Tag Archives : long positions


New year updates 1

Disclosure: Long 777 HK, long ISIG, long MOMENT 4.69% 2022, short MOMENT 11.5% 2016, short EXAS, no position in GCVRZ, 

Happy new year! My apologies for the long hiatus from blogging. It’s been a busy couple months of holiday travel and a solid finish to 2014 thanks to the performance of several long positions in December. I’m looking forward to making a fuller report in a forthcoming quarterly letter. In the meantime, I felt some quick updates on ideas that have been discussed on the blog and elsewhere were overdue.


China trip and NetDragon (777 HK)

I will be visiting Hong Kong and parts of mainland China later this month. If I have any readers there and you would like to say hello, please drop me a line. If you are a fundamental investor with interest in joining any management meetings, I have a few opportunities for that as well.

The NetDragon thesis is largely unchanged following Q3 results, which were poorly received as expense growth for the education business ramps in advance of revenue generation. NetDragon now has more than half its R&D staff working on online education initiatives. Meanwhile, the core gaming franchise remains strong and has a potential new hit that has already recorded 240,000 PCU. The company repurchased 2.8% of shares outstanding in December.

 

Public commentary on Insignia Systems (ISIG)

ISIG remains a significant position for Cable Car despite an unusual activist situation in the marketplace. Given recent events, Cable Car has adopted a policy of not discussing the investment thesis publicly. However, I remain open to speaking one-on-one with other investors. If you are a shareholder and would like to discuss the company, please contact me directly.

 

Momentive Performance Materials reorganization

I was wrong about both the legal outcome and the potential downside for the 1.5 Lien notes, at least from a mark-to-market perspective. The plan of reorganization went effective in October and the former 1.5 Lien notes (now 4.69% second lien senior secured replacement notes) traded down to the low 80s context. At last trade, the replacement notes yielded 8.3% to maturity, much wider than other similarly capitalized industrial credits. I also failed to fully account for the impact of legal fees on the post-petition accrued interest, which remains in escrow pending a partial settlement (expected to be approximately 70% of billed fees, the same as the first lien notes). There is a further fee reserve against this amount to cover pending appeals. With the intercreditor action between the secured noteholders dismissed except for one narrow class of claims, cash recoveries under the plan as implemented are uncertain and appear limited.

That being said, I continue to find the risk/reward attractive, and arguably more so today. From a purely relative value standpoint, the replacement notes seem to be considerably cheaper than they should be. Interest rate risk and concern over high yield in general could negatively impact market values, but the notes are over-secured and the recapitalized Momentive is much more conservatively levered. Unfortunately, the ratings agencies are unlikely to rate the replacement notes unless someone pays them to do so, which may limit the number of natural buyers. The new notes should otherwise be investment grade. As mentioned before, comparable high yield issuers such as Berry Plastics have notes of similar coupon, duration and position in the capital structure that trade above par, despite what appears on the surface to be a worse financial position. I’m hard pressed to think of a good fundamental reason why second lien MOMENT notes should trade 300 bps wider than second lien BERRY notes, but perhaps there are technical reasons Berry is not comparable or greater concerns about Momentive’s underlying business than I have observed.

Furthermore, the terms of the replacement notes remain open to appellate review. At current levels, that certainly seems like a free call option. The Momentive bankruptcy raised some important questions regarding the proper determination of a market rate of interest for secured creditors. Both the coupon of the replacement notes and the original make-whole claims are the subject of an appeal currently before the district court. From a naïve, non-technical standpoint, the market outcome of the legal process to date—that senior secured creditors could recover anything less than par value while junior creditors received significant recoveries—is unusual enough to lead me to believe the appeals process has potential. From a legal standpoint, it is quite a bit more difficult to handicap the odds of success on appeal, but noteholders remain highly motivated to pursue the case. There remains an outside chance at a full recovery including the make-whole payment, which could result in nearly 50% returns from current trading levels. More likely in my view is an upward adjustment to the coupon on the replacement notes. Even if the court upholds Judge Drain’s reliance on Chapter 13 precedent for his basic methodology, in my opinion the small incremental increase to the interest rate already made at the end of the confirmation process belies the objectivity of the process. The chosen 4.69% coupon is essentially arbitrary and clearly did not reflect the full market value of the notes.

I expect the appeal to survive a motion to dismiss on equitable mootness grounds, since it would be relatively straightforward to adjust the coupon. I expect the senior unsecured notes, which I am still short, to fail to clear that hurdle.

 

Exact Sciences (EXAS) and Cologuard reimbursement

Despite my public comment, CMS retained its original crosswalk to codes 81275, 81315, and 82274 in its 2015 payment determination for code G0464. The ultimate payment rate was the subject of some drama over the past few weeks, as the rates document was initially published on December 19 with a lower reimbursement level before being retracted. The reimbursement rate in the document was approximately 74% of the crosswalked values, an adjustment that normally only applies to tests prior to 2001. This was corrected, but several localities in the revised document have significantly lower payment rates than the National Limitation Amount (NLA), which is itself slightly lower than the sum of the three crosswalked codes. For example, reimbursement in Jurisdiction K, which contains populous states such as New York, is 45% lower than the NLA. Medicare reimbursement is based on the lower of the amount billed, the NLA, or the local payment amount. Some market commentators and even Exact’s own press release seem to imply that the NLA is the only reimbursement amount for all Medicare patients, which is not the case. It is a maximum.

Expect a further post discussing this in more detail. I am still looking into the reasons for the lower local reimbursement amounts, and Cable Car has a pending FOIA request for the other public comments on the CLFS in order to respond to potential justifications for a higher reimbursement level. I still intend to submit a reconsideration request, which could potentially impact the 2016 reimbursement level.

As a reminder, Cable Car is short EXAS primarily on the basis of lower-than-expected uptake. I believe setting a lower reimbursement rate is a public health imperative that could actually encourage wider screening.

 

Lemtrada approval and GCVRZ

Sure enough, not long after discussing why I was unwilling to bet on Lemtrada approval, GCVRZ had one big day after the drug was approved. It didn’t quite triple, and it now trades about 50% above the price the day before approval. I stand by the reasoning in the post and increasingly suspect I may have dodged a bullet. The price reflects considerable uncertainty over the timing and success of the US launch. My post did not address in detail the risk that Lemtrada has a slow launch in the US. However, there is a distinct chance that Lemtrada fails to achieve the $400 million first-year sales milestone even with contribution from the US. Due to the number of alternative MS treatments on the market, Lemtrada’s status as a last-line therapy emphasized on the label, and the time required for physician acceptance, US sales might not be sufficient for the milestone in the first year even if the drug is ultimately a blockbuster. In the absence of US data so far, the picture of the pace of sales from Europe does not look encouraging.

Although bound by the terms of the CVR not to deliberately interfere with sales, Sanofi’s incentives are at odds with CVR holders as well. The company could conceivably justify a slower launch, focusing on building physician relationships over meeting near-term sales goals in order to maximize the long-term value of the product. That they might avoid a ten-figure payment to CVR holders would be a nice bonus. If the $2 milestone appears more likely once sales data begin to come in, I would expect Sanofi to buy back CVRs or conduct another tender offer. Unless and until they do so with the benefit of internal sales data, I view the likelihood of GCVRZ paying more than zero to be low.


Thank you for following along last year. I look forward to many interesting investment opportunities and conversations with you in 2015.


This magic MOMENT: while the risk/reward is fine 3

Disclosure: Short MOMENT 11.5% Senior Subordinated Notes (60877UAM9), Long MOMENT 10% 1.5 Lien Senior Secured Notes (60877UBA4).

The 1.5 Lien Notes last traded at 93. If they prevail at a hearing on September 9, noteholders will receive 104.17 in cash. If not, replacement notes are still unlikely to be worth less than current trading levels.

If you’ve gotten past the pun in the title and are still with me, read on for what I think is a compelling and actionable near-term opportunity in the Momentive Performance Materials (MPM) bankruptcy cases. Spending some quality time with the MPM docket has been a bright spot in an otherwise challenging quarter for Cable Car. Barring a successful appeal by the Subordinated Notes trustee, which I think unlikely, I’ll have the chance to discuss the success of my short position in the Subordinated Notes in Cable Car’s next quarterly letter. I have been following the case closely in support of that position, and in the process decided to invest in the Senior Secured Notes following the sell-off from last week’s make-whole decision. The remainder of this post discusses the 1.5 Lien Notes. A similar opportunity with slightly less appealing pricing (but more liquidity and lien priority1) exists in the 8.875% First Lien Senior Secured Notes (55336TAC9).

Cable Car focuses primarily on equity securities, but I occasionally find value elsewhere in the capital structure. For a number of structural reasons, reorganizations often present interesting opportunities to invest in debt securities. Institutional ownership restrictions, the prevalence of relative value frameworks, and legal complexity can often lead to mispricing. Distressed debt often has a potential return profile similar to equity (both long or short), even when it is not being explicitly equitized.

As a non-lawyer (though I am the proud son of a mediator!) and passive investor, I have a deliberately limited approach to bankruptcy cases. Unlike many specialist distressed debt investors, I will generally only even consider participating after a plan of reorganization has been proposed, which after some analysis I believe is likely to be confirmed. I am content to let larger players do the heavy lifting of negotiating a prepack or a restructuring support agreement, for which they are often well compensated by the right to provide exit financing on preferential terms. Even after a plan has been put forward and controversies have been fully briefed, securities prices may not yet reflect the proposed distributions under the plan, or the reasonable range of outcomes in the legal process (subject to interpretation, of course). I’m a firm believer that potential outcomes can be bounded and questions of interpretations assessed, even by the non-specialist. There’s something very appealing about quantifiable outcomes for value investors with a probabilistic approach. With extensive public bankruptcy docket updates nearly in real time, reorganizations present a rather delightful reading comprehension exercise—at least if there’s something wrong with you and, like me, you kind of enjoy poring over a bond indenture. From experience, I can say it at least beats reading critical theory.

In any case, all that is a very long-winded way of saying that while I think I have a handle on this situation, I am not a distressed debt expert. So if you are, and you’re reading this, please don’t be shy about pointing out where my analysis may be flawed. Or just say hello!


MPM is a quartz and silicones producer that was purchased for $3.8 billion in a leveraged buyout by Apollo in 2006. The bankruptcy proceedings formally value the enterprise at just $2.2 billion today. For a detailed discussion of the Debtor’s business and the proposed plan of reorganization, see the plan disclosure statement. The details of the operating business are not important to rehash here, except to note that MPM will benefit from restructuring. Although hopelessly overleveraged at 16x last year’s (possibly cyclically depressed2) EBITDA, MPM is a leader in its business and generates enough earnings to comfortably support a more realistic capital structure. The proposed plan reduces net debt by about $3.2 billion, including a $600 million equity injection. If confirmed, MPM will emerge with about $1.2 billion of net debt against $300 million in EBITDA. Using management’s 2015 EBITDA forecast, the pro forma entity would have about 4.5x Total Debt/EBITDA and 3.8x EBITDA/Interest coverage. These metrics are roughly consistent with an issuer rated BB or B.

Elements of the plan have been contentious. The First Lien and 1.5 Lien trustee unsuccessfully argued that the notes were due a significant make-whole payment in addition to the par value of the notes and accrued post-petition interest. Votes for or against the plan were due prior to the adjudication of the make-whole dispute, and they offered Senior Secured noteholders something of a Hobson’s choice: either vote to reject the plan and accept replacement notes with or without the make-whole, or vote to accept the plan and receive payment in cash, but give up the right to pursue the make-whole adversarial proceeding. Unsurprisingly, both classes of Senior Secured voted to reject the plan. I will come back to that decision in a moment.

In principle, any replacement notes should have a net present value equal to the value of the Senior Secured claim. In practice that is not such an easy number to pin down. The court heard testimony, unfortunately filed under seal, from fixed income experts who opined on the proper choice of discount rate. Depending on the terms of the new notes, prevailing market conditions could result in replacement notes having a market value other than the value of their claims. Indeed, after Judge Drain issued a bench ruling denying the make-whole claim, disappointed Senior Secured noteholders drove the price down to its current low 90s context.

If the plan is confirmed as currently proposed, then we can calculate exactly what the 1.5 Lien holders will receive. Assuming for convenience a September 15, 2014 effective date, the notes are due 5 months of post-petition interest, or about 4.17 cents on the dollar, which would be capitalized. The notes trade flat, so paying 93 points for 104.17 in principal is equivalent to buying 100 face value of the new bonds for 89.28. The new bonds have a proposed maturity of March 15, 2022 (7.5 years) and a coupon of 275 basis points above comparable Treasuries. The nearest Treasury maturity currently has a yield of about 2.2%, so the new bonds would carry a coupon of approximately 4.95%.

By my math, that works out to a 6.8% yield to maturity. Even at the current ask of 96, the yield to maturity is 6.28%. While not very appealing in absolute terms—I wouldn’t be terribly excited to earn 6.8% in my portfolio for the next 7.5 years—it is an attractive yield on a relative basis. It is worth examining where similar securities currently trade. As everyone knows, “high” yield debt is not currently yielding very much right now.

The court’s choice of 4.95% is at least one view of the “right” yield for reorganized MPM notes. At the moment the market appears to disagree, but selling may have been exaggerated by disappointment over the make-whole ruling. Institutional buyers that are restricted from buying debt in bankruptcy may find the notes appealing after emergence.

While there isn’t a neat benchmark for 7.5-year senior secured industrial paper, there are a few comparisons that suggest the replacement notes should yield something less than 6.8%, and in any event not more. According to FactSet, as of September 4, a BAML index of B-rated industrials yields 4.935% with 5 years to maturity and 6.333% with 10 years to maturity. A 7.5-year MPM note could be reasonably interpolated somewhere in between. BB credits yield between 4.288-5.736%. Furthermore, the 1.5 Lien notes have the benefit of being partially collateralized by their junior security interest, while the index includes unsecured and subordinated debt. The notes would be the most senior part of the capital structure of reorganized MPM other than an undrawn ABL revolver. The nearest maturity, similarly structured bond I could find in a comparable industry is part of another Apollo LBO, Berry Plastics. BERRY 5.5% Second Lien Senior Secured Notes due May 15, 2022 (085790AX1) are B-/Caa1 rated and yielded 5.62% on their last trade.


I led with the relative value discussion because I think this is a situation with very limited downside risk. Because the coupon is based off a spread to Treasuries, there is no market interest rate risk until the plan is confirmed, after which of course a rise in market interest rates would be the most significant ongoing risk factor, barring an unexpected collapse of the entire restructuring process and forced liquidation. However, there are multiple ways in which an investment today could generate very attractive returns in a very short time frame:

  • Most straightforwardly, if 4.95% is the correct market rate of interest for the bonds, they should trade to par after emergence.
  • Alternatively, trading in line with the BERRY notes would result in a gain of about 7 points.
  • If plan confirmation is delayed for any reason, the notes continue to accrue post-petition interest at 10%, increasing the eventual recovery.
  • The Senior Secured trustee could appeal the make-whole decision and win (very unlikely).
  • Apollo could call the replacement notes for cash as a goodwill gesture or if financing on better terms becomes available.
  • The Senior Secured noteholders could prevail in their Rule 3018 motion to change their votes to accept the plan.

It is this last possibility that I think most interesting, and it is a key motivating factor for the investment. In conjunction with the plan confirmation hearing on September 9, a requisite majority of both classes of Senior Secured notes has petitioned to change their votes to accept the plan. The market is giving investors a free option on the success of the motion and setting up a compelling risk/reward tradeoff: if the motion succeeds, noteholders will be paid in full in cash, earning more than 11 points on their investment in 2 weeks. If the motion fails, investors are unlikely to lose much, if anything, if my reasoning above holds.

While, again, I am not a lawyer, I think there are reasons to believe the judge may be sympathetic to the motion. The legal standard for a 3018 motion is to show “cause,” which commentators have suggested is a lower standard than “good cause.” To change its vote, a party in theory needs to persuade a judge only that doing so would not result in a harmful outcome. I think it will be difficult for the Debtors to argue that in this case, confirmation of the plan as written is harmful to the Debtors. They are left with a public interest argument that allowing a change of votes would somehow constitute a “do over” that might unfairly prejudice future restructuring processes. Given the unappealing voting options available to the Senior Secured classes, I’m skeptical of that argument. Past cases have hinged on whether or not the goal of the party trying to change its vote was to unfairly benefit its own interests by blocking confirmation of the plan. Although the Senior Secured creditors opposed confirmation of the plan as written, they are not attempting to block plan confirmation through the change of votes. In this case, changing votes to accept the plan would result in the acceptance of the plan as it was first proposed.

Here I would like to take a moment to pick on a stranger on Twitter. I joined “Finance Twitter” only a couple months ago, but I already have found it indispensable in at least one regard. For bench rulings, and in particular the Momentive ruling, two excellent reporters provided breaking news on Twitter. Their quick takes actually preceded newswire headlines on the rulings, which was pretty cool.

Nevertheless, I think Maria has it wrong when she writes:

During the last confirmation hearing, Judge Robert Drain expressed frustration that the parties had not come to a negotiated settlement, stopping the proceedings several times to encourage Apollo and the Senior Secured holders to settle the make-whole dispute. Prior to ruling, Judge Drain was quoted by Bloomberg as saying: “This is a bunch of lawyers standing around avoiding an obvious solution [...] You know most people when offered payment in cash take it.” That is just what the Senior Secured noteholders are now trying to do. Judge Drain demonstrated a strong preference for a consensual solution to the restructuring process. Denying the Rule 3018 motion could motivate the Senior Secured noteholders to appeal, lengthening the restructuring process and adding costs to the Debtors.

I think there’s a good chance the motion is granted and noteholders recover in full in cash. I would welcome your thoughts.

 

1 If you’ve been following the case, you’ll understand why I specifically wrote lien priority, as opposed to seniority in right of payment!
2 A more nuanced view of the silicones cycle is necessary to evaluate the Second Lien notes, which will receive equity in the reorganized entity. Some commentators have suggested that the current level of earnings represents a cyclical trough and Apollo put together a sweetheart deal. That may be true: I have not done more than the superficial analysis needed to give myself comfort that the business is at least not falling off a cliff.


NetDragon write-up selected as runner-up in FactSet Top Idea Tournament 3

Disclosure: Long NetDragon (777 HK).

The buyside networking and idea-sharing website SumZero and FactSet are sponsoring an ongoing investment idea contest this year. It’s a great forcing mechanism for me to put pen to paper on some of my highest-conviction positions, and time permitting I hope it will lead to more material I can publish here.

I’m pleased to share that my report on NetDragon was selected as a runner-up from among 130 submissions in the first leg of the contest, which focused on non-US ideas.

I am sharing the investment thesis publicly in hopes of receiving feedback. If you find the time to read the report, please consider taking a moment to share your thoughts — especially dissenting views — via email or in the comments below.


Click here to download the write-up.

By accessing the report, you acknowledge that the information contained therein is for information purposes only and should not be considered a recommendation to take any action with respect to any security.


Food for thought

Disclosure: No position in FSIC. This post has been edited to remove details of trading activity. This post is intended to follow up on prior analysis and should under no circumstances be considered an advertisement for the performance of past specific recommendations.

I wanted to share the outcome of another special situation which provides some thoughts on how to identify future similar opportunities. (Also, I realize I’ve been writing a lot about tender offers lately, but it’s a consequence of them being relatively easy to discuss in full. I’m a little bit reluctant to describe my core portfolio investments without presenting an exhaustive, detailed rationale for the position. I haven’t had time to do them justice in writing yet!)

I closed a post about a tender offer last month by saying, and I apologize for quoting myself, “…it would have been possible to accumulate and successfully tender a lot more than 99 shares. Food for thought.” In truth I was thinking of a particular opportunity at that moment. FS Investment Corporation (FSIC) had an ongoing tender offer that I did not wish to publicize, as more participants would increase the odds of proration. I believed that the tender was unlikely to be significantly prorated, despite occurring at a significant premium. A holder could potential tender large amounts of stock at a premium, without worrying about a potential decline in price afterwards. FSIC was conducting a Dutch auction between $10.35 and $11.00, while trading around $10.15, well below its net asset value of $10.27. The tender closed on May 28th, and sure enough, the company bought back 96% of tendered shares at $10.75.

It remains quite difficult to predict with certainty when a tender offer will not be oversubscribed, but there are certain characteristics that make it more likely, one of which is of course that there aren’t a bunch of blog posts talking about how great it would be to participate in the tender. There were several other factors that made FSIC an attractive candidate, however:

  • FSIC was a newly public listing of a previously OTC entity with a largely retail shareholder base (tax sensitive and generally less likely to tender)
  • The offer was large relative to the market cap
  • The company had had an ongoing tender offer policy to provide shareholders with liquidity, and previous offers were recent and under-subscribed near the low end of the Dutch auction range
  • FSIC is broadly diversified and traded below NAV, making it a relatively low-risk short term holding
  • FSIC announced special dividends later in the year for continuing shareholders
  • The minimum increment in the Dutch auction was relatively small ($0.05), making for a smoother supply curve and potentially less proration at any given point

In short, FSIC was an unusually good setup for a tender offer, and based on the size of the offer, it was highly scalable too. I estimate it could have contributed meaningfully to funds as large as $200 million AUM. Such opportunities do not come along very often!


Closing the loop on GLRI 3

Disclosure: Long GLRIW, Short GLRI. This post has been edited to remove details of trading activity. This post is designed to follow up on prior analysis regarding a current investment and should under no circumstances be considered an advertisement for the performance of past specific recommendations.

Although there’s a business to run, I do aspire to follow up on blog topics when I say I will. Only a few months in and it seems I’ve already forgotten about one. (I will cover the rest of the seed topics mentioned in my first post eventually). About 9 weeks ago, I said I would discuss how to value the post-transaction Glori Energy (GLRI) business. To my handful of non-blood relative readers, sorry!

Valuing GLRI

As it turns out, I couldn’t quite get comfortable with the valuation exercise myself. I have been exiting my position in the warrants and am presently fully hedged on the remaining position. As mentioned before, Glori has an interesting model. They acquire producing oil fields, apply their proprietary technology, and if successful increase recoveries and reduce the decline rate of the field. In principle the business should be able to generate attractive internal rates of return by purchasing oil fields at an implied yield (from the seller’s perspective), increasing that yield through their recovery technology, and then selling at a premium to redeploy the capital into other fields. By repeating this process using leverage, the business could produce attractive returns over the long term.

While yields might be attractive on a project basis, the ultimate returns to shareholders are considerably more difficult to assess. It is uncertain what projects will be acquired, on what financial terms, and of course with what degree of success in improving the ultimate recoveries. GLRI’s disclosures indicated that the AERO recovery system has had mixed success, including at least one field where recoveries did not improve at all, with a great deal of sensitivity to the geologic conditions of the fields where it is deployed. From my perspective, that makes the success of the technology simply too difficult to handicap, and I will happily let others underwrite the long-term success or failure of the business.

As for valuation, using multiples of forecast EBITDA or earnings is a bit silly given the uncertain acquisition profile, though that hasn’t stopped a few sell-side firms from trying. At the arms length valuation established by the transaction and the new fully diluted market cap, the best one could do in my opinion would be to attempt to extrapolate from the yield profile of the most recent acquisition to the company as a whole. Treating the stock like a fund, assuming the technology works as promised and the company can redeploy all of its available capital in acquisitions on similar terms, what would be the notional levered cash flow yield? At least that is how I would try to approach it. The stock is a little like investing in a listed oil and gas private equity vehicle, and with confidence in the underlying technology, one could conceivably compare the prospective risk-adjusted long-term returns to similar investment opportunities elsewhere. At the current price, there is implied value to the technology. If it doesn’t succeed increasing recoveries, then GLRI should be worth little more than its net asset value. The right assessment of asset value is of course an entirely separate discussion, which depends on reserve valuation estimates, the oil price, and interest rates, but it is significantly below the current enterprise value, and there are plenty of other options for E&P speculation.

Arbitrage

As the initial write-up indicates, this was a special situation relating to a one-time transaction. I am ultimately not willing to underwrite speculation on the value of the business itself.

Meanwhile, the conversion right on the warrants has made for an interesting arbitrage situation. The 10:1 conversion window runs May 16-June 15, and creates a sort of convertible arbitrage opportunity during this period. At times during the window, it has been (and may again become) possible to purchase 10 warrants for less than the value of 1 share of GLRI. GLRI was difficult to locate early in the window, but for accounts large enough to participate in a pre-borrow program, I chose to hedge the entire warrant position by shorting GLRI. As the price of the underlying has risen closer to the $10 strike price, the warrants have become more efficiently priced. The slight premium to GLRI in the current price reflects option value over and above the conversion right. This is of course a basic idea behind convertible bond arbitrage — by owning a convertible security with an embedded option and hedging the price risk by shorting the underlying, one can capture some option premium while limiting downside. Cable Car does not generally engage in convertible arbitrage, but at the moment it offers a potentially more attractive risk/return tradeoff than selling the unhedged warrant position outright.


How odd: sometimes the little guy wins 1

Disclosure: Long HCT, watching NYRT and SPLP

“Odd lot” arbitrage is one of my favorite niches of the stock market.

The recent media firestorm about the costs and benefits of high-frequency trading (HFT) sparked by Michael Lewis’ latest book has prompted a lot of public hand-wringing about whether the stock market is fair to all participants. It most certainly is not. Retail stockbroking is in general marked by high commissions, significant hidden costs, sales loads, information asymmetries, and aggressive sales practices that put an individual investor at a distinct disadvantage to institutions. One thing it does not suffer from anymore, however, is high spreads (on most issues). Decimalization and market-making competition over the past few decades have significantly reduced the cost of market orders.

In fairness, I haven’t had a chance to read Flash Boys, so I’m not going to join the chorus of financial market participants talking their books on the relative merits of HFT. For the record, I think the latency arbitrage HFT strategies publicized by Lewis provide a net benefit to smaller investors by lowering spreads, while making it harder for large traders to execute orders without moving the market. This unusual role reversal reminds me of another instance where the tables are turned. The arbitrage opportunity created by tender offers is another delightful corner of the stock market where investors sometimes can benefit from their smaller size.

An “odd lot” or “small lot” in the US is a position of less than 100 shares. For legacy reasons, exchanges have special handling rules for odd lots, though they are now generally handled automatically. Historically, many brokerages charged additional fees for these lots, and trade pricing was disadvantageous as well. Today, odd lots do not generally incur additional costs, but at brokerages charging fixed commissions, the cost of transacting an odd lot can still be very significant relative to the transaction value.

Periodically, some public companies and closed-end funds will offer to repurchase shares at a premium to the market price. When this happens, economically rational shareholders will tender, and it is common for the offer to be oversubscribed. In such situations, the tender will be prorated, but sometimes companies will include a proration preference for odd lots. The issuer will buy the entire odd lot to spare the small holder the commissions associated with disposing of the small number of shares that would have otherwise gone unpurchased. A typical SC TO-I filing might include language like this:

Odd Lots. The term “Odd Lots” means all Shares tendered by any person (an “Odd Lot Holder”) who owned beneficially or of record an aggregate of fewer than 100 Shares and so certifies in the appropriate place on the Letter of Transmittal and, if applicable, the Notice of Guaranteed Delivery. Odd Lots will be accepted for payment before any proration of the purchase of other tendered Shares. This priority is not available to partial tenders or to beneficial or record holders of 100 or more Shares in the aggregate, even if these holders have separate accounts or certificates representing fewer than 100 Shares. To qualify for this priority, an Odd Lot Holder must tender all Shares owned by the Odd Lot Holder in accordance with the procedures described in Section 3. By tendering in the Offer, an Odd Lot Holder who holds Shares in its name and tenders its Shares directly to the Depositary would also avoid any applicable Odd Lot discounts in a sale of the holder’s Shares. Any Odd Lot Holder wishing to tender all of its Shares pursuant to the Offer should complete the section entitled “Odd Lots” in the Letter of Transmittal and, if applicable, in the Notice of Guaranteed Delivery.

The risk arbitrage set up occurs whenever shares trade below the tender price. An investor can buy 99 shares or fewer, tender at the higher price, and capture the differential within a short period of time (as little as the length of a trade settlement if guaranteed delivery is allowed). The strategy is not riskless, as tender offers can fall through for various reasons, but it is the closest thing to a freebie I have seen in the stock market.

Naturally, I am not the first to discuss these opportunities. They are frequently and often breathlessly the subject of investment blogs. The holy grail of odd lot tenders occurred in 2011 when a Russian nickel company bought back shares with a 999-share odd lot preference (thanks to a 10:1 ADR ratio) at a large premium, resulting in over $10,000 profit potential per accountholder. Most tender offers are quite a bit more pedestrian, worth a few hundred dollars at most.

I almost didn’t bother writing this post after finding an extensive discussion on an investor forum that chronicles almost every odd lot setup over the past year, along with various strategies for exploiting the technique and variations such as odd lot cashouts in reverse splits. There is even one enterprising individual offering a subscription service to send a notification of every upcoming tender offer, although this can be accomplished for free using a simple SEC filings search! Perhaps this literature review will nevertheless be interesting to someone.

Amusingly, articles sometimes spark a backlash from commenters worried the publicity will kill the golden goose. Quite frankly, I fully expect odd lot arbitrage to disappear entirely someday, as trade commissions continue to face downward pressure. Many closed end funds that conduct periodic tender offers have already removed odd lot priority. It will likely persist as long as retail brokerages charge flat fees even for small transactions, but it’s a historical anachronism that is going away eventually.

In the meantime, though, it’s a nice way to recoup some of the costs of investing. Right now, there is an opportunity in American Realty Capital Healthcare Trust (HCT), a healthcare REIT that recently listed on NASDAQ. Shares closed today at $10.20 and the company is conducting a tender at $11.00 that expires on May 2, for a potential return of $79.20 in a few weeks. Details here. As always, do your own diligence before making any investment.

At the moment, there is also a less compelling opportunity in NYRT, another newly listed REIT, and a riskier tender for SPLP, which will only be profitable at the higher end of the Dutch auction range. I am watching both and will participate only if the price falls.

Note from the sample SC TO-I language above that this is not a strategy that scales well for individuals. Separate accounts are expressly excluded. Each beneficial owner is limited to 99 shares. However, as an adviser, Cable Car disclaims beneficial ownership of its clients securities at the time of a tender. For multiple client accounts, odd lot arbitrage is at least worth the effort of this writing. Cable Car is presently long HCT on behalf of clients.

$79.20 may not seem like much, but it is meaningful for the little guy, who sometimes does come out ahead in the end.


INXBW Update 1

Disclosure: Long INXBW.

The transaction closing date has been postponed a few times and is now scheduled to be completed on April 10. Meanwhile, Glori completed an oilfield acquisition, likely representative of its strategy going forward, through a $40m deal with Petro-Hunt. The closing delay is related to unspecified SEC requirements; my best guess is that Infinity received SEC comments requiring a response and/or was required to provide investors more time to evaluate the Petro-Hunt deal.

About a week ago, the warrants traded up to 77 cents, which is still a significant discount to the common but provides less of a margin of safety. Since then, the warrants have been very illiquid. Remarkably, there have been no trades at all for the past 3 trading sessions, a good illustration of why this particular situation is best suited for small accounts. Even small accounts can miss out; since Cable Car manages separate accounts for each client, I have yet to establish a position for one of my most recent clients. That in turn provides an interesting illustration of the pros and cons of separate accounts. On the one hand, my newest client may not be able to participate in this particular investment opportunity. On the other hand, in a pooled vehicle, earlier clients’ proportionate share of the position, provided I could not increase it, would be unfairly reduced by new capital. Of course, one’s perspective on the benefits of participating in any particular idea depends entirely on how it turns out. If the transaction is not completed and the warrants are ultimately worth only 60 cents, perhaps my new client got lucky!

I would still happily buy more INXBW around 70 cents, but at the moment there are no sellers.

I have some ideas for how to think about the value of the post-transaction entity, which is somewhat challenging to value. In order to avoid contributing to further lack of buying opportunities, I will refrain from discussing them until after the transaction is consummated.


INXBW: A different kind of SPAC arbitrage 1

Disclosure: Long INXBW. Please be sure to read the disclaimer — no content on this blog is investment advice.

This is a post originally shared on the investment ideas forum SumZero. It is a relatively illiquid opportunity suitable only for small accounts, but it describes an interesting corner of the stock market. In brief, an investor can buy warrants in Infinity Cross Border Acquisition Corporation (INXB) for about 70 cents today, which will be convertible into shares worth 80 cents in 6 weeks. There is downside to 60 cents in the event a planned merger with Glori Energy falls through and further upside if investor demand for Glori is high after the transaction.


Back in 2009, when cash was paramount and everything was on sale, SPACs (special purpose acquisition companies, i.e. blank check firms that IPO with a mandate to reverse merge with another company later) became a popular arbitrage vehicle for those who still had funds to invest.

A SPAC is typically structured so that the initial investors have some sort of opportunity to get their money back if they disagree with management’s proposed acquisition. Usually this protection is in the form of a mandatory tender offer at the IPO price and/or a liquidation right, again at or near the IPO price, if a deal is not approved by shareholders and consummated by a certain date. During the financial crisis, the price of many SPACs that had yet to find their acquisition targets dropped well below the IPO price, offering investors a low-risk opportunity to buy below cash and then take advantage of the liquidation right or tender once a deal was announced. This often resulted in the deals failing to close, but the original shareholders were usually long gone and the arbitrage could generate 10-20% returns in a matter of months.

There was a certain poetic justice to this, as SPACs are a great example of Wall Street’s excesses. Why do your own diligence on an IPO when you can fund a shell company to do it for you? Why pay a private equity firm fees to manage a portfolio of private companies when you can pay an often untested management team $10-20m in stock options to buy just one? Often the proposed acquisition target won’t even be in the same industry as the SPAC initially planned.

The structure has a colorful history too, as it was first used by (often fraudulent) stock promoters in the 1980s before becoming discredited and more heavily regulated. It reemerged during the last decade with the protections just described, and it was a popular IPO vehicle during the boom. There was a great Steven Davidoff article on a recent SPAC IPO that describes the history in more detail.

Enter Infinity Cross Border Acquisition Corp, traded on the NasdaqCM as INXB, INXBW, and INXBU for the common, warrants, and units (common plus warrants) respectively. Backed by the Infinity Group, an Israeli-Chinese private equity firm, it was originally supposed to buy something in China. But no matter — the SPAC eventually identified an interesting oil extraction technology start-up to buy and take public, Glori Energy. Glori’s VC backers will retain a controlling stake and take INXB shares at the IPO price of $8, with customary lock-ups. Infinity and the Thomas Hicks family office are buying additional shares at that price as well.

There is downside risk below 60 cents if INXB trades below $6 after the transaction. However, with the major investors injecting capital at $8, equivalent to an 80-cent warrant price, buying warrants at 70 cents is like buying into the offering with a $1 margin of safety.

Glori could be a very interesting business if its technology really performs as advertised at scale. Glori has a proprietary biomass system called AERO that is supposed to reduce the decline rate of older oil wells under certain conditions. In principle, this means Glori can purchase a well at standard industry multiples based on the usual recovery rates, then apply its technology and ultimately extract more value from the well over time than the seller could have. The plan is for Glori to roll-up small producing wells with the right geological characteristics — yes, including some in China — monetizing its technology by applying it in the field. If the investor presentation (Jan 9th 6-k exhibit 15.1) is to be believed, Glori may be able to achieve IRRs in excess of 40% on well acquisitions assuming AERO performs as intended.

As an aside, I personally have limited expertise with oil & gas exploration and have no real way to evaluate the technology. It apparently works in some pilot projects, but whether it will scale and Glori’s acquisition strategy will be successful is not a question I have tried to answer for this arbitrage situation. I would welcome comments from anyone with a background in exploration & production.

Back to the opportunity today: unlike many SPACs that required majority shareholder approval and ended up in mandatory liquidation rather than consummating a deal, Infinity learned its lesson from SPAC arbitrage and has a relatively lenient standard in its articles of association for the transaction to proceed. The maximum tender condition is set such that INXB must retain at least $8m in its trust account. In other words, a maximum of 4.75m of the 5.75m public shares may be tendered into the deal, or 83%. Only 17% of the public shareholders need hold onto their shares for the deal to close.

That said, there is still a meaningful risk that the deal does not go through. SPAC arbitrage is still popular, even when the discounts to liquidation value are quite small, as in the current environment any yield is potentially preferable to sitting on cash. For example, INXB common shares currently trade at $7.95 and traded as low as $7.60 early last year, versus an $8 IPO and mandatory tender offer price. It is probable that a substantial number of arbitrage funds who hold INXB will tender into the deal. Based on available filings as of 9/30, it appears that 13-F filers and mutual funds that are or might be arbitrage funds own approximately 2 million of the shares outstanding, but there could be other, smaller arbitrageurs who are not required to disclose their positions. 824k shares were tendered through January 31.

If the deal closes, the tenor and strike price of the warrant change, but they also gain a conversion right during the 30 days after the transaction closes. 10 warrants are convertible into 1 share of stock, so provided INXB continues to trade around $8 after the deal, the warrants would be worth at least 80 cents. If the deal fails to close, the company will liquidate and the warrants will be worth 60 cents in liquidation. There is a parallel tender offer for warrants at 60 cents but it does not affect the maximum tender condition.

INXBW currently has an ask of 70 cents, so the situation sets up a risk/reward trade-off of 10 cents down, 10+ cents up. Although there is a risk that too many shares tender, Infinity and the other deal participants are highly incentivized to ensure that the transaction closes. I’m betting they can convince $8m of investor capital to participate in the deal. The tender expires on March 17, and the warrants become convertible for a one-month period beginning 31 days after the transaction closes.