reason for the discount?

1,500 Class B = 1 Class A (Economic Rights) 10,000 Class B = 1 Class A (Voting Rights) 74x1,500 =111,000 No Discount in Class B

Why do Tata Motors Futures trade at a discount to spot?

Capital Structure Risk Arb Example: Sakuma Exports Preferred Stock

http:/ /fundooprofessor.wordpress.com/2011/03/01/ ben-graham-framework-36/

Sakuma vs Network 18

News story of 3 Jan 2012

Example Capital Structure Arb: ISPAT INDUSTRIES

http:/ /fundooprofessor.wordpress.com/2011/02/19/ bfbv-examination-question/

http:/ /fundooprofessor.les.wordpress.com/2011/02/ ispat_pa_22122010.pdf

Current Status of ISPAT

Fundamental Performance Need for Hedge Lottery Ticket?

Tender Offers 1. Delisting (SEBIs Delisting Regulations) 2. Takeovers (SEBIs Takeover Code) 3. Buybacks (SEBIs Buyback Regulations)

Slides from JAN 2004 COURSE Case on Digital Delisting

1.

2.

Issues: What is the intention of the acquirer (Digitals parent)? To buy the public float at as low a price as possible and then to increase its value! How? What is the total size of the offer? 1,66,85,463 shares. At Rs 750, what is the sum committed by Digitals parent? Rs 1,245 cr. or $276 million. What are the requirements for a successful book building process from the acquirers viewpoint? A minimum of 66,64,195 shares must be tendered, or the process will fail; and The cut-off price is equal to Rs 750 or less. If the book building process fails, what will happen to the market price per share? To answer this question intelligently, one must know the answers to the following four questions: 1. What was the stock price before this process started?

3.

4.

5. 6.

2. 3.

Answer: Rs 662 per share where was Nifty at that time? Answer: 1615 Where is Nifty now? Answer: 1935, an increase of 19% How has the company performed in the latest quarter? 1. Answer: done well

1. 2.

Based on the above data, if the book building process fails the price should be 787 (662x1.19). In other words, it should not be below current market price of Rs 780. However, an avalanche of supply if the process fails, may take the price to below this level for a temporary period (assuming Nifty does not crash by that time).

8. 9.

What if the minimum quantity requirement is met but the cut-off price is more than Rs 750? Will the acquirer accept the higher price? Is the acquirer really stuck up on the limit of Rs 750? Note that in the letter of offer it has stated, the Acquirer considers Rs. 750 per Share to be an acceptable price and is prepared to acquire the Shares at this price. The Acquirer reserves the right not to acquire the offered Shares at any higher price established pursuant to the reverse book-build set forth in the Guidelines. Does this mean that if the cut-off price is Rs 751 will it reject the offer and let the whole process fail? I dont think so! Why? Two reasons: In the initial disclosure to BSE, the acquirer said, Hewlett Packard is of the view that a price in the region of Rs 750 per share is very attractive price for the public shareholders of the company. [emphasis mine] The market price of more than Rs 750 indicates something! If the acquirer is willing to pay more than Rs 750, then the next question becomes, how much more? An additional Rs 100 will cost the acquirer Rs 166 cr. or $37 million taking the total cost to $ 313 million. Peanuts? On peer valuation basis, is it easy to justify an additional Rs 100 per share? Answer: Yes What is the price beyond which the acquirer is likely to say No? A very difficult question

10.What is the intention of Digitals minority institutional stockholders: 1. Institutional stockholders would like to sell their holdings to Digitals parents at the maximum possible price. 2. They would not like to remain minority stockholders. 3. They would be quite capable of understanding the complexity in the process of book building. 4. They would be in a position of having a one-to-one talk with Digitals parent to strike a deal. 5. They would be in a position to act in concert 11.What is the intention of Digitals minority non-institutional stockholders? 1. Many brain dead investors 2. The complexity of the book building process 12.What is the bargaining power of the minority non-institutional investors? 1. Very little, given that they are widely scattered and have no means to communicate with each other and also given their minor role in the overall process due to their low stake.

13. Given that the market price is more than the price indicated by Digital, does it make sense for any minority shareholder to tender? Suppose you are holding Digital shares and want to sell the stock and are wondering what to do. 1. Given that the market price is more than Rs 750, you can sell in the market. But if you sold, you will face regret if the book building process produces an exit price of more than Rs 750. So you should hold because even if you do not tender in book building you can tender in the next offer. 2. But if you hold and the book building process fails, then there will be an avalanche of supply of shares in the market and the price may fall to below current level, at least for a temporary period, and you will face regret. Its better to face the second type of regret than the first. But if everyone thinks like this, then no one tenders and the process fails and the second type of regret becomes a certainty! 14. The Free Rider Problem. 1. If the book building process is successful, then the value of the shares is likely to rise. 2. Many investors want to have a free ride and may not tender their shares.


1.

Conclusions: What are the chances that a minimum quantity of 66,64,195 will be tendered?

My view: 95% 2. Note that on day one, 11.3 lac shares have already been tendered. 2. What is the likely cut-off price? 1. My view: Rs 850 minimum 3. Expected value = minimum Rs 845 (95% chance of Rs 850 and 5% chance of Rs 750). 4. Current market price = Rs 780. 5. Indicative return = 8.3% flat (not bad for a few days) 6. Odds are decent (low risk of a permanent loss and a reasonable return). 7. But dont bet the bank on this! 8. There may be better opportunities out there!
1.

The Disaster in

What should we do now?

If you dance too near a grave, Make sure you dont fall into it!- Sam Zell, Grave Dancer

Habil Khorakiwala Gambled with Derivatives using BORROWED money.

And Lost

To reduce the cost of overseas acquisitions, he went overboard on forex derivative exposure Revenues : 3000 crs Forex debt: 2500 crs Forex derivatives : 10,000 crs

Forex derivatives: 9742 crs crs

Result? 2200 crs of forex losses Failure to meet debt repayments Welcome to CDR!

81% Drop

Leverage+Derivatives+Stupidity= Disaster

wockhardt at the bottom

appropriate place

1.CDR provides a moratorium on the payment of interest. 2. Debt repayments are spread over a longer period of time. 3. Interest cost is reduced. 4. part of the liability is converted to equity. 5. cash ows tied to the cdr package. 6. divestment of non core assets.

Animal Healthcare Business

Net sales: Rs 77 crs Sold for: Rs 170 crs PSR: 2.2 times

nutrition business

Nutrition Business

Consideration: Rs 281.6 crs Sales: Rs 148.7 crs PSR: 1.9x

Sale Blocked; Abbott Walks away

wockhardt- valuations Jan 2010 Market Cap : 1900 crs (@175) Borrowings : 4200 crs

Derivative Losses Net Sales

: :

2200 crs 3000 crs

How would you value the debt of the company?

Lenders are going to receive much less than the book value of debt

Rule of Maximum value of senior issues

A mirror image of rule of minimum value of a debtfree company. The value of the stock of a debt-free company. cannot be less than the value of bonds it can easily service. Debt-capacity bargains

Rule of Maximum value of senior issues

"A senior security cannot be worth, intrinsically, any more than the equity share would be worth if it occupied the position of that senior security, with no junior securities outstanding.- graham The aggregate fair value of all senior securities of a company cannot be more than the value of the entire company, with identical assets, were it debtfree.

Rule of Maximum value of senior issues

Why this rule must hold true?

Because, senior security holders, cannot, in aggregate, get more out of a company, than they could, if they owned the entire company, free of all prior claimants i.e. debt-free. The rule of "Maximum Valuation for Senior Issues" arises out of the common sense principle that the senior claimholders (bonds and preferred stocks) cannot possibly get more out of a company by virtue of their xed claim than they could realize if they owned the business in full, free and clear.- Graham

Rule of Maximum value of senior issues

This relationship must hold true regardless of how high the interest or the dividend rate, the par value or the redemption price of the senior issue may be, and, particularly, regardless of what amount of unpaid interest or dividends may have accumulated.Graham

Company forced to restructure debt Analysts Stops Covering the Stock Lack of Information - very little disclosures Shareholder Meeting in December 2009

Company told us that we were the ONLY ones who inspected the CDR Document!

Our work showed Emerging Equity Value post CDR implementation to be well in excess of prevailing market cap

Private market value exceeded stock market value Ranbaxy was sold at 4 times Revenues in Private Market Piramal Healthcare was sold at 9 times Revenues in Private Market Wockhardt was selling at 0.5 times Revenues in Stock Market

Why not Kingfisher? Too early! Business is crap

Thank You