How to Analyze and Profit Off Going Private Transactions


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Jae Jun

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Investing in special situations has been around for a while.

Actually in his 1965 letter, Buffett talks about special situations, which he calls “workouts”.

These are securities with a timetable. They arise from corporate activity – sell outs, mergers, reorganizations, spinoffs etc.

In this category we are not talking about rumors or “inside information” pertaining to such developments, but ti publicly announced activities of this sort.

We wait until we can read it in the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize.

Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc.

The gross profits in many workouts appear quite small.

It’s a little like looking for parking meters with some time left on them.

However, the predictability coupled with a short holding period produces quite decent average annual rates of return after allowance for the occasional substantial loss.

This category produces more steady absolute profits from year to year than generals do.

In years of market decline it should usually pile up a big edge for us; during bull market it will probably be a drag on performance.

On the long term basis, I expect the workouts to achieve the same sort of margin over the Dow attained by generals.

 

In fact, Buffett believed in this type of investing so much that he invested 23% of his portfolio into workouts which you can see from his 1969 letter.

Warren Buffett portfolio allocation

Warren Buffett 1969 Portfolio Allocation

And look at his returns during his early partnership days.

Warren Buffett Performance Portfolio

Warren Buffett Partnership Performance

As well as what Buffett and his team has accomplished with Berkshire Hathaway over 50 years.

Berkshire Yearly Performance

Berkshire Yearly Performance

But Be Careful with Workouts…

An area where I’ve made a couple of big mistakes earlier in my investment journey came from special situations.

Buffett mentions that there will be the “occasional substantial loss”.

Portfolio allocation is vital and so is not being greedy with these types of investments.

Losing a substantial amount of a 1% position isn’t going to ruin your performance, but I’ve made the mistake of allocating up to 10% to a single special situation which ultimately turned out to be a sickening ride down.

The key is to diversify with special situations. Don’t go all in with a single opportunity.

Participating in specials situations is like picking up pennies or dollars in front of a bulldozer. Just be certain you know where the bulldozer is.

The Vital Checklist

To keep yourself safe, you should always complete this checklist before investing any money into a special situation.

  1. Make sure both parties have done their due diligence
  2. Financing and regulator approval is complete
  3. Get preliminary shareholder sentiment or controlling shareholder approval
  4. Obtain regulator (SEC, FCC, any and all) approval
  5. Get final shareholder approval at a meeting called for that purpose
  6. Check to see that insiders are continually vesting or buying shares

If you cannot answer all these points, then it’s too early to be investing in the special situation. Every time a checkpoint is officially cleared or announced, expect the spread to get smaller. If you wait until all 6 points are cleared, then it’s likely that the spread will be too thin to bother investing in.

That’s where the discipline to move on is required.

How to Apply This to the Going Private Transaction for SFX Entertainment (SFXE)

Let’s apply the rules above to a going private transaction that was announced at the end of May.

CEO of SFX Entertainment, Inc. (SFXE) Sillerman reaffirms that going-private transaction is moving forward; deal terms unchanged.

Sillerman affirmed that his proposed going-private transaction to acquire the company made public in a May 26, 2015 news release is continuing to move forward under the terms of its original definitive agreement.

Based on the May 26 filing and some other notes, here’s a short summary of the important points.

  • CEO and Chairman Robert Sillerman owns 37% of the company and wants to buy out the remaining shares to go private.
  • Cash offer for $5.25 per share. Previously submitted the same proposal for $4.75 a share on Feb 26.
  • “Special committee” unanimously approves the proposal
  • Proposal includes a 45 day “go shop” period
  • Proposal is not subject to financing
  • Shareholders will need to vote for the decision

1. Make sure both parties have done their due diligence – Pass

A going private transaction usually revolves around a majority owner wanting to take the company private and SFXE is the same case here.

The only party in question here is Sillerman.

Being the majority shareholder, it’s clear that he wants to buy out the company at a cheap price. Looking at the brief history of the company, SFXE IPO’d at $13 and has falled steadily since. The assumption here is that Sillerman wants to take it private at a low ball price.

2. Financing and regulator approval is complete – Pass

There is no financing conditions or requirements. On the surface, it seems to imply that Sillerman has the money locked down to proceed.

Because this is a private going transaction and not two companies merging, regulatory approval isn’t required.

3. Get preliminary shareholder sentiment or controlling shareholder approval – Uncertain

Looking up some articles and even this video from CNBC, the initial sentiment for the deal isn’t good. Shareholders feel like they are being ripped off.

However, if you look at the failing business fundamentals, I wouldn’t be surprised if some investors want out.

A $5.25 cash out will be tempting to some suffering investors.

4. Obtain regulator (SEC, FCC, any and all) approval – N/A

No regulator approval needed for this going private transaction.

5. Get final shareholder approval at a meeting called for that purpose – TBD

A shareholder vote still has to go through and is the biggest hurdle in this process. This is where the special situation gets into the gray zone. If you want to participate in this, do you buy before the voting for that extra spread and risk a  collapse if the vote doesn’t go through?

Or do you wait until the vote goes through and risk losing the spread?

Seeing how the initial reactions are negative, my preference would be to stay out until all votes have been confirmed.

With the current stock price at $4.59, the current spread to $5.25 is 14%.

6. Check to see that insiders are continually vesting or buying shares – Pass

It’s just a one man show here and with Sillerman owning 37% and wanting 100%, this is an easy point to check off.

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Weighing the Upside vs Downside and Odds

Going down the checklist, the main cause of concern is based on the shareholder approval. People who got in at the IPO price are definitely going to be upset – but that’s why you shouldn’t invest at an IPO price anyways.

There is still a 14% spread on this going private special situation, but is it worth the risk?

With a 14% upside limit, what’s the downside if the votes don’t go through?

Before the first proposal in February, the stock price was around $3.50.

That means the potential drop is $1.09 which is roughly 24%.

What about the odds of it going through?

This is where it becomes total art because nobody outside of the circle knows.

So far, the upside/downside isn’t that bad considering the current situation.

If the odds are that this transaction has an 80% chance of going through, it’s a good one to get into.

But again, I have no idea and that’s why the occasional workout will blow up and cause substantial loss.

How to Find Special Situations

There are several ways to automate the process of finding special situations.

I have multiple systems set up to look for things like tenders, dutch auction, going private, and other keywords used in filings.

You can use follow my Google Alerts tutorial to get email alerts based on text searches. It’s extremely powerful what you can come up with.

Another method is to use Search Edgar which has full text search for SEC filings. Enter the terms that you want and then get alerts sent to your email.

And if the situations needs it, follow this tutorial to quickly detect changes in the footnotes between quarterly or annual reports without having to read every single line.

Summing Up

There are always multiple special situations throughout the year and they help with growing a portfolio as it is not reliant on what the market does.

The key is to identify the risks and to make decisions based on the facts of the workout.

Limit risk by using the checklist above and allocate an appropriate amount.

Don’t be greedy and try to kill two birds with one stone because there will be the occasional substantial loss.

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