Takeover arbitrage: watch the conditions

Buying into takeover plays can be very profitable. But James Greenhalgh has learned to read the fine print.

I love a good takeover arbitrage situation. If you have some spare cash, buying stock in companies that have agreed to be acquired can generate much better returns than leaving your money in the bank. Provided you get your probabilities right, of course.

Over the years, Intelligent Investor has recommended a number of takeover arbitrage situations in the Ideas Lab. So far they have worked out pretty well. A few have been minor disappointments but some have been very successful—the Centrebet takeover in particular springs to mind. And yes, I am aware of the expression ‘picking up pennies in front of a steamroller’.

If you’re interested in how to play the arbitrage game, Table 1 in Takeover arbitrage profits ease (access available to non-members) provides some pointers.

Table 2 in that article shows a list of potential arbitrage candidates at the time (back in 2010). We didn’t follow this list up because they weren’t official recommendations, but on average the three situations marked as ‘Attractive’ worked out very well. Ross Human Directions was the standout, with a bidding war resulting in the company being acquired at 75 cents a share (compared to a price at the time of 59 cents). These are the sort of opportunities we look for.

Bid for Gerard Lighting

So I was interested in the bid for Gerard Lighting announced recently. Private equity group CHAMP has offered $1.05 a share. But with the price now trading at $1.02, there’s probably not enough in it for us to recommend. A counter-bid is possible but unlikely.

Having reviewed the Scheme Implementation Agreement, the bid seems pretty straightforward and fairly unlikely to fall over. A failed bid is the biggest risk if you dabble in takeover arbitrage, so you need to understand any points of weakness.

These can usually be identified by closely reviewing the conditions of the offer (in Gerard’s case, they’re on pages 9-13 of the Agreement).

I’d argue private equity bids are more likely to fall over than those made by corporate buyers. I’m talking here about agreed bids, not phantom bids like that for David Jones recently, or the hostile offer for Perpetual made in late 2010.

Bid for Spotless Group

While the bid for Gerard Lighting seems vanilla enough, the drawn-out bid by private equity firm PEP for Spotless Group (see Resistance is futile for Spotless Group) was much more worrisome for the arbitrage speculator.

Under the following conditions (amongst others), PEP could withdraw its bid:

1. If the All Ordinaries index fell by 20%;
2. If Spotless’s earnings fell short of an agreed amount;
3. If debt funding was not forthcoming; and
4. If equity funding was not forthcoming.

Some of these conditions have now been satisfied and the Spotless bid looks likely to proceed. But whenever a bidder imposes a number of onerous conditions, it’s far more likely to fall over.

So if you’re considering takeover arbitrage, make sure you read the conditions attaching to the bid very carefully. Particularly when a private equity firm is involved.

Conditions are there for a reason and only one needs to go unfulfilled for you to be left sitting on a rather unpleasant loss.

Do you dabble in takeover arbitrage? Have you learned any lessons? What are some of your tips?

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