Glencore's grab gets heavy-handed

The dramatic developments in London on Friday in the long-running attempt to merge Glencore and Xstrata underscore how difficult it is to execute a mega-merger of mega-miners.

Late in the week, ahead of the scheduled scheme of arrangement meeting planned for Friday, the merger appeared doomed. Shareholders with sufficient firepower to vote down the merger remained opposed to its terms and Glencore's Ivan Glasenberg appeared to have adopted an unyielding stance.

At the eleventh hour, however, Glasenberg decided to not just lift the terms of the share swap but alter the nature of the deal from a merger-of-equals to a more conventional takeover. Where previously Glencore was offering 2.8 of its shares for each Xstrata share he proposed an exchange ratio of 3.05:1, effectively a $4.3 billion increase in the value of the consideration.

While there were shareholders holding out for a ratio of 3.25:1, by itself that probably would have gotten the deal across the line.

Glasenberg, however, added another change to the nature of the previous deal. Where previously Xstrata's chief executive, Mick Davis, was to be head of the merged group, now Glasenberg himself wants that job. Effectively the increased offer and changed governance arrangements turned a merger-of-equals into a takeover.

The reasons for the proposal that Glasenberg, rather than Davis, become CEO weren't articulated but may relate to a view that Glencore's shareholders, mainly Glencore executives, wouldn't accept paying a premium for Xstrata unless they were in control.

The change in the nature of the proposal has caused Xstrata, which was previously supportive of the deal, to back off. It said the proposed ratio, a 17.6 per cent premium to the Xstrata price in February when the merger was first unveiled and a 22.2 per cent premium to the price on Thursday was significantly lower than would be expected in a takeover.

It also noted that the intention to replace Davis as CEO and amend the management incentives (which were vast and controversial) in the original scheme represented significant risk around the retention of Xstrata's senior management and the management intended to be responsible for about 80 per cent of the combined group's earnings.

In effect, by altering the nature of the deal from a pure merger to a takeover Glasenberg has caused Xstrata to treat it as a conventional takeover, where the premium for a company as strategic as Xstrata would normally be significantly higher than Glencore is proposing.

Because it remains a scrip deal, the issue of management is also a sensitive one, particularly as Xstrata has a big pipeline of new projects coming on stream. The prospect of losing Davis and his senior team (who have a big following in the market) and leaving the Xstrata operations to be led by Glencore's commodity traders would unsettle Xstrata shareholders despite the respect the market has for Glasenberg and his deal-making skills.

Glencore has also tried to give itself the option of lowering the threshold for success, from the 75 per cent level (after excluding its own 34 per cent Xstrata shareholdings) of a scheme to the simple majority (in which it could include its stake) of a conventional takeover. That would, however, require Xstrata's support and the tone of Xstrata's initial response to the revised proposal wasn't encouraging.

The Glencore/Xstrata relationship is unusual because of the Glencore shareholding but more particularly because Glencore has played a major role in sponsoring Xstrata and its success and markets some of its key commodities.

Nevertheless, the difficulties in executing what was initially a friendly deal supported by both companies aren't completely novel. There have been a litany of attempted mega-mergers and takeovers involving the biggest resource groups that have failed.

The most obvious was BHP Billiton's attempt to acquire Rio Tinto, the subsequent failure of the agreed iron ore joint venture in the Pilbara and the bid for Potash Corp that was blocked by the Canadian government. Xstrata itself has been involved in two major failed deals – its own attempt to impose a hostile merger on Anglo American and a merger with Brazil's Vale.

Part of the problem is that proposals for big resource company combinations unsettle competition regulators and governments, who can veto or undermine the economics of a deal by demanding undertakings and other concessions. Those sensitivities also mean a mega-merger is a protracted process – the Glencore/Xstrata merger was announced at the start of February.

Time, as the BHP bid for Rio demonstrated, involves risk. In that instance the emergence of the financial crisis caused BHP to walk away.

In the Glencore/Xstrata deal, the implosion in key commodity prices, particularly iron ore and coal (where Xstrata has a big exposure) mean the fundamental relativities have changed quite materially over the course of this year and are still highly volatile.

The fact that it is a paper swap means that the fluctuations in share prices flow directly through to the value of the offer. As a commodity trader, and one with an increasing exposure to agricultural commodities, Glencore is less exposed to the dive in mining commodities than Xstrata.

The reality that there are only a handful of the mega-miners is also a complicating factor. Institutions want a big price in exchange for allowing the passing of control of a mega-miner and there are inevitably issues of ego and prestige (usually referred to as "social" issues) to be resolved at the senior management and board level.

With Glencore having been forced by Xstrata's shareholders to transform a friendly and agreed merger into a hostile takeover there is no certainty as to the outcome.

Xstrata shareholders will inevitably ask for an even bigger premium, the Xstrata board will try to use the leverage it has in a scheme or Glencore's need for it to support a conventional bid to force another increase and Glencore's own shareholders will be exerting pressure on Glasenberg not to pursue the deal regardless of cost.

If they can't agree a merger, the reality that Glencore has a 34 per cent shareholding in Xstrata will make for an awkward relationship in future if the tensions created by Friday's developments persist.