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Absolute Return Podcast #67: The Art of SPAC Arbitrage

The Art of SPAC Arbitrage, Accelerate Financial Technologies, Absolute Return Podcast, Julian Klymochko, Michael Kesslering, Merger Arbitrage, ARB, Mergers and Acquisitions

May 11, 2020–Liberty Global and Telefonica Combine U.K. Units in $39 Billion Deal. What is the Strategic Rationale Behind this Deal?

Struggling Retailer Neiman Marcus Files for Bankruptcy as Coronavirus Hammers Department Stores. Are More Insolvencies to Come?

Mergers Up in the Air as COVID-19 Hits Asset Values. Which Deals are Getting Hit and Which Could Go Higher?

The Art of SPAC Arbitrage. A Discussion on One of the Fastest Growing Asset Classes.

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.

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Transcript

Julian Klymochko: Welcome ladies and gents to The Absolute Return Podcast, episode 67 I’m your host, Julian Klymochko.

Michael Kesslering: And I Mike Kesslering.

Julian Klymochko: Today is Friday, May 8. Have a few really important market events that we wanted to touch on this week’s podcast, first.:

    • Liberty Global, one of John Malone’s entities. They did a deal with Telefonica to combine each of the companies’ UK units and a massive $39 billion deal. Basically the biggest deal after this Coronavirus bear markets started. We are going to chat about the strategic rationale behind this deal. 
    • Next step, struggling retailer Neiman Marcus files for bankruptcy as coronavirus absolutely hammers department stores. Are more insolvencies to come? We are going to chat about which companies we think are going to file for bankruptcy next. 
    • Mergers are up in the air as COVID-19 hits asset values, which deals are getting hit and which could go higher? That is right. Coronavirus is affecting a lot of companies in a negative way, but some businesses are doing significantly better. We are going to chat about those dynamics.
    • Lastly, we are going to talk about the art of SPAC Arbitrage a discussion on one of the fastest growing asset classes in the market. 

Liberty / Telefonica Deal

Julian Klymochko: First, I wanted to touch on this Liberty-Telefonica deal. What happened here was Liberty Global. They agreed to come combine its British cable operations, which are Virgin Media with Telefonica’s UK telecommunications business, which is O2 in a game changing $39 billion deal. That is right, that is billion with a B. The two companies will form a 50/50 joint venture, which Liberty Global and Telefonica hope will becoming internet and mobile powerhouses, demand for super-fast broadband grows and 5G rolls out across the UK. Now this business combination, which is the largest mergers since the global health related shutdown started, it creates what is known as a quad play telecom operator, and it’s known as a quad play because they offer four things.

That is Cable TV, internet, landline, and mobile phone services to consumers in one package. And consumers really like this, they can offer the combined package at a discount to what you could buy through four separate providers. This is a trend that is really catching on and it’s really consumer friendly, so that is one of the strategic rationales behind the deal. Now this deal will really reshape the competitive environment in the UK, as the pro-forma company will have the country’s largest mobile network and the second largest broadband internet network. They are going to be quite the competitor and the telecom space and what’s really interesting in the age of coronavirus work-from-home dynamics, we spoke about this on last week’s podcasts of deals coming together. When you can’t actually go out and do physical due diligence, you can’t visit the assets and you can’t do a deal and shake hands in person.

The background on this deal. These companies began speaking in earnest around December 2019. Face to face meetings between the executive stopped after about March 11. Then after that, teams throughout the world made hundreds of video calls just to crunch the numbers, hammer out regulatory matters and negotiate the terms and finally sign this deal. It is really interesting that massive deals, nearly $40 billion are getting done in the age of work from home. 

Lastly, interesting dynamics on the Telefonica aside because they have been looking for a deal to sell O2 for a number of years. They tried to sell to a rival that was blocked by the regulators. They also tried to IPO, which failed, so it looks like third try is going to be the charm for this O2 asset. As for this Virgin Media deal, Liberty getting rid of Virgin media, it is the fourth time this business has changed hands.

Basically, it was founded as CellNet under BT and demerged, relaunched, and what’s interesting in that asset value side, O2 is being sold in this deal, valued at 12.7 billion pounds, but it was initially acquired in 2005 by Telefonica for 18 billion pounds, so a 15 year hold for that O2 two asset by Telefonica and they lost one third of its value. Not the best investment and it looks like they are just trying to move on and wash their hands clean of this, UK based mobile asset. What are your thoughts on this deal? It is nice to see a $39 billion transaction and it continues the trend that we discussed last week of M&A window really opening up.

Michael Kesslering: Yeah, it is nice to see a large-scale deal and as well, I think one thing that you had mentioned that this has not been really a good investment for either of these parties. In moving forward, instead of, you know, continuing to compete, in a space where they’re not really winning per se, they’re combining and looking to realize some of the synergies that can be kind of squeezed from this and, and squeeze out cash flow. With regards to synergies, they expect 540 million pounds worth of run rate synergies or this is all through cost cutting. I believe in their press release they said that there was too early to talk about, you know, potential job cuts. I think that’s a fairly obvious thing that’s going to happen with this.

Julian Klymochko: Sensitive subject right now though but that is what synergies are, right. Basically job cuts.

Michael Kesslering: Exactly, it is just newspeak, you know, in Orwellian terms its news speak for jobs being cut. Really looking at the deal as well. Listeners of the podcast are well aware of, admiration for John Malone.

Julian Klymochko: Cable cowboy. 

Michael Kesslering: Cable Cowboys. Yeah, it is one of my favourite business books of all time. It is very interesting but really this, looks like him trying to slowly get out of Europe in Liberty Global.

Julian Klymochko: Yeah, salvage the asset.

Michael Kesslering: He has been very successful in consolidating the American cable industry as well as areas of the media industry and communications in general. Has not had as much success in Europe. This is really one other aspect of the deal is that it does have a built in mechanism to potentially float the combined entity in an IPO in three years’ time, which that ultimately looks like it would be the exit.

Malone is really a fan of, these are kind of complex transactions where you are combining a couple of entities that were prior not combined, and then leveraging up a little bit and that’s just something that Malone has loved to do time and time again. Just in the last month with some of his other Liberty entities in the U.S., he took Formula 1 and the Liberty XM Sirius, took those assets and did an asset swap between the parties, which was quite complex. At the end of the day, it really looks like just trying to pull back from Europe and an investment that really has not worked out.

Julian Klymochko: Certainly, UK market has been extremely challenging from a business perspective and another business that has been extremely challenged going through super tough time are department stores. I mean, that has been the case for many years. Basically, they’ve been on secular decline for the past 5, 10 years, but the coronavirus pandemic has really hammered department stores and we saw one of the first victims with 113 year old department store Neiman Marcus was the latest victim to file for chapter 11 bankruptcy protection this week.

Some other retail casualties of this downturn include J. Crew and then Canadian shoe retailer Aldo and those both filed for bankruptcy in the last few days. Wanted to touch on what happens specifically to Neiman Marcus. Their financial condition had been in really, really bad shape for years given its over leveraged balance sheet and declining sales. And this was the result of an elevated $6 billion US leveraged buyout by Ares Management and the Canada Pension Plan Investment Board in 2013 so they LBOed it seven years ago and they put a decent chunk of cash into it. CPP put in about a billion Canadian dollars, which went poof to zero.

Every Canadian out there lost some money on this deal, unfortunately. That’s really been the case of nearly every retail leverage buyout that you look at. We can talk about a list of them. There is Toys “R” Us, Sports Authority, Payless Shoe Source, Gymboree, all retail leveraged buyouts, private equity deals that have gone to zero. And what I wanted to touch on with respect to these retail leveraged buyouts over the past, say, decade or so, is they really handed the entire retail market to Amazon on a silver platter. What happens in a leveraged buyout, commonly known as a strip and flip, where they look to, not invest in the business, they strip it of its cash flows, they lever it up such that most of the free cash flow goings goes to paying interest and paying down debt. These private equity firms took all these retailers private with a ton of debt and much of their cash flow was used for debt servicing and whatever access cash flow they’d try to pull out as quickly as they could from the business and not reinvest in these retailers at all.

Certainly not invest in growth initiatives, let alone sustaining capital expenditures and the lack of investment in growth (i.e., developing omni-channel strategies) developing and internet retailing strategy absolutely handed the entire market to Amazon, which was actually investing heavily, super heavily into their retailing operations. Now they are so far ahead that investing any into a, omni-channel strategy at this point is, moot for a traditional retailer because Amazon is so far ahead. Some of these department stores, they basically have zero chance to catch up here. A big, big, big strategic blunder on the part of the private equity owners and we gave you a list. There has been dozens and dozens of these formerly great retailers that really did not get the investment they deserved and now they are going bankrupt. Another example was not a leveraged buyout, but it was a public company, JC Penney. They are in big trouble. They are expected to file for bankruptcy next week. Right, Mike? I think that is the case. 

Michael Kesslering: Yeah, yeah. Why they are looking to file for bankruptcy next week, is the media reports, I believe it was today. There were some leaked reports that they were actually in negotiation with their creditors, debtor-in-possession, for financing to cover them through their bankruptcy proceedings. Now  Debtor in possession financing is really just meant to finance operations in the short term, and ensure that the company doesn’t have to shut their operations completely. As well as it is typically senior to all the other credit, so it is really just meant to provide capital to preserve the value for the rest of creditors and typically you’ll see the first week creditors will, be involved in that any way typically. But this all stems from them missing a $17 million payment, on Thursday, which they have five days to cover.

So that would bring them to late next week as well as a 30 day grace period on a $12 million payment, that the company missed on April 15. That grace period ends on next Friday, so it is all kind of coming to a head, next week. There is likely to be an announcement that they are pursuing bankruptcy as you mentioned, Julian, like both Neiman Marcus. I guess to more of an extent, they certainly does not look good for a luxury retailers or retailers that really don’t have much of an online presence. With both Neiman Marcus, fitting into that camp obviously JC Penney is not a luxury retailer, but really has been struggling for a number of years and JC Penney‘s is a penny stock now; it is literally a penny stock.

Julian Klymochko: Soon to be a donut.

Michael Kesslering: Yeah, so I mean, at the end of the day, some LBOs really gone awry, but they only thing I would add with LBOs in terms of, you know, cost discipline. That is a good thing. Like cost discipline of itself in theory is good. You know, zero based budgeting and things of that nature. Sound very good in theory, but where it really becomes detrimental and you just start having the business eat itself. To pay out a dividend, as you mentioned Julian. When you just start not investing in the growth of the firm or even the sustaining Capex, as you have seen in retail. There is a certain amount of Capex that needs to go into the actual retail stores. To keep them vibrant. To keep it being a place that you would actually want to go shop at and that’s something that I think some private equity firms get involved and the have a different idea that, investment into the layout isn’t needed. That is just proven to be false.

Julian Klymochko: Yeah, exactly and another fascinating aspect of this whole retail distress led by this big downturn is that Brookfield asset management, they are a huge mall owner, largely through their acquisition of GGP, General Growth Properties a number of years ago. But Brookfield planning to devote a $5 billion fund to shoring up retailers hit hard during this downturn. This initiative is aimed at taking non-controlling stakes in a number of retailers, so they are really going to their customers and bailing them out here. It will be interesting to see if that initiative is successful, but ultimately they are trying to make the most of their asset values interesting times. They are also interesting times in the world of M&A because this pandemic has pummelled a number of different types of businesses, whether it be, airlines, shopping malls, department stores, movie theatres. A lot of businesses are seeing their fortunes hit while others are actually seeing a business better than ever.

One deal that recently closed was, an acquisition of PokerStars and with a lot of people being at home more often, they’re playing more poker from home with casinos closed, right. A lot more at home gambling leading to record results at PokerStars. I wanted to touch on a couple of deals that went a bit haywire here. The first one was Borg Warner acquisition of Delphi in which we do have a position. What happened? Roughly six weeks ago. These are auto parts manufacturers and Delphi like most businesses drew down their credit facility just to give them extra liquidity and cash on hand. Given their revenue would be significantly impacted. Borg Warner said that was a breach of covenant of the deal. Basically what they’re trying to get out of it is, an opportunistic price reduction, which just announced this week that they did in fact get, which was effectively our thesis on getting into this trade.

The only cut the deal by 5%, which was a huge win for arb’s. The stock, Delphi stock was up double digits this week, so that one looks like it is going to have a great outcome. One that did not have a great outcome was, Front Yard Residential, whose would be acquire Amherst Holdings actually backed out of the deal on the day it was supposed to close. They basically, checked the boxes on all the conditions and on the day they were supposed to close. They announced that they terminated the deal. Unfortunate for investors and Front Yard Residential as the stock did tank about 25 to 30% on that deal break. They did not really give a reason; they just sort of blame the pandemic in general. But I suspect that Amherst financing went away and they were not able to close. That was one in which ARBs needed to take the L on, one potential win. If we wanted to talk about, GAIN Capital. Which is a brokerage company, got to disclose, we have a position and this one. There businesses experiencing record financial results as a result of this health crisis and activists got involved in the stock there. Currently undergoing a friendly deal to sell at six bucks a share and activist and saying, look, your results are off the chart. Your stock would be way higher if this deal didn’t exist. I think you should sell for eight bucks a share. This shareholder vote has not happened yet. Trying to get in there and the stock is trading at a decent premium, to the $6 bid. I believe it is north around $6.50 or so. The market’s starting to price that in. Another interesting one, one deal to follow, it is a micro-cap deal, but it adds big, big implications.

That is RIFCO which is I believe a red deer based subprime auto lender publicly traded on the TSX venture. They had struck a friendly deal pre corona to sell to a private investment group called CanCap Group for roughly $25 million deal. Real under the radar illiquid deal but nonetheless, when it came to closing, CanCap said they are terminating the DL claiming a MAC, a material adverse change or material adverse effect. Now this MAC clause has really never been claimed successfully in Canada in the history of MAC clause. It is what material adverse change clause is so called MAC clause is, something that is material and bad to the target company that allows an acquirer to walk from the deal. And historically it has been extremely difficult to be successful in a MAC claim in court. However, it has happened once before in the U.S. a number of years ago. The acquisition of, Acorn, they were a pharmaceutical company in the acquire Fresenius. Actually, they were able to get out just because of business deteriorated exceptionally, over that timeframe.

Michael Kesslering: Just to add Julian. In terms of a MAC clause is, the biggest test as well as we’ve discussed before, is that you have to prove that the company. The target company itself has been impacted more so than just the industry. It is not just like, say an oil firm, you know, oil goes down, and all the companies in that industry are affected. It has to be really specific to that company.

Julian Klymochko: Yeah, so this RIFCO, CanCap situation, we are following very, very closely. There has been good coverage in the Globe and Mail as well. I encourage listeners to follow that on their own. If they are interested in the world of M&A and Merger Arbitrage. It could have big, big implications. It is something to watch. We are currently following it. It is unresolved. Could go to trial quickly. We will watch that one. 

And the last thing I wanted to chat about this week has put out a blog post on SPAC Arbitrage. Now most people actually probably don’t even know what a SPAC is, what SPAC is: number one, it is an acronym for Special Purpose Acquisition Company. They are also known as blank check companies. SPAC is a cash rich shell company that raises money from investors and then IPO and seeks to acquire a private company target.

And they typically only have a fixed time period to do this. Your average SPAC will IPO, raise money from institutions, call it $200 million. We have seen them anywhere from 40 to 800 million raised in the IPO. They don’t have operations, they just have cash, which goes into T-bills and they go on the hunt over the next couple of years for an acquisition candidate. It was an asset class that started establishing itself in 2007. Really died out after that and recently re-emerged basically in 2017 and has skyrocketed since th 2019 was a record year for SPAC financingen.. They raised $12 billion last year and 59 SPAC IPOs represented 25% of total IPOs. And in the first quarter of this year, there are 13 SPAC IPOs, which represented nearly a third of all initial public offerings. Currently there is 98 SPAC outstanding representing an aggregate market value of nearly 28 billion.

Just to give you a size of that asset class and I just wanted to comment on this notion of SPAC Arbitrage, because typically you can go into the market and buy these things at a discount to their cash, and the key to this arbitrage is the fact that if they announce a deal, they allow you the option to redeem your shares for the value of the treasuries plus the accrued interest. Back last year when they’re earning, you know, 2% on their cash, after IPO at 10 bucks, the NAV could be, you know, $10.40, $10.50 after a couple of years and if they do announce a good deal, you have significant upside. One that was announced recently was a Virgin Galactic to Chris space that came from a SPAC represented significant upside. The Arbitrage basically, and so you looked to buy these at a discount.

If you buy the SPAC units, you actually get common shares and warrants. You can redeem the common shares at net asset value and hold on to the warrants for more upside. If they don’t announce a deal, they liquidate and you get a net asset value paid back to you. You get your $10 back plus the accrued interest, so you get a decent baseline yield. The best analogy is that you get equity upside if they announced a great deal and you get the downside of T-bills, which is, you know, extremely low. And that’s why we like the SPAC Arbitrage trade so much is because the risk-reward dynamics are very favourable to the investor here. We will encourage listeners to take a read through the blog post, “The Art SPAC Arbitrage,” to get a better sense of how all of this works and the attractiveness of the risk reward dynamics behind the trade. Mike, you got any thoughts on it? 

Michael Kesslering: Yeah, there also can be some very interesting dynamics around the transaction as what you can see is. I would bring up one SPAC right now that is going through an interesting stage and that is Far Point Acquisition Corp. Where they came out with a press release yesterday recommending that shareholders vote against their transaction with Global Blue Corp. Where a management team earlier recommended a transaction is now saying that shareholders should use their power to vote against the deal that they have previously recommended. 

Julian Klymochko: The deal that they put together, I have never seen that before. I am not sure if that is unprecedented, but I have never seen it.

Michael Kesslering: Yeah, like they have all the incentives, like in terms of a SPAC structure, the incentives for the management teams are to do a deal. That is really the only way they get, paid. In this situation, Global Blue Corp, they focus on international luxury travel, which has been highly impacted by the pandemic. But after this initial announcement came out, then Global Blue came out with their own announcement saying that they plan to continue working towards closing the deal. Where it is a very interesting situation. You also have the fact as you had mentioned, Julian, where a SPAC has to liquidate after a certain point of time while their liquidation date, Far Points liquidation date is coming up June 14. They are kind of in a tight window here to either extend or close this deal. It is a very, very interesting situation to follow. Very, very niche

Julian Klymochko: And many SPAC are backed by big name investors. For example, this one Far Point is backed by third point in Dan Loeb, who is a hedge fund manager is quite the reputation. There are lots of SPACs, nearly a hundred of them representing nearly a $30 billion asset class and we’re seeing a ton of SPAC IPOs even in this environment. The thing is, there is actually a Chinese cloud company IPO today they raised over $500 billion and it was the first IPO, post-coronavirus bear market, that was not a SPAC and not a biotech stock. Really, interesting IPO dynamics happening in the markets. SPAC is popular as ever despite the tough market and I think we will see this trend continue and really this asset class to continue to grow and grow because investors really like it, but that is about it for us this week on The Absolute Return Podcast. Hope you enjoyed it and if you did, you can always check out more at absolutereturnpodcast.com or you should definitely check us out on Twitter. Mike, what is your handle?

Michael Kesslering: Is @M_Kesslering 

Julian Klymochko: You can give me a follow, that is @Julian Klymochko, K-L-Y-M-O-C-H-K-O. We wish you all the best in your investing, trading, speculating, and perhaps short selling, but until next week we will chat with you soon. 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 www.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. 

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