October 29, 2019—Softbank Bails Out Near-Bankrupt WeWork as its Valuation Tumbles from $47 Billion to $8 Billion. Did Softbank Commit the Sunk Cost Fallacy?
Hudson’s Bay Strikes a Friendly Go-Private Deal as Insiders Bump Their Bid by 9%. But will it be Enough for the Shareholder Activists?
Pension Funds Acquire AltaGas Canada for $1.7 Billion. Why are Pension Funds Owning Infrastructure Assets?
A Discussion on Why Merger Arbitrage is a Great Fixed Income Alternative with the Merger Yield at 5.7%.
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Transcript:
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian Klymochko: Welcome podcast listeners. This is The Absolute Return Podcast, episode 37; I am your host, Julian Klymochko.
Michael Kesslering: And I am Michael Kesslering.
Julian Klymochko: Today is Monday, October 28 2019. A little bit late recording the podcast this week. Busy this weekend with some traveling. Nonetheless, we wanted to chat about a few major market events over the past number of days.
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- One thing we are going to chat about, hopefully for the last time on the WeWork file is Softbank came with a big bailout package because WeWork was pretty much teetering on the brink of bankruptcy. So we’re going to chat about that financing package, and the interesting structuring behind that.
- In addition to the sunk cost fallacy and the notion of investor cognitive biases and some mistakes not to make as an investor.
- Some M&A news with Hudson’s Bay striking a friendly go private deal as insiders bumped their bid by 9 percent. We are going to chat about. Is this enough for the shareholder activists against the initial proposed deal?
- Another M&A deal. Some pension funds acquired AltaGas Canada for almost two billion dollars. Why are pension funds owning infrastructure assets?
- In addition, we are going to chat about the investment merits of spin offs and carve outs.
- Lastly, we wanted to chat about merger arbitrage as a great fixed income alternative and some research that we recently put out on that.
Softbank
Julian Klymochko: Softbank, who we have been speaking about a lot lately, as you know, they run the giant 100 billion dollar vision fund. And they’ve been a key financier of these massive private technology companies. One of them being WeWork, but it is not so much technology, more of a real estate play. Nonetheless, Softbank, it is a Japanese conglomerate and manager of the Hundred Billion Dollar Vision Fund. They agreed to fund a $9.5 billion bailout of struggling co-working start up WeWork, which is really on the ropes. They are going to run out of cash within a week, allegedly. They really needed this money, and Softbank stepped up to the plate, ultimately injecting 9.5 billion into the company and is structured in a pretty complex way. Five billion of that is in new debt financing, a mix of senior secured notes, unsecured notes and a line of credit. They are also doing a three billion dollar tender offer to existing shareholders. This is been done at around $19 per share, which is down from $110 per share back when they valued at 47 billion dollar valuation. So down over 80 percent there and they are also accelerating an existing commitment for $1.5 billion. This is in equity at $11 and 60 cents per share. So a dramatically different price than the tender offer, and this one is about 90 percent lower than its most recent $110 per share valuation. Nonetheless, a massive drop and WeWork was really struggling here. They ran out of cash and was basically near bankruptcy until Softbank came, stepped up to the plate.
In addition, pretty controversial. The now former CEO, Adam Newman, he is exiting with a 1.7 billion dollar windfall. He is participating in this tender offer for almost $1 billion, one third of his share stake. He is also getting a $500 million dollar line of credit loan facility to repay the margin loans he had against his stock. Because the thing with margin loans is if the stock goes down, which it obviously did dramatically here, it fell 90 percent. Typically, margin lenders will liquidate that stock to protect the loan. Just given the illiquid nature, he was really in quite the bind here. And the banks were really concerned on the security of this loan just to the dramatic fall in the valuation of WeWork shares, and this 500 million loan was really a critical part of the deal negotiations because of this margin loan and the fact that Adam Newman controlled the company through his super voting shares. He had a big stake in the company. He controlled the board of directors, and so if he did not get onside, then the company basically would go into freefall. However, many employees extremely upset with this, frustrated because he is exit exiting with $1.7 billion. But the vast majority of employees, thousands are losing their jobs and the vast majority have underwater stock options and equity in the company. That is worth far less than it had been historically. You also had Softbank executive and former Sprint CEO Marcello Claure joining the company, as I believe, chairman or some senior role.
Nonetheless, I got a quote here. He said, “The size of the commitment that Softbank has made to WeWork in the past and now is eighteen point five billion. To put that thing into context, that is bigger than the GDP of my country where I am from, which is Bolivia.” This is Marcello Claure talking here. That is a country where there is eleven million people, and to put that in further context, Softbank’s total investment, eighteen point five billion of which about 13 billion is in equity. It is for 80 percent of a company now worth 5 to 8 billion. So certainly, they suffered massive losses on this. I wanted to bring up the notion of this cognitive bias that some investors suffer. The sunk cost fallacy, basically, when you’re throwing good money after bad money just based off past decisions, when you’re perhaps deep in the hole and you go on and double down, basically in business, sunk costs are typically not included in consideration when making future decisions. However, you see many unsophisticated or amateur investors making this mistake where they look at the money they put in and say, oh gosh, I have already sunk all this money. I better double down in an effort to recoup the costs already put in. However, those should be completely irrelevant based on future decisions. A real head scratcher from Softbank here. What are your thoughts on their recent financing decision and decision to bail out WeWork?
Michael Kesslering: Yeah. So this ended up being a very good deal for Adam Newman, but like you had mentioned, he had the ultimate veto authority over any potential deal. They did have to get him on board, which the optics of that are terrible. But the only other scenario is that it goes to zero, so it’s kind of like a mutually assured destruction where Softbank blinked first. Specific to Newman, he will actually still have a minority ownership stake at it is believed to be around 10 percent still. Then as well, specific to Softbank as well. They were the only ones that actually invested out of $47 billion valuation. When you talk about this destruction of capital, there are other investor’s, Benchmark a very prominent VC firm. They will still have made money as a whole. But, you know, Softbank was the one pushing up this valuation to $47 billion really just by themselves.
Julian Klymochko: Right. I believe every investor since about 2015 or 2016 is now deeply underwater as is their employee stock options.
Michael Kesslering: Absolutely, and so when you look at the valuation of the company now having an equity value of five to eight billion dollars and an unknown enterprise value, just because the capital structure is a little bit unclear with their legacy costs. When you look at their listed competitor, IWG, they have a market cap of $4.3 billion and an enterprise value of $12 billion, and to put that in perspective, IWG is cash flow positive.
Julian Klymochko: Right and similar business model.
Michael Kesslering: Absolutely but that business being cash flow positive where it seems they are being penalized for being cash flow positive.
Julian Klymochko: Or alternatively, even at this valuation, 90 percent lower. WeWork could arguably still be overvalued.
Michael Kesslering: Absolutely, and so looking at this transaction as a whole, we have talked about, WeWork a number of times on this podcast. And I really just want to reiterate that this has been probably the most interesting company and deal dynamics between WeWork and Softbank that, you know, I’ve seen in the last 10 years. It is a really interesting deal that was kind of a sign of the times in the VC world, and really this is an example. You know, there is a lot of outcry against, you know the Adam Newman deal where he is being effectively getting good value out of destructing a whole lot of capital. But really, this is an example of the IPO process working the way that it should. Is really this was a company that came to public investors with terrible corporate governance and a ridiculous valuation, and investors ultimately pushed back.
Julian Klymochko: Right and it makes you wonder, where Softbank and the other directors were this entire time. They could easily fix those problems of the problems with corporate governance and spiralling losses. It really took the public investors at the point of initial public offering for people to finally realize that those are major, major problems.
Michael Kesslering: Absolutely, and as well with Softbank, just my last comment on Softbank is this has been reflected in their share price. I believe they are down about 30 percent over the last six months. They are trying to raise another Vision Fund, another hundred billion dollar fund so Vision Fund two and that has to be quite difficult right now.
Julian Klymochko: Right and I wanted to touch on that point as well. You look at a professional investor like Softbank and the Vision Fund and the guy who runs it, Masayoshi Son, has had pretty tremendous track record of success. One being his flagship investment in Alibaba, which is one of the greatest of all time. And you think, you know, why has he suffered from this amateur investor’s mistake, this cognitive bias, that he really shouldn’t be suffering. Then you look while he is out there marketing this Vision Fund two which he is hoping to raise another hundred billion dollars. So perhaps this WeWork, deal is ultimately some face saving mechanism just so he doesn’t have the real negative press of his biggest investment and the first vision fund going zero in a dramatic fashion and basically just imploding after a hugely negative failed IPO and all the horrible press that it’s received over the past couple months. So basically, he wants to bail it out, and unfortunately, committing this sunk cost mistake, but nonetheless, he wants to fix that which looks to me more of a marketing ploy to instil confidence in his investment process. The other thing that I wanted to touch on just this notion of a Softbank and their effect on the market. I do not want to understate the implications in the early stage start up financing world. But he was really pushing companies to grow as fast as possible despite massive losses and he represented nearly limitless funding source. Now that dynamic has totally changed where he is now pushing his start-up companies to become profitable as quickly as possible. Well, that really displays the notion of companies that are capital intensive. If you lose faith of the capital markets, you are dead. And that’s why It’s important to become at least cash flow break even as quickly as possible, because then you’re not reliant on fickle capital markets, which as we’ve seen in this WeWork saga, can really turn instantly. Right, how quickly did WeWork go from toast of the town, hundred billion dollar valuation to near-bankrupt, in record time?
Hudson’s Bay
Julian Klymochko: Wanted to update listeners on another active M&A file that we have been following over the past number of months. What happened with Hudson’s Bay is they actually struck a friendly deal with a group led by its chairman, Richard Baker, at a price of $10, 30 cents per share. This is a 9 percent slightly improved offer from their initially unsolicited $9 and forty-five cents offer. Their upped bid is worth about one point nine billion dollars. Now, the stock traded as high as ten dollars and seventy-two cents back in August on expectations that the bid would be raised quite a bit. I am sure many market participants might be somewhat disappointed in a 9 percent increase. Nonetheless, you look at them over the past five years. Hudson’s Bay being in the department store space, which has been incredibly challenged, the stock has lost about half of its value. That is way under the IPO price. That happened, when was that? Seven/eight years ago. So a long time ago, and a massive fraction of its all-time high value. But the thing is, Hudson’s Bay, it’s nearly 350 years old, and over time, they’ve built up a tremendous portfolio of real estate assets in which management has come out and said could be worth as much as forty five dollars per share.
And what we’ve seen happen on Hudson’s Bay is that there have been a number of shareholder activists that have gotten involved and were battling against this takeover price, this takeover bid by insiders who control the stock. But luckily for investors, it is subject to a minority or a majority of minority approval. I don’t think it’s going to be enough. I think ultimately the reason why he came with such a low offer at 9:45, they always see you have a leg up in negotiations is if you come out with the first offer, because it really gets investors anchored to it no matter how ridiculous it was – 9:45 being ridiculous given that, it is a small fraction of the net asset value, that management claims to be forty to forty-five dollars per share. Nonetheless, market currently pricing in a 17 percent annualized yield in this merger arbitrage situation, faces a tough time. I think ultimately in order to get this over the finish line that this insider group will have to increase it again by a further amount. What are your thoughts on it?
Michael Kesslering: Yes. So when looking at the original press release with the announcement of the increase bid, the company did mention that they had an independent advisor value the real estate portfolio at 8 dollars and 75 cents a share. The rationale was because this bid is higher than that. You know, investors are getting full value for the real estate portfolio, although that isn’t entirely the picture, because when you mentioned that this has been a very popular stock with hedge funds over the last number of years because of their real estate assets. That was because these assets are currently being used for the Hudson Bay stores and disclose their other brands. The argument was that if these properties were redeveloped into a better use, that they would be worth those earlier quoted in the $40 per share range, I have seen twenty-eight dollars per share quoted as well. But this valuation just being on an as is, doesn’t assume any redevelopment. So it’s a little bit of a tricky situation where, yes, redevelopment is capital intensive, but I don’t think investors are getting full value, especially when the thesis has always been around redevelopment of these assets.
Julian Klymochko: Right, and that is something that listeners should be aware of, this notion of a fairness opinion from an investment bank. Now, what an investment bank is paid to do effectively and I know this because I used to be in that business, is that they are paid by the board of directors and management to justify whatever they want to tell investors to get the deal done. It is not done in an official capacity, but it is more of a nod and wink type of transaction where they are brought on. They are not going to be paid millions of dollars to tell managements something they do not want to hear, right.
Michael Kesslering: Absolutely, and in terms of the investment bank that did the formal valuation, so what I previous referred to was an independent advisor valuing the real estate portfolio. That was a real estate specific broker, whereas then an investment bank came in and get a formal valuation of the company in its entirety. In that evaluation, they came to a range of $10 to $12 and 25 cents a share. At this ten dollars and thirty cents, that’s really near the low part of the range. So even given from their own advisers, this is a pretty low offer. I would also mention you did say that, you know, this is unlikely to appease minority investors. You know the Richard Baker consortium. They own about 57 percent of shares. You would need a majority of the remaining 43 percent, and just some quick math, like I mean, there is a couple of activists. So Land & Buildings, they have a position. I do not remember what their stake is off the top my head.
Julian Klymochko: I believe its 5 percent or lower.
Michael Kesslering: Yes, and then Catalyst’s Capital owns about 16 percent of HBC.
Julian Klymochko: And they just did a tender offer. That is a slight discount to this 10.30, right.
Michael Kesslering: Yeah, it was like $10 and 10 cents.
Julian Klymochko: They are not looking to flip it for a quick 20 cent per share profit?
Michael Kesslering: No, it just would not be worth their time. So just what the quick math, you have over 20 percent of shareholders or roughly that. That are likely unimpressed by this offer, I would definitely agree with your assertion that there ultimately would have to be another upbeat.
Julian Klymochko: Yeah. Clearly, there is a lot of value here. And what you’re seeing in the market is just a negotiation kind of back and forth. So ultimately, they likely will come back. This buyer group will come back, in our opinion, nonetheless. You got to exercise some caution, because one comparable story to this, which ended in tears was Sears holdings, which for a long time was thought to have tremendously valuable assets. They never really acted on them, the company ended up going bankrupt, and shareholders had zero. That is something to keep in mind. Obviously, Hudson’s Bay core business highly challenged some tremendous assets on a sum of the parts basis. But nonetheless, when you have a lot of value destruction on the operating side and this difficulty on real estate development, liquidating inventories and then all the obligations with a massive workforce, then it’s easier said than done. So it’s an interesting situation to watch and we’ll see how this one develops in the future.
AltaGas
Julian Klymochko: I wanted to touch on another really interesting M&A deal up in Canada. A couple of Canadian pension funds, specifically the Public Sector Pension Investment Board and the Alberta Teachers Retirement Fund Board, they’re teaming up to buy infrastructure, a company, AltaGas Canada, for one point seven billion, which represents more than double the IPO price, which happened just one year ago. This deal was struck at thirty-three dollars and fifty cents cash. That is a premium of thirty one point four percent. So healthy, slightly above average premium for shareholders on that one. So they got to be happy because that was also an all-time high. Now, what AltaGas Canada does and how they came into fruition is they are actually spun out of parent company AltaGas Canada and in an IPO just last year. Well, technically, this is more of a carve out. A spin off is when they just spin off the shares to current investors in a carve out is when they take a subsidiary or division of the company and have their own IPO to new shareholders and raise money for the parent company. But what happened was AltaGas was looking to raise cash to pay back debt after a 4.5 billion takeover of Washington based WGL Holdings.
So AltaGas Canada ended up going public just one year ago October 2018 at fourteen dollars and fifty cents a share. They have gas distribution and wind farm assets in B.C., Alberta, Nova Scotia and Northwest Territories. These are really the representative infrastructure assets, which pension funds are so craving these days. We are really not shocked to see a couple of pension funds looking to further build out their infrastructure portfolio by acquiring AltaGas Canada. What is surprising here and I wanted to bring this by for listeners to see, is that AltaGas Canada went public at fourteen dollars and fifty cents per share. This IPO was really not well-received at all by the market. It had to be downsized, they only raised two hundred and thirty nine million, they wanted to raise more than that. It was actually priced at a lower level than the initial marketing range set by the underwriters when they were marketing the IPO.
Investors were not keen on it. However, the stock just crushed it, and this really represents how well you can do when you looked for these special situations, such as spin offs or carve out, as historically, they have tended to produce market-beating returns. And you’re certainly seeing that here. But nonetheless, you’ve got to think were these pension funds asleep at the switch, when AltaGas was evaluating alternatives for this subsidiary, and now they’re ending up paying more than double the price where it IPO’d just one year ago.
Obviously, they could have saved a fortune by sweeping in at that time and paying AltaGas even a premium to that fourteen fifty. Instead, they are now paying 33.50 per share, which perhaps not the best result, but certainly a great result for AltaGas and their shareholders. What do you think about this deal?
Michael Kesslering: Yeah, good point that you make. That they could have saved themselves some money. You know if this had been done a year ago as well as like the investment banking fees and just the subsequent pricing and what not. But in terms of the strategic rationale of this this transaction, you mentioned that AltaGas, the parent company, owns 37 percent of of AltaGas Canada. They had already monetized the rest of their ownership. This is just monetizing the last bit of their minority share.
Julian Klymochko: They would have monetized that in the IPO one year ago and got cash for it.
Michael Kesslering: Yes, and so this fits in with AltaGas long term financing plans as these were just seen as non-core after their previous acquisition. Looking to the actual merger arb spread right now. It’s currently trading at about a 4.3 percent annualized return if you’re using an April 2020 close, although there could be some variance to this as there needs to be approval from both the Alberta and B.C. Utilities Commissions. So timing is a little bit out of the company’s hands, certainly. But as well, you know what you did mention why infrastructure investments are so popular for pension funds. And really it just comes down to the long term nature of the assets as well these assets typically come with a contracted output where asset price is already negotiated.
Julian Klymochko: Right, very stable cash flows.
Michael Kesslering: Absolutely, and so ultimately they will have stability of their cash flows, which for any long term organization, like a pension fund or an insurance company, these are very favourable as it helps them to match with their long term liabilities.
Julian Klymochko: Yeah, plus they do have annual spending obligations to their beneficiaries. So that’s something to keep in mind, and why we’re seeing this skyrocketing demand from pension funds and other institutional investors like that get really big in the infrastructure and utilities space. But with that being said, I saw some analysis today that looked at EBITDA multiples of utilities companies and they seemed to be an all-time high or at least a 20 year high. So certainly, investors should express some caution in this sector. They are stable and somewhat recession resistant, i.e. not cyclical. However, valuations seem quite high in the utilities space. That is something to keep in mind when potentially looking to allocate capital to that sector.
A great fixed income alternative
Julian Klymochko: Given we have been speaking so much about M&A mergers and acquisitions and merger arb specifically on this podcast. I wanted to highlight a piece of research that we started putting out, our Alpha Rank merger monitor, which keeps track and models out every single merger transaction in North America for the purpose of analysing it from a merger arbitrage perspective. I believe merger arbitrage, it is a great fixed income alternative because the way it works is a merger arbitrageur will buy a target company at below the takeover price and look to earn the difference between the price that can buy it in the market and ultimately the price they receive when the deal closes, and there is a number of ways doing that. On a cash deal, it is pretty simple. You just buy it at a discount to the cash price. The cash takeover value, and then on a share deal, then you would go ahead and short the acquiror’s stock to try to earn that spread. Under our research, current yield is kind of in the five and a half percent range. So that’s a relatively attractive yield, and typically, the average merger arbitrage yield, assuming these deals close, it’s priced off a risk premium to cash. Cash yields kind of 1.5 to two point zero percent these days, and merger arbitrage premium is typically in that 3 percent range. We are seeing pretty good yields out of the merger arbitrage space this year. There is a lot a lot of attractive spreads out there, and the beauty is that, you know, it’s priced to cash and they’re very low duration. The average M&A deal closes within four months. As opposed to bonds and other fixed income securities, you are not taking that duration risk, so it is a really good strategy for investors are concerned about rising interest rates, which I know hasn’t happened lately.
But certainly with rock bottom yields that we’re kind of seeing these days in the long term treasuries space, you’ve got to figure at some point those would go up and merger arbitrage is a good strategy to help isolate you from that potential duration risk.
The other thing is, you know, it puts together a risk reward profile that’s very similar in terms of expected return and volatility, similar to, say, BBB bond yields or are kind of a corporate bond index, but you don’t have that duration risk. The other thing that makes merger arbitrage more advantageous is the fact that most of the gains is in the form of capital gains as opposed to interest that’s earned off of bonds. That is something to keep in mind as potential more tax efficiency, because most investors are taxed on a friendlier basis on capital gains as opposed to interest, which is typically taxed fully as income. Tends to be twice as a high tax rate, so it is important to keep that in mind as well, although it is not an easy strategy. Certainly requires a lot of specialization and a lot of in-depth analysis to affect this transaction. Sorry, affect this strategy on an effective basis.
Michael Kesslering: Absolutely, so when our listeners are going over the merger monitor that we put out, you can see the effect of yield. We do have a chart of that, and Julian had mentioned those in the 5.4, 5.7 percent range for a current yield at the time that we published. Even walking today, it is showing up just over 6 percent. There is some daily volatility there in terms of the implied yield and not just has to do with mergers closing, failing and new mergers being announced as they’re all at different spreads.
Julian Klymochko: Typically every day you see a new deal announced on average, I would say, and, you know, nearly every day seeing a deal close as well.
Michael Kesslering: Absolutely, and one other thing that I wanted to point out with the merger monitor is a couple of the tables that we have are closed mergers and failed mergers. If you look at the closed mergers, you can see there is really only one that is above 200 days to close as opposed to looking at the failed mergers there. Most of these are over 200 days to close, so what you could kind of imply from that is and this is very common sense, but the longer that a merger is still open, the higher probability that it may not close, especially when regulators are involved, if there’s any anti-trust concerns.
Julian Klymochko: Yeah, exactly. Those long ended and then ultimately failing deals are typically, because they get hung up in the regulatory process then the deal ultimately breaks because they can’t get regulators onside. That is a common reason for deals to fail and that is why it requires a decent amount of expertise to execute the strategy. Nonetheless, when executed properly, it provides a really nice risk return profile, low volatility, absolute returns. Something that investors should consider, in my opinion, adding as a small portion of the portfolio just due to those various characteristics that we’ve discussed.
And that’s all about it for us this week on episode 37 of The Absolute Return Podcast. If you liked it, you can always check out more at absolutereturnpodcast.com . Feel free to leave it or review on Apple’s Itunes or any other podcast application that you utilize, and that is it for us. And we will chat with you next week, cheers.
Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.
