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S ecial Situations



Market neutral returns of 23% in 3 months

1 pccps = 1 stock + 1 warrant + 1 preferred

1/2 stock

=

Buy Spot Sell in Futures Create cheaply!



News story of 3 Jan 2012



Bhavook The Rocket!



Buffett’sCase on

ArcataCorporation



28 Sept, 1981: KKR agrees to buyArcata

printing and forest productsbusiness and a contingent claim.

10,700 acres of Arcata timberlandacquired by govt. in 1978.



Arcata Timberland



$97.9 mil compensation over manyinstallments deemed inadequate; plusco got 6% simple interest- claimed

more, compoundedValue of the stock = value of thebusiness (less debt) + the value of

contingent claim



KKR offered Arcata’s

shareholders $37 plus two-thirds of contingent claim if materialized.



How did HE

Analyse thissituation



How likely is it that KKR willgo through with this

transaction?

Deal subject to “satisfactoryfinancing”

Given KKR’s credentials, lowprobability of deal failure



What will happen if the deal

with KKR fell through?Other buyer likely to emerge



What is the Redwood Claim worth?

Somewhere between zero and “a whole lot.”Why did Mr. Buffett not value this claim?



Started buying at $33.50. offer price

was $37 plus two-thirds of the claim.Started buying on 30 September.

Payment expected by next January.

Heads I win a little, tails I win a lot

Not counting the value of contingent

claim, expected return = 40% p.a.annualized.



Financing glitches appear.(“Shit Happens”)

The stockholders’ meeting was

postponed again, to April.Such news usually treated by

the arbitrageur community asbad bad news.



Stock declines, Mr. Buffettbuys more.

On March 12 KKR revises offer,first cutting it to $33.50, thentwo days later raising it to

$35.00.



March 15: Arcata Board Rejects KKR bid and accepts rival bid of $37.50 plus 50% of contingent

claim.

Stockholders approved deal, $37.50

paid on June 4.



BRK received $24.6 mil versus itscost of $229 mil.

average holding period close to 6

months.

Annualized return came to 15%

return excluding any value for theredwood claim.



What about the contingent claim?

The trial judge appointed two

commissions:

One to look at the timber’s

value



The other to consider theinterest rate question.

January 1987: Timber valued

at $275.7 mil compoundinterest @14% p.a. awarded!

Wow!



August 1987 the judge upheld

these awards

Total value of claim = $600 mil.

Government appealed. In 1988,claim settled for $519 million.

BRK received an additional $29.48

per share, or about $19.3 million.



Risk Arbitrage TeachesProbabilistic Thinking



Risk Arb: Pursuit of profitsfrom an announced corporate

event such as sale of thecompany, merger,

recapitalization, reorganization,

liquidation, self-tender, etc.



In most cases the arbitrageur expects to profit regardless of

the behavior of the stockmarket. The major risk he usually

faces instead is that the

announced event won’t happen.



To evaluate arbitrage situations youmust answer four questions:

1. How likely is it that thepromised event will indeed

occur?



2. How long will your money be

tied up?



3. What chance is there thatsomething still better will

transpire - a competingtakeover bid, for example?



4. What will happen if theevent does not take place

because of anti-trust action,financing glitches, etc.?



Annexure to 3rd Edition of Security Analysis



Probabilistic Thinking

works in StraightEquities too



“Our purchases of Wells Fargo in

1990 were helped by a chaotic market in bank stocks. The disarraywas appropriate: Month by month

the foolish loan decisions of oncewell-regarded banks were put on

public display.



He Listed Three Risks1. Earthquake

2. Systemic3. Real estate exposure



“None of these eventualities can be

ruled out. The probability of the firsttwo occurring, however, is low and

even a meaningful drop in real estate

values is unlikely to cause major problems for well-managed

institutions.



“Consider some mathematics: Wells Fargo currentlyearns well over $1 billion pre-tax annually after

expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just itsreal estate loans - were hit by problems in 1991, andthese produced losses (including foregone interest)

averaging 30% of principal, the company would roughlybreak even.”



“A year like that - which weconsider only a low-level

possibility, not a likelihood -would not distress us.



“In fact, at Berkshire we wouldlove to acquire businesses orinvest in capital projects thatproduced no return for a year,

but that could then be expected to earn 20% on growing equity.



“Nevertheless, fears of aCalifornia real estate disaster

similar to that experienced in NewEngland caused the price of Wells

Fargo stock to fall almost 50% within a few months during 1990.



“Even though we had bought some

shares at the prices prevailing before the fall, we welcomed the decline

because it allowed us to pick up many

more shares at the new, panic prices.”Fear is a Foe of the Faddist,but a Friend of the Fundamentalist.



“In my view nothing iscertain; nothing is

absolute. And that is theview, I might add, of

modern science.



“So it seems to me with

respect to any decision thatyou're going to make, whatyou have to try to figure

out is what are the odds,what is the likelihood of something happening, and if

it does happen, what benefit do you get?



“And if it doesn't happen,what do you lose? Then you

make your decision by

looking at the likelihood of different possibilities, andthe gains if they happen,

and the losses if theydon't happen.



“You try to get the best possible likelihood-adjusted

result, of the best average result, if you want to put it

that way. And then you mightadjust that, because you

might say, “Well, that's thebest average result, but in

fact I'm more risk-averse, so

I'm not going to take thatmuch risk.”



“Or you might say,"That's the best average

result, but I'm willing totake more risk, so I'llshoot for the moon.



“Arbitrage is an actuarial business, just like

so much of life. Each judgment wasprobabilistic. What you needed to do wasmake sure you didn't get so big in one

position, even if the odds were very good,that if it went bad it wiped out everythingelse. You had to maintain your balance.”



“It's very simple algebra. And it was

all worked out in the course of aboutone year in correspondence betweenPascal and Fermat. They worked it out

casually in a series of letters. Yourbrain isn't designed to figure it outspontaneously.



“It's not that hard to learn. What is hard is to get so

you use it routinely almost everyday of your life. TheFermat/Pascal system is dramatically consonant withthe way that the world works. And it's fundamental truth. So you simply have to have the technique.”

Fermat/pascal Letters:

http://www.york.ac.uk/depts/maths/histstat/pascal.pdf



Fermat/pascal Letters:

http://www.york.ac.uk/depts/

maths/histstat/pascal.pdf



The only certainty is that there isno certainty.

No such thing as a “sure thing”

“Shit Happens”



Every decision, as a consequence, isa matter of weighing probabilities.

Despite uncertainty we must decide and we must act.



Deciding and Acting are different

things. Deciding to not decide isalso a decision.

Sometimes the best decision is tonot make a decision - preserving optionality



Sometimes we have to choose the“least worst option”.

E.g. War on drugs

or Bank bailouts



We need to judge decisions not onlyon the results, but on how they

were made.

Process vs. Outcomes



Probabilistic Thinking

Process/Outcome



Why am I telling you so muchabout Risk Arb?



Risk Arb forces you to thinkrationally using an expected value

framework

And BFBV is about rationality…

The lessons learn from Risk Arb canbe applied in other fields



Risk Arb requires constant re-evaluation of odds, and relative attractiveness

e.g. Milestonese.g. Opportunity cost

Mistakes costly, but non-correction of mistakes even more costly



The

in Risk Arb



Risk Arbitrage islike picking uppennies in frontof a steamroller

1. Deal Risk



2. ReinvestmentRisk



3. Focus Risk



19 December 2008 Case: Eicher Motors



Is there a place for SpecialSituations in a portfolio?

Alternative to cash



The commercial vehicle business of

Eicher Motors Limited along with the

related components and design

services businesses will be transferred

to the joint venture company which isa step-down unlisted subsidiary of

EML on slump sale going concern

basis at a value of Rs202 crores



Volvo will contribute Rs 1,082 crores in cash

and will also transfer its Indian truck

distribution and service network to the jointventure. In lieu of cash and the service and

distribution network, Volvo will be allotted

45.6% equity shares in the joint venture. EMLwill consequently hold the balance 54.4% equity

and thus the joint venture will be a subsidiary of

EML and its financials will be consolidated with

the financials of Eicher Motors.



Volvo will also buy 8.1% equity stake in

Eicher Motors Limited from the promoters of Eicher Motors Limited at a

consideration of 157 crores which

equates to Rs.691 per share. Now takinginto account it’s direct and indirect

holding, Volvo’s economic ownership of

the joint venture will be 50%.



The joint venture will have exclusive

distribution rights in India for all present and future Volvo truck

products. All future Volvo group

truck projects in India will be routedthrough this joint venture subject of

course to agreement on the terms and

conditions.



Option value4% of sales at sub level- with growth

Why high quality earnings stream?Marty Whitman’s SOTTLook-through earnings for Eicher Motors



Is this good news or bad news?

Quality of earning streamCapital Intensive business outVolvo keeping manufacturing

Potential for dispute?



EML and promoters have also entered

into a separate non-compete agreementwith the joint venture for not getting

into trucks and buses business in India.

Volvo shall pay a non-competeconsideration of Rs.39.4 crores each to

Eicher Motors and to the promoters.



Post-closing Eicher Motors will

receive a consideration of 202 crores from the joint venture and it will be

debt-free. In addition there will be

the 39.4 crores of non-compete feeswhich will come in. So both put

together this will be around 240

crores.



“Eicher Goodearth (promoter of EML) intends to

propose to the EML board to consider a buybackof shares from the public shareholders in the same

proportion as the promoters have sold to Volvo.

So the promoters have sold 8.1% out of 58.2%

stake and that equates to around 13% of the

promoter holding. So we are recommending to

the EML Board to do the same to the public

shareholders and at the same price of Rs.691.”



14,08,969/1,07,43,018 = 13.11%.Can it get better?



Buy 100 shares at 225



y

Tender 13 shares at 691

Effective cost of 87 shares = 13,517 orRs 155 per share.

Accounting vs. Economics

Think cash flow!

Your cost of remaining 87 shares issimply the net cash outflow from the

investment operation.



With 2.43 cr shares post buyback,you will pay Rs 378 cr for thisdebt-free company.

What do you get in return for thispayment?



Cash of Rs 360 cr.

54% stake in JV



Recent change - sebi has relaxed the rules



Peer valuationHolding company

What will happen when buyback is announced?



What Happened Afterwards



What Happened Afterwards

Market Cap 3 Years Ago: Rs 621 cr.Market Cap Now: Rs 4,248 Cr.



How do THEY create their own SPECIALSITUATIONS?



That’s why it makes sense toride along in a sidecar with

l h h “ li t



people who have “complimentaryskills” of getting such lucrativedeals which are not available to

others.

Refer to uU document byZeckhauser



Capital Structure Arbitrage

Exploiting relative valuation gapsbetween different securities which

form part of the same capital

structure.



In Pure Capital Structure Arb,you have long and short positions.

In Capital Structure RiskArbitrage, you may be long only



Market neutral returns of 23% in 3 months

1 pccps = 1 stock + 1 warrant + 1 preferred

1/2 stock =

Buy Spot Sell in Futures Create cheaply!

A convertible bond is convertible into 2 shares. Theb d t d l b i i f i t t



bond on a stand-alone basis is a safe investmentworthy of selling at 100 without any conversion

option.The current stock price = Rs 55 per share.

The current bond price may be Rs 115. (Premium of Rs 5)

The investor believes that the stock as well as themarket is overpriced and due for a fall.

Shorting the stock against a long position in theconvertible will be a profitable trade



Graham’s Rules on Converting and Switching

Example: An investor holds a convertible bondwhich was originally issued at Rs 100.



Interest rate is 10% p.a.

The bond can be converted into 1 equity share of the company at any time during the next ten

years at the option of the holder.

The price of the stock is Rs 200.

The price of the bond may be Rs 210

The investor bought this bond primarily as acommitment in the stock.



The stock pays a dividend of Rs 5 per share.Current dividend yield is 2.5%.

The bondholder should not convert the bond into

stock. If he did so, he will not only give up hissenior claim but will also suffer from a loss of

current income.



Moreover, he will surrender an instrument which

has a current market price of Rs 210 in exchangeof another instrument which has a current marketprice of Rs 200, with no additional benefits

accruing to him due to the exchange.

By holding the bond, he has nothing to lose andeverything to gain.

Principle Derived: “Never Convert a Convertible”



“Parity,” “Premium,” and “Discount.”

When the price of a convertible bond or preferred

is exactly equivalent, on an exchange basis, to thecurrent price of the equity shares, the two issuesare said to be selling at a parity.



When the price of the senior issue is above parity, itis said to be selling at a premium and the differencebetween its price and the conversion parity is called

the amount of the premium, or the “spread.”If the price of a convertible is below parity, the

difference is “discount.”



A convertible issue selling on a parity with theequity is preferable thereto, except when its price isso far above an investment level that it has becomemerely a form of commitment in the equity share.



Rule on Switching - Holders of equity shares who

wish to retain their interest in the company shouldalways exchange into a convertible issue whenever itsells at both an investment level on its own account

and also close to parity on a conversion basis.

Notice this is the reverse of the rule, “never convert

a convertible”.



26.8 x 6 = 160.80 which is 12% cheaper than Tisco Stock



Current Discount is 12%



Rs 2 per share dividend

on Rs 26 dividend yield (tax free) = 7.7%



Slides from a presentation made on 13 october, 2011

DVR enjoys1/10th the



1/10th thevoting right of

Equity but gets5% extradividend rights.

Discount of

46%



Post Split Equity shares = 269 cr shares @ 186 ≅ Rs 50,000 cr.

Post Split DVR = 48 cr DVRs @ Rs 101 ≅ Rs 4,800 cr. (Almost $1

billion)

Discount of Rs 85 per DVR x 48 cr DVRs = Rs 4,100 cr.



http://breport.myiris.com/ICICISL/TATENGLC_20110530.pdf

Why No Mention of “DVR”?



Why don’t they

switch?



Why the discount?



28% discountIs corporate

governance atPantaloons betterthan at the house

of Tatas?

Month Promoter Stake in DVR



Jun 2011 9%

Mar 2011 19%

Dec 2010 19%

Sept 2010 36%

Jun 2010 36%

Mar 2010 53%

Dec 2009 57%

Sep 2009 80%

Jun 2009 84%

Mar 2009 84%

Dec 2008 84%

Is there a technicalreason for the

discount?



1,500 Class B = 1 Class A (Economic Rights)10,000 Class B = 1 Class A (Voting Rights)

74x1,500 =111,000No Discount in Class B



Why do TataMotors Futures

trade at adiscount to

spot?



Capital Structure Risk Arb Example:

Sakuma Exports Preferred Stock



http://fundooprofessor.wordpress.com/2011/03/01/ben-graham-framework-36/



Sakuma vs Network 18



News story of 3 Jan 2012



Example Capital Structure Arb:

ISPAT INDUSTRIES



http://fundooprofessor.wordpress.com/2011/02/19/bfbv-examination-question/



http://fundooprofessor.files.wordpress.com/2011/02/ispat_pa_22122010.pdf



Current Status of ISPAT



Fundamental Performance

Need for Hedge

Lottery Ticket?



Tender Offers

1. Delisting (SEBI’s Delisting Regulations)

2. Takeovers (SEBI’s Takeover Code)3. Buybacks (SEBI’s Buyback Regulations)

Slides from JAN 2004 COURSECase on Digital Delisting

• Issues:

1. What is the intention of the acquirer (Digital’s parent)?



• To buy the public float at as low a price as possible and then to increase its value!

• How?

2. What is the total size of the offer?

• 1,66,85,463 shares.

3. At Rs 750, what is the sum committed by Digital’s parent?

• Rs 1,245 cr. or $276 million.

4. What are the requirements for a successful book building process from the acquirer’s viewpoint?

• A minimum of 66,64,195 shares must be tendered, or the process will fail; and

• The cut-off price is equal to Rs 750 or less.

5. If the book building process fails, what will happen to the market price per share?

6. To answer this question intelligently, one must know the answers to the following four questions:

1. What was the stock price before this process started?

• Answer: Rs 662 per share

2. where was Nifty at that time?

• Answer: 1615

3. Where is Nifty now?

• Answer: 1935, an increase of 19%

• How has the company performed in the latest quarter?

1. Answer: done well

• Based on the above data, if the book building process fails the price should be 787 (662x1.19).1. In other words, it should not be below current market price of Rs 780.

2. However, an avalanche of supply if the process fails, may take the price to below this level for a temporary period (assuming Niftydoes not crash by that time).

8. What if the minimum quantity requirement is met but the cut-off price is more than Rs750?

9. Will the acquirer accept the higher price?

• Is the acquirer really stuck up on the limit of Rs 750?

• Note that in the letter of offer it has stated, “the Acquirer considers Rs. 750 per Share to be an acceptable price and is prepared to acquire the Shares at this



Share to be an acceptable price and is prepared to acquire the Shares at thisprice. The Acquirer reserves the right not to acquire the offered Shares at anyhigher price established pursuant to the reverse book-build set forth in the

Guidelines.”• Does this mean that if the cut-off price is Rs 751 will it reject the offer and let the whole

process fail?

• I don’t think so!

• Why? Two reasons:

» In the initial disclosure to BSE, the acquirer said, “Hewlett Packard is of theview that a price in the region of Rs 750 per share is very attractive price for

the public shareholders of the company.” [emphasis mine]» The market price of more than Rs 750 indicates something!

• If the acquirer is willing to pay more than Rs 750, then the next question becomes,how much more?

• An additional Rs 100 will cost the acquirer Rs 166 cr. or $37 million taking the totalcost to $ 313 million.

• Peanuts?

• On peer valuation basis, is it easy to justify an additional Rs 100 per share?• Answer: Yes

• What is the price beyond which the acquirer is likely to say “No”?

• A very difficult question

10.What is the intention of Digital’s minority institutional stockholders:

1. Institutional stockholders would like to sell their holdings to Digital’s parents atthe maximum possible price.



2.They would not like to remain minority stockholders.

3.They would be quite capable of understanding the complexity in the process of book building.

4.They would be in a position of having a one-to-one talk with Digital’s parent tostrike a deal.

5.They would be in a position to “act in concert”

11.What is the intention of Digital’s minority non-institutional stockholders?

1.Many brain dead investors

2.The complexity of the book building process12.What is the bargaining power of the minority non-institutional investors?

1.Very little, given that they are widely scattered and have no means tocommunicate with each other and also given their minor role in the overallprocess due to their low stake.

13. Given that the market price is more than the price indicated by Digital,does it make sense for any minority shareholder to tender?

• Suppose you are holding Digital shares and want to sell the stock andare wondering what to do



are wondering what to do.

1. Given that the market price is more than Rs 750, you can sell in themarket. But if you sold, you will face regret if the book buildingprocess produces an exit price of more than Rs 750. So you shouldhold because even if you do not tender in book building you cantender in the next offer.

2. But if you hold and the book building process fails, then there will bean avalanche of supply of shares in the market and the price may fallto below current level, at least for a temporary period, and you willface regret.

• It’s better to face the second type of regret than the first.

• But if everyone thinks like this, then no one tenders and the process failsand the second type of regret becomes a certainty!

14. The “Free Rider” Problem.

1. If the book building process is successful, then the value of theshares is likely to rise.

2. Many investors want to have a free ride and may not tender their shares.



• Conclusions:

1. What are the chances that a minimumquantity of 66,64,195 will be tendered?

1 M i 95%



1. My view: 95%

2. Note that on day one, 11.3 lac shares

have already been tendered.2. What is the likely cut-off price?

1. My view: Rs 850 minimum

3. Expected value = minimum Rs 845(95% chance of Rs 850 and 5%chance of Rs 750).

4. Current market price = Rs 780.

5. Indicative return = 8.3% flat (not badfor a few days)

6. Odds are decent (low risk of apermanent loss and a “reasonable”return).

7. But don’t bet the bank on this!

8. There may be better opportunities out

there!



What should we do now?

“If you dance too near a grave, Make sure you don’t

fall into it!”- Sam Zell, Grave Dancer



HabilKhorakiwalaGambled



Gambled

withDerivatives

using

BORROWEDmoney.

And Lost



To reduce the cost of overseas acquisitions, hewent overboard on forex derivative exposure

Revenues : 3000 crsForex debt: 2500 crs

Forex derivatives : 10,000 crs



Forex derivatives: 9742 crs crs

Result?

2200 crs of forex losses



Failure to meet debt repaymentsWelcome to CDR!



81% Drop

Leverage+Derivatives+Stupidity= Disaster



1.CDR provides amoratorium on the

payment of interest.

2 Debt repayments are



2. Debt repayments are

spread over a longerperiod of time.

3. Interest cost isreduced.

4. part of the liabilityis converted to equity.

5. cash flows tied tothe cdr package.

6. divestment of noncore assets.

Animal Healthcare Business



Net sales: Rs 77 crs

Sold for: Rs 170 crs

PSR: 2.2 times



Nutrition Business



Sale Blocked; Abbott Walks away

Consideration: Rs 281.6 crs

Sales: Rs 148.7 crs

PSR: 1.9x



Rule of Maximum value of senior issues



A mirror image of rule of minimum value of a debt-free company.

The value of the stock of a debt-free company.cannot be less than the value of bonds it can easily

service.

Debt-capacity bargains




"A senior security cannot be worth, intrinsically, anymore than the equity share would be worth if it

occupied the position of that senior security, with no

junior securities outstanding.”- graham

The aggregate fair value of all senior securities of acompany cannot be more than the value of the

entire company, with identical assets, were it debt-free.

Rule of Maximum value of senior issuesWhy this rule must hold true?

Because senior security holders cannot in



Because, senior security holders, cannot, in

aggregate, get more out of a company, than theycould, if they owned the entire company, free of all

prior claimants i.e. debt-free.

“The rule of "Maximum Valuation for Senior Issues"arises out of the common sense principle that thesenior claimholders (bonds and preferred stocks)

cannot possibly get more out of a company by virtueof their fixed claim than they could realize if theyowned the business in full, free and clear.”- Graham




“This relationship must hold true regardless of howhigh the interest or the dividend rate, the par valueor the redemption price of the senior issue may be,

and, particularly, regardless of what amount of unpaid interest or dividends may have accumulated.”

Graham

Company forced torestructure debt



Analysts Stops Covering theStock

Lack of Information - very

little disclosures

Shareholder Meeting inDecember 2009



Company told us that we were the ONLY ones who

inspected the CDR Document!



Our work showed “Emerging Equity Value” post CDR

implementation to be well in excess of prevailingmarket cap

Private market value exceededstock market value



Ranbaxy was sold at 4 timesRevenues in Private Market

Piramal Healthcare was sold at

9 times Revenues in PrivateMarket

Wockhardt was selling at 0.5

times Revenues in Stock Market



Thank You

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