Tag Archives: arbitrage

Delaware: incorporate for the taxes, stay for the arbitrage

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A little known court ruling in Delaware from 2007 has had some big consequences.  While it has provided some benefits for investors, it also results in the inefficient use of resources, increased costs for mergers and acquisitions, and arbitrage.  After examining the source of these effects, it may be possible to reduce the costs while keeping the benefits.

The case, which found that a shareholder could vote on a proposed deal if they held stock on the date of the vote, as opposed to the date of record (when the offer was made). This has allowed hedge funds and activist investors to take positions in a target companies after a deal price has been announced, then vote stop the deal in order to determine a fair price through what is called an appraisal.  This has resulted in what is known as appraisal arbitrage. While this plan can backfire if the judgement decreases the price, professional investors are in as good a position as anyone to decide whether a price is too low, and there is an additional incentive that mediates the cost of the appraisal and the possibility off loos.  However this outcome is actually quite rare: 80% succeed in getting a higher price.

Hedge funds argue that investors can actually be made better off by these deals because it allows bad deals that would have otherwise gone through to be recognized by professionals and provides an avenue to rectify the situation (with interest!).  Recent examples in the news demonstrate this. The threat of appraisal by Carl Ichan didn’t prevent Dell from going private, but it did secure a higher price per share for investors. Currently, Dole is in court over its acquisition last year being too low, and Darden Restaurants is currently dealing with Starboard Value LP, a hedge fund who wants to stop the sale of its Red Lobster Chain of restaurants.

While such actions by activist investors and hedge funds have made investors better off in the past, it’s called arbitrage for a reason.  Once the case arrives in court, the price is arrived at via the discounted cash flow method.  According to David A. Katz, a partner at Wachtell, Lipton, Rosen, and Katz, “Discounted cash flow analyses, however, often produce values in excess of what a buyer would be willing to pay or the value of the company’s stock in the public trading markets.”  In addition to the inflated measure of value the company has to pay 5.75% interest on the judgment, even if the original price is found to be fair.  This amounts to a practically risk free profit if the deal was even close to fair to begin with.

Appraisal arbitrage can be seen as less an economic issue and more of a legal anomaly.  To fix this problem, while preserving the economic benefit for consumers, the court should allow for the use of whatever valuation method is most appropriate to the company in question.  Most importantly, it must reduce the interest rate that it pays on the judgments to be pegged to treasuries to end the arbitrage opportunity.  In this way, activists and funds will intercede only when investors need them most.

 

 

 

 

 

Hedge Funds’ “Appraisal Arbitrage”: Profiting from Buyouts

Dole Food Co., the relatively unexciting agricultural corporation and famous pineapple producer, became the center of an increasingly popular trend in hedge fund investing during its recent buyout. According to the Wall Street Journal, last year Dole Food Co. sold itself to its founder, in this case by purchasing all of the public shares in order to take a public company private. While most investors would have seen this as an average buyout, a few hedge fund managers took the opportunity to use an old legal strategy called “appraisal arbitrage” to grab a slice of the profits from the deal.

According to Latham and Watkins, one of the world’s most profitable law firms, appraisal rights have “historically been a back-water of the public company M&A process and practice, largely ignored and often thought irrelevant.” Well, not anymore. In a nutshell, appraisal arbitrage is a strategy in which a minority of investors purchase a large minority share of a public company just before the shareholders vote to decide whether to accept the terms of a buyout. Appraisal rights are the statutory rights of a minority shareholder to seek a fair stock price determined by a 3rd party appraiser and for the acquiring entity to repurchase the shares for the fair price. Basically, these hedge fund managers are purchasing shares of companies which have entered into undervalued buyout deals, forcing a fair appraisal of the company’s assets through judicial order, and then profiting from the presumably more generous valuation.

This supposedly previously obscure strategy has been gaining popularity in recent years. According to the Wall Street Journal:

Appraisal claims were brought on 17% of takeovers of Delaware companies in 2013, the most since at least 2004, according to a coming study from Brooklyn Law School and Case Western Reserve University. Based on deal prices, those claims were valued at $1.5 billion, an eightfold increase from 2012.

One potential risk to this strategy is a stipulation in the rule that states that the investors who wish to request a fair appraisal must either vote no or abstain in the decision to proceed with the buyout, and they must not make up the majority. This means that if the investors own more than 50% of the shares, then this rule doesn’t hold and the buyout simply doesn’t go through and nobody profits. The hedge funds investing in the Dole Foods Inc. buyout were lucky, as the buyout passed with just 50.9% of the vote. Overall, this is one strategy where it pays to know something that no one else knows.

While it appears to be based upon fair law and is therefore a legal strategy for investors, its abuse potential, just like high-frequency trading and hostile takeovers, could be grounds for a healthy dose of skepticism about whether it’s ethical for outside investors to meddle in others’ purchases. However, in many cases, it seems that this strategy is one in which the rest of the shareholders of a company may also enjoy the benefits of a more fair valuation of the share price. At the very least, it forces a second opinion in the determination of a company’s fair value. In the end, this is a zero-sum game, and therefore is an issue in which many economists and investors will likely disagree about the ethics.