By Britt Erica Tunick
With merger activity on the rise, hedge funds are counting on a big feast from BHP Billiton’s hostile bid for Potash Corporation of Saskatchewan.
Hedge fund managers snapped up shares of the target of what would be the largest takeover of 2010 when Australian natural resources company BHP Billiton first launched its nearly $40 billion hostile bid for Canadian fertilizer producer Potash on August 16.
“If you’re not in this deal, you should not be in this business,” says Tom Sandell, founder of Sandell Asset Management, who describes the deal as Merger Arbitrage 101. Despite Potash’s resistance to BHP’s initial $130-per-share offer and local government protests, Wall Street remains optimistic that a deal will ultimately take place, he says. Hedge fund merger arbitrageurs are taking a traditional approach to the deal by shorting shares of BHP and buying shares of Potash in anticipation that the stock will rise as the company’s shareholders force BHP or rival bidders to ante up more than the offer on the table.
Acquiring Potash would allow BHP-which primarily exports iron to the United States, China, Brazil and India-to diversify its revenue stream by adding a product expected to benefit from growing demand for food, particularly livestock, as the number of people that make up the middle class of China and other developing countries continues to increase. Potash is not just the name of the company but also a fertilizer made of potassium oxide that is used by farmers as they scramble to step up production of the wheat and corn necessary to feed cattle.
While Potash struggled to fend off BHP’s bid with a lawsuit alleging that its potential acquirer misrepresented key facts pertaining to its bid, Chinese fertilizer company Sinochem hurried to secure funding for a rival bid. Sinochem has been going back and forth on its plan for a counterbid for several weeks, with the latest reports indicating that the company will likely abandon its effort.
Potash’s lawsuit claimed that BHP had intentionally driven its stock price down during the past couple of years by announcing plans to develop a new mine in Canada. That mine would be Saskatchewan’s first new potash mine in nearly four decades. Despite BHP’s efforts to have the suit dismissed, a Chicago judge recently ruled that a hearing on the matter will proceed on November 4. Potash investors, meanwhile, filed a class-action lawsuit against the company, alleging that its board abused its power by refusing to consider BHP’s $130-per-share offer and creating a poison pill without shareholder approval.
There is also considerable political resistance to selling Canada’s second-largest mining company. The Saskatchewan government has been putting up quite a fight, insisting that BHP’s original offer would mean the loss of roughly C$3 billion dollars in the province over the next 10 years. Even though Canada’s federal government could ultimately block a deal that is not considered beneficial to Canada, BHP management’s insistence that it would make up for any lost revenues, coupled with the reality that the company’s initial plans to build a potash mine of its own could be equally damaging to the region, make it unlikely the government will ultimately kill the deal.
“The hedge fund community likes this deal because you can see the logic behind what BHP is trying to do,” says Bill Collins, founder, CEO and chief investment officer of hedge fund firm Brencourt Advisors, which takes an event-driven approach to investing and has invested in Potash as part of the firm’s merger arbitrage strategy. Of course, merger arbitrageurs are particularly excited that the price could go higher the longer the battle goes on. “The fundamental valuation of the agricultural chemicals industry has improved markedly since BHP’s bid was announced. As a result, we believe BHP’s $130 bid is now close to where we would expect Potash to trade in the absence of a bid. A premium for gaining control of Potash could easily reach up to $160 or higher, depending on whether a competing bid emerges,” says Collins. Sandell says BHP could pay up to $170 per share and still have the deal make sense.
Potash shares took off the day after BHP’s offer was revealed. On August 17 the company’s stock closed at $143.17 per share, with 47.4 million shares changing hands, a 28% increase from the stock’s $112.15 closing price on August 16, when only 4.6 million shares were traded. Since then Potash shares have climbed as high as $150.47-the company’s closing price on September 8-and have hovered between $140 and $150. Most recently, the stock closed at $142.42 on October 20. Hedge fund traders credit the stock’s buoyancy to widespread belief that BHP will ultimately raise its offer.
“The deal consideration is at a valuation at the moment which is viewed as somewhat low, and the market’s expectation is that BHP will return with a higher bid at some point,” says Jesse Ho, a portfolio manager with Carlson Capital. He says such high demand for the deal, and others similar to it, is indicative of the increased number of opportunities in risk arbitrage. And because money is so cheap right now, almost any cash transaction is accretive to companies from an earnings-per-share perspective. Meanwhile, improving confidence among potential acquirers, coupled with low interest rates and a receptive financing market, is expected to lead to an increase in M&A activity. In the case of BHP’s bid, such factors have led to interest in the deal beyond the traditional merger arbitrage players.
The BHP-Potash battle is just a sign of the bounceback in merger activity in recent months after vanishing in the second half of 2008, when the market’s collapse and the disappearance of funding all but dried up deal activity. Hedge funds specializing in merger arbitrage have already seen improvement over the past year, but now fund managers believe a larger merger cycle has finally developed that will mean a major boost in deal activity. So far this year the AR Event Driven Index is up 8.07% through the end of September-a stark contrast with 2008, when the index lost 20.35% for the year.
“The environment for activism and deals, which tend to be somewhat correlated, is good,” says a fund manager for one multibillion-dollar hedge fund firm. He cites four reasons M&A is on the upswing: More than $1 trillion in cash is sitting on corporate balance sheets in the United States, borrowing costs are historically low, valuations on a P/E basis are near 10-year lows and roughly $500 billion of private equity money will expire if not deployed within the next five years. “The confluence of those factors, plus the fact companies are struggling for organic growth, makes it seem like we’re poised to see a lot of M&A,” says the fund manager. “And that’s good from an activist standpoint because there are only a few of us that are actually left-just as the opportunity set is getting favorable,” he says. Since 2008 investors have forced fund managers to stick to their knitting, which has significantly reduced the number of firms able to take activist positions.
But the wide spreads that existed in 2007 and early 2008 have not returned, and fund managers say spreads on the whole are fairly tight right now. With so much cash on the books of many potential acquirers, there is a lot less leverage in current deals, which translates into little financing risk. BHP’s deal would be an all-cash acquisition. With shares of Potash trading at roughly 13% above the bid in mid-October, the deal still has a negative spread-typical for hostile deals.
Moreover, some are expressing concerns now that the market has heated up. The BHP-Potash deal is a case in point.
“There are more than just merger arb funds invested in this deal. It’s huge, it’s highly strategic, and you have a highly qualified and financially capable bidder-all against an agriculture backdrop that is positive at the moment,” says Stephen Raneri, founder of LionEye Capital Management, a hedge fund firm he launched in early 2009 after several years of heading up the research for Ramius Capital Group’s North American merger arbitrage fund. He is leery that the presence of so many traders who aren’t merger arbitrage specialists makes the deal a bit riskier. “The more involvement in a situation by nonspecialists in transactions, the trickier it can be and the more concerned I get about whether or not it’s a good opportunity,” Raneri says.
Though LionEye has already made money on Potash, Raneri has temporarily retreated to the sidelines. But with the situation constantly changing, he says he is ready to jump back in as soon as the right opportunity emerges.
