A false sense of Yancoal securities

Yanzhou’s crack at taking Yancoal private is an attempt to neutralise a clever, and very costly, insurance mechanism embedded in Yancoal’s stock at the time of its Gloucester merger.

One only has to look at the trading in Yancoal Australia securities over the course of this year to get a sense of why China’s Yanzhou has approached its locally-listed vehicle with a proposal to privatise it.

At the start of the year Yancoal’s shares were trading at around $1 but over the past three months or so they have steadily slid to around 70 cents. Yancoal’s unusual ‘contingent value rights’ (CVRs) started the year at around $2.40 but over the past three months or so have traded up to $2.75.

One doesn’t have to be a cynic to suggest that the divergence in the performance of the two securities might have something to do with Yanzhou’s decision to try to take out the 22 per cent of Yancoal it doesn’t own, offering 0.91 Yanzhou CHESS depositary interests for each Yancoal share.

The existence of the CVRs dates back to 2011 when Yanzhou approached Gloucester Coal with a proposal to merge it with its Australian subsidiary, Yancoal. Yancoal was the vehicle Yanzhou created to acquire Felix Resources in 2009.

The merger with Gloucester solved a problem for Yanzhou as the mix of cash and shares it was offering got Yanzhou close to the 30 per cent local equity it had promised the Foreign Investment Review Board as the price of approval for the Felix takeover. Gloucester shareholders received cash of $3.20 a share and shares in the enlarged Yancoal that were valued at around $6.96 each.

Gloucester was owned 64.5 per cent by Hong Kong’s Noble group, which supported the merger. Gloucester’s independent directors, however, weren’t as enthusiastic or as convinced that the scrip component of the offer would give their shareholders the claimed $6.96 of value at a time when, with hindsight (or the directors’ foresight) coal values were in bubble territory. So, apart from insisting on the cash component, they took out some insurance.

They negotiated the inclusion of the CVRs, which gave their shareholders up to $3 a share of protection should the Yancoal shares trade below $6.96 within 18 months of the scheme of arrangement’s implementation.

That 18-month period ends in December. The value of the CVRs could be settled in either cash or scrip – but the terms of the CVR specified that, to avoid dilution of other Yancoal shareholders, that scrip had to come from Yanzhou’s shareholding.

The problem for Yanzhou is that the general downturn in the coal sector has been exacerbated by the US dollar-denominated leverage in Yancoal – and by the fact that the existence of the CVRs has created an unusual incentive for hedge funds to drive the price of Yancoal shares down.

As Noble didn’t elect to receive the CVRs there are about 87 million of them on issue. With Yancoal shares trading at around 70 cents there is no question but that the CVRs will be exercised. Yanzhou would either have to stump up $261 million of cash or issue the equivalent in scrip and see its 78 per cent shareholding heavily reduced, potentially to around 40 per cent.

Its problem is that, as the December maturity date for the CVRs looms ever closer, the incentive increases for buyers of those securities to drive down the Yancoal price in order to maximise the number of shares they receive in the event that Yanzhou elects to settle them in scrip.

The proposed privatisation of Yancoal wouldn’t include the CVRs, so in effect, if Yanzhou’s offer succeeded it could either pay cash to retain 100 per cent of Yancoal (which would be unpleasant) or settle the CVRs with shares and in the process re-float an entity which it would still own around 63 per cent of. In the process it would have met its undertaking to FIRB.

There is, however, some way to go before that occurs and Yancoal’s independent directors, who include former Gloucester independents, are going to have a major say in how the proposal works out.

Yanzhou has proposed an exchange ratio of 0.91 Yanzhou CDIs for every Yancoal share held which, on the volume weighted average prices of Yanzhou’s Hong Kong-listed shares over the past two months, equates to a value of about 91 cents per Yancoal share.

At today’s Yanzhou share price, however, the value on offer is only about 74 cents, which is hardly compelling in circumstances where the minorities have a lot of leverage.

The independents would be fully aware of the strength of their position given, not just that the proposed scheme of arrangement requires their unanimous approval, but the unusual and intensifying pressure on Yanzhou created by the CVRs.