Investing in “Special” Situations

There’s nothing special about special situations. It’s like that line from Shawshank Redemption where Red says,

“I know what you think it means, Sonny. To me, it’s just a made-up word, a politician’s word, so that young fellas like yourself can wear a suit and a tie and have a job.”

Buffett used to call them workouts. That’s closer to the nature of these investments.

Special Situations, Event Driven, workouts — or whatever you want to call them — trade on the expectation of a corporate event. To keep it simple, if bankers are hired to run a process / advise on fair value or lawyers are hired to draft agreements, there is a corporate event. Mergers, acquisitions, spin-offs, unsolicited offers, restructurings, liquidations are some examples. 

You make money if a value-generating corporate event plays out. When that corporate event plays out is also important. This is the analysis in a nutshell:

(i) how certain is the value being negotiated?

(ii) how certain is the event that will crystallize value?

(iii) what conditions need to be satisfied to make it all happen?

The amount you might lose if you’re wrong keeps the analysis honest.

If you look at a bunch of corporate events, you’ll notice that ‘if it looks like a duck, walks like a duck and quacks like a duck’, you can group them. If the negotiation dance and agreements are similar, i.e. sale processes are conducted the same way, agreements are versions of the same basic template (merger agreements, asset sales, registrations, disclosures, etc.) and the corporate event follows a defined process (SEC review of filings, antitrust review, judge’s approval etc.) the securities will behave similarly. If you can group them, you can compare them. 

That’s the theory of it. In practice, it’s a lot more hectic!

Here’s one from late last year (what’s going through my head is in italics):

In October of last year, Neighbourly Pharmacies (NBLY.TO) issued a press release “Neighbourly Enters into Letter of Intent to go Private with its Controlling Shareholder Persistence Capital Partners (PCP).” 

Immediately interesting!

When a company receives an unsolicited offer from a majority shareholder, the odds of a negotiated deal are high. Approximately 2 out of 3 unsolicited offers result in a deal, based on historical base rates.  

The press release told us that PCP, a 50.2% owner put an offer price of C$20.50 per share in front of the Board. An Independent Committee of the Board had already commissioned a fairness opinion from TD Securities, and TD Securities had arrived at a C$20.50 - C$25.50 fair value.  

This has clearly been in the works for a bit. We already have an initial price. The board has already hired advisors. TD has already provided a fairness opinion.  Game on! 

Proposals from a majority owner are a well-choreographed three-step tango. The dance steps - a Board receives an offer from a controlling shareholder, an independent special committee pushes for a sweetener to show their effort to get the best deal for minority shareholders, the parties agree on a price bump, et voila, you have a deal.

With the stock trading in the C$18.50 context, looks like we can make C$2.00 to C$7.00 a share (11% - 38% upside) if the final price comes withing the fairness opinion range. At the mids - that’s C$4.50 or 24% upside- that’s compelling. 

To diligence this corporate event, we go through the analysis steps we laid out above:
(i) How certain is the value being negotiated? 
(ii) How certain is the event that will crystallize value? 
(iii) What conditions need to be satisfied to make it all happen? 
(iv) How much can we lose if things go wrong?

Taking it from the top, how certain is the value being negotiated? In 2021, Neighbourly IPO’d at C$17/sh, climbing to a high of C$40/sh. It remained comfortably above C$20/sh all the way to the beginning of 2023. Persistence, involved with Neighbourly since 2015, was rolling up rural pharmacies in Canada. The algorithm: buy pharmacies for 6-7x EBITDA, drive same-store-sales in the 3-4% range, improve operations and get margins to 10%. Rinse and repeat, acquiring 35-50 stores a year.  Precedent take-private transactions averaged ~ 12x -15x EBITDA, creating Neighbourly at C$18.50 – C$26.00. In 2023, the company was beating expectations, but with interest rates rising rapidly on inflation concerns, there was no public market bid for levered equities. 

Sanity check, in June of 2023, Stuart Elman, the chairman of the Board and a principal at Persistence bought C$600k worth of stock in the open market at C$17.78/sh. 

The company was covered by 3 analysts, one called the offer a “bitter pill” and another lowered her price target from C$33.00/sh to C$25.50, saying in a note that shareholders should push for higher than C$20.50 offered.

Alright, it’s all triangulating to a deal in the low-to-mid C$20s. Have a couple of sanity checks. The fairness opinion re-affirms the expected takeout range. Second step of this three-step tango is a price bump to…lets call it the middle of the fairness range…C$23.00…and this deal should come together.

Next diligence step, how certain is the event that will crystalize value? Neighbourly was one of a vintage of levered roll-ups that IPO’d in 2020 and 2021. With the public markets so negative on levered equities in 2023, many PE sponsors of these companies were taking them private again. Precedents included Dialogue Health, Magnet Forensics and 9 others with strategic reviews / take privates announced during the year.  The cautionary tale was Dentalcorp, where the Independent Board and PE Sponsor weren’t able to agree on terms.  

With that context, there were a couple of specifics in the Neighbourly review stood out. First, there was a letter of intent at an indicated price. To get to that stage itself is a commitment. Second, the Board was already spending money and had hired TD Securities who had already delivered a fairness opinion. Third, the press release stated that equity and debt financing were in advanced stages of negotiation. And finally, the press release had guided to the transaction closing in Q4 2023 or early in Q1 2024. As highly lawyered as this press release was, all the data points guided to a high probability a deal comes together.

Feeling pretty comfortable with the value we’re looking to get. Feeling pretty confident this deal is going to come together. Need three things to happen here: the parties agree on a final price, the debt financing has to come together and the equity financing has to come together. It’s unlikely Persistence even started this process without indications from an equity anchor investor and banks. 

A month later, in mid-November, Neighbourly drops another press release titled “Neighbourly Extends Exclusivity and Provides Update on Letter of Intent with Persistence Capital Partners.” The incremental details: debt financing in place from the Bank of Nova Scotia and RBC. Exclusivity extended to mid-Jan to allow Persistence to finalize equity financing. The transaction is expected to close in Q1 2024.

Wait a sec?!? Why does Persistence need an extension? Neighbourly stock had fallen down to the C$17.50 context. That said, Persistence paid for that Debt Commitment, no bank rents out its balance sheet for free – that’s a sign of commitment. Is there an issue with the Equity Commitment? What’s going on here?

The third diligence step, what conditions need to be satisfied here to make it all happen? The parties have to agree on a final price and equity financing has to be firmed up. By my math, Persistence needed C$275m in incremental equity. I called Neighbourly’s Investor Relations to talk through Persistence’s Equity financing and negotiations with the special committee – here’s the Q&A: 

“Does Persistence need to find new sources of equity for their existing Neighbourly fund vehicles? Do Persistence’s existing LPs need an exit through a GP led secondary?”  No. Persistence’s current equity financing doesn’t have a vintage and timeline – that money is committed long term.  

“Weren’t Equity financing discussions already in an advanced stage with an anchor investor etc.? Has the sentiment in the Equity syndicate changed – why the delay?”  There were certain partners that were being contemplated at first and those partners were at the table. Further equity partner options subsequently emerged that were very serious. From what I understand, there’s no shortage of strong interest from very serious partners.

A broader equity syndicate of still interested parties? Why do you need a broader equity syndicate? Didn’t the original equity indications commit? Unsatisfying call. But it’s unlikely Persistence would pay for Debt Commitments and gone through all this trouble if they felt a deal wasn’t possible. 

A month later, in mid-December, Neighbourly drops a press release titled “Neighbourly Provides Update on Proposal from Persistence Capital Partners.” The bombshell – Persistence revised its indication down to C$18.50 with the claim that this is the price it’s equity financing sources support. Simultaneously, Persistence put out a press release titled “Persistence Capital Partners Proposes Fully Financed Offer to Take Neighbourly Private at C$18.50 per share.” The PR elaborated that Persistence had approached and discussed the transaction with over 90 potential equity financing sources. 

What the @@@@! That’s a twist. We’ve gone from a C$20.50 offer to C$18.50? The company’s numbers have been good and they’re doing better than expectations. How did this happen? Neighbourly stock was trading down to the C$15.00 context.

The focus now shifts to the final and most important element of diligence – how much can we lose if things go wrong?  Before Persistence’s initial offer, Neighbourly’s stock was trading at an undisturbed C$12.00 per share. But a levered security with limited liquidity and no exit, wouldn’t the stock fall lower? The market had rallied, but apart from Persistence, who was the incremental buyer? Best assumption, Neighbourly stock trades down to high single digits, low double digits on technical. 

With a fully financed offer on the table, the only condition left to be satisfied was the parties agreeing to a price. Based on our downside estimates, the Neighbourly stock at C$15.00 was certainly suggesting higher than a 50% probability of a deal. 

Somebody must know something! The stock keeps inching higher. This is trading like the deal is on. Somebody definitely knows something.

Another month later, in mid-Jan, Neighbourly entered into a definitive agreement to go private at C$18.50 per share plus a contingent value right of $0.61 per share. 

For the time and effort invested, we ended up netting a C$0.61 untradeable CVR. Well played Persistence Capital Partners! Well played!

Basically, Canadian investors in the register were eager for liquidity. Persistence knew it. The Board’s Special Committee knew it. The Three Step Tango ended up in a price negotiated down for liquidity, which the minorities were glad to accept. 

—

While Neighbourly’s Take Private didn’t work out as expected, there is always a constant stream of corporate events, some of which work out spectacularly. 

If you’re intrigued and want to dive in, here are a few current unsolicited offers from majority (or very large) shareholders:

Target Hospitality Corp (TH) – On March 25^th, 2024, TDR Capital LLP, a 64% holder of TH has offered $10.80 per share for all the shares they don’t own. 

23ANDME Holding Co. (ME) – On April 18^th, 2024, Anne Wojcicki, CEO, Founder and Chairman of the Board with 20% of shares outstanding and 49% voting power, is considering making a proposal to acquire the shares she does not currently own.

WideOpenWest (WOW) – On May 2^nd, 2024, Crestview Partners, a 38% holder of WOW has offered $4.80 per share for all the shares they don’t own. 

Finally, here are a few hard learned lessons as you start your special situations journey:

(i) Figuring out what are the financial and strategic incentives of the key party driving the outcome is a key principle. Sometimes it’s hard to figure out who the key party is that’s driving the outcome. It could be a foreign regulator. It could be a large shareholder. It could be a board pre-empting an acquiror. The key party driving the outcome may change as the corporate evolves.

(ii) Don’t annualize expected returns (a 2% return over six months is 4% annualized). In some buckets i.e. merger arbitrage, investors annualize returns for an apples-to-apples comparison with other yield instruments. Annualizing has its purposes, but it assumes you will find other similarly yielding investments right after the corporate event is done – that’s a bird in the bush you cannot count on. Also implicit in annualizing returns, since most corporate events take under a year, you’re invariably making a nominal yield look more attractive. Inverting, to make the argument, risk is by far the more important variable, but no one seems to annualize that.

(iii) Don’t get tempted by what looks like a technical dislocation, which of course makes annualized returns look even more juicy. It could be real risk and an unexpected variable baking in. The patience to confirm your assumptions can protect you from being psychologically short a costly put on your time.

Disclaimer: Rukun owns none of the stocks mentioned. This Article Shall Not Constitute an Offer to Sell or the Solicitation of any offer to Buy. No part of this Article is a recommendation or a solicitation. The information and beliefs contained herein are believed to be correct, but there is no guarantee.

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