Will Shareholders Vote Down Buyout Entrust’s Private Equity Buyout?

In another illustration of the pointlessness of “Go Shop” periods the board of Entrust (ENTU) ignored three buyout offers received in the 30-day go shop period that were higher than that of the group that includes the CEO. Moreover, the Entrust management buyout shows all that is wrong with buyouts by private equity funds where management remains with the firm and has an incentive to lowball the buyout price. Shareholders expected an increase of the $1.85 merger consideration, and shares traded as high as $2.10 during the go-shop period. We believe that due to the high level of dissent from shareholders and even a board member it will be difficult for management to achieve the required approval by 2/3 of the shareholders.

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In March 2008, Entrust received a $3 per share cash buyout proposal from a strategic acquirer. The board rejected the proposal and decided to remain independent for at least another six months. In September, Robert Sayle of Thoma Bravo contacted Entrust with an acquisition proposal. This was the second approach by Thoma Bravo. The first had been made one year earlier in September 2007. This time, Thoma Bravo proposed an all cash transaction for $1.75 per share. In February of this year Thoma Bravo increased that price to $1.85.

The financial adviser’s opinion shows that the price is “fair” and mostly falls within the range of values calculated by a variety of methods. However, the ranges are very wide for the most part, and Entrust’s $1.85 is near the bottom end of almost every range. This makes us think that in the first iteration, the acquisition price fell below the range calculated. The analysts then changed the assumptions for the various methods until each range was wide enough to capture the $1.85 acquisition price at its lower end. After all, valuation opinions are highly subjective exercises that can include or exclude comparables for any number of perfectly reasonable justifications. As an aside, the financial adviser originally was Lehman Brothers, and when that firm was taken over by Barclays, the same team was re-hired to continue working on the deal.

Thoma Bravo had indicated to the board that it wanted to keep current management in place. This is a standard practice in private equity-sponsored buyouts. Management responded by barring Thoma Bravo from discussing management compensation during the initial phase of the negotiations. It is common to give management incentives in the form of equity and options once the company is private. The result is that management can make more money selling a company to a private equity fund and growing it than keeping it public. Moreover, the lower the price at which the company is take private, the bigger the eventual payoff for management. It is clear from the proxy that management compensation played a significant role throughout the buyout negotiation between Thoma Bravo. The board was well aware of the potential conflicts between management’s desire to acquire the firm on the cheap and their role as defenders of shareholder interests.

“[...] in light of Thoma Bravo’s expressly stated reluctance to move forward with the proposed transaction without further direct communications with Company management regarding specific employment terms, the Strategic Planning Committee determined that Thoma Bravo could speak directly with Company management regarding specific future employment terms, but must provide any term sheets in advance to the Strategic Planning Committee and must conclude its discussions with Company management expeditiously. “ Source: DEFM14A, page 34

5.2% holder Arnhold & S. Bleichroeder Advisers has sent a scathing letter to management that objects to the low valuation and points out that since the date of the signing of the agreement the value of all tech firms has increased significantly. Of the 3.2 million shares held by A & S Bleichroeder, 2.7 million were bought between April 20^th and May 29^th at prices between $1.87 and $2.10 with an average of $1.93. Therefore, they will not be able to vote the shares bought after the record date. It is not clear which accounts of A & S Bleichroeder hold the shares and whether Jean-Marie Eveillard or the First Eagle Funds (FESGX) are involved. A & S Bleichroeder also runs merger arbitrage portfolios with an activist bent whereby it seeks to maximize payout in acquisitions. Some of its wins include an extra dividend payment when SL Green bought Reckson Associates and a 50% increase in the merger consideration in the buyout of public shareholders of the Bank of International Settlements (that’s the one that coordinated the Basel II framework).

Nervous about the outcome of the shareholder vote management postponed the vote to July 10 but kept the record date of May 11. Since the record date more than 24 million shares have traded, compared to 61.5 million outstanding, and the resulting turnover in the shareholder base makes it less likely that sufficient shares will be voted in favor of the transaction. Buyers of the shares can not vote because they bought after the record date, and sellers have incentive to go through the trouble of voting.

One independent director, Douglas Schloss of merger arbitrage firm Rexford Management, took the unusual step of dissenting publicly with the remainder of the board. Typically, board decisions about the sale of a firm are taken unanimously. A public dissent by a director is an extremely rare event and investors should assign it significant meaning. Schloss’ criticisms of the Thoma Bravo deal are quite powerful:

• Based on all of the information presented to the Board of Directors, I do not believe that the acquisition price of $1.85 per share is fair to the shareholders. (Assuming the merger closes either before July 15th or after September 15th and assuming the purchaser utilizes the $23 million of cash that is required to be on hand at closing as part of the acquisition consideration, the purchaser is only paying approximately $1.45 per share to the Company’s shareholders.)
• Given current general economic conditions, it does not seem to be the right time to sell the Company. The equity value of “small cap” companies like the Company is generally depressed by the dramatic lack of liquidity in the market. The Company bookings have grown in each of the past five years, the Company is cash flow positive and has substantial cash balances on hand. There is no necessary reason for the Company to be sold at a low valuation at this time, especially in light of the fact that the Company received written indications of interest from two large strategic buyers at significantly higher prices per share than offered by Thoma Bravo.
• Mr. Conner, the Company’s CEO, is scheduled to receive a “success fee” of $2.5 million, plus a 5.7% equity interest in the acquiring corporation, upon closing the merger. In addition, Mr. Wagner, the Company’s CFO and Mr. Kendry, the Company’s Chief Governance Officer, are scheduled to receive aggregate “success fees” totaling $1,402.022 and, collectively, a 2.1% equity interest in the acquiring corporation, upon closing of the merger. Though each of these gentlemen would be entitled to receive similar cash payments under their “change-in-control agreements”, such payments would only be made if they lost their jobs. In my view, each of Mr. Conner, Mr. Wagner and Mr. Kendry is an “interested party” and should have had no involvement at all in the sale process following the negotiation of such success fees with the acquirer. Mr. Conner and other members of management are totally conflicted with respect to the “go shop” period. In my view, the amount of consideration to be received by Mr. Conner, Mr. Wagner and Mr. Kendry in relation to the value to be received by the shareholders is completely unjustified.
• The Company’s largest shareholder, Empire Capital, has a designated representative on the Board of Directors who had strongly requested to serve on the Strategic Planning Committee, which was initially a two-person “special committee” created to review strategic alternatives available to the Company. In my view, rather than representing the interests of all shareholders, Empire’s representative continued to push for a transaction at this point in time given Empire’s previously disclosed intention to maximize the value of its investment.
• Wilson Sonsini Goodrich & Rosati, counsel to the Strategic Planning Committee, is not an “independent” legal counsel as such concept is generally construed in transactions of this nature. Wilson Sonsini Goodrich & Rosati regularly performed legal services for the Company and its management, thus it was not in a position to provide “independent” legal advice to the Strategic Planning Committee (which was functioning as a “special committee” with respect to the merger process) or other independent members of the Board of Directors. In addition, Wilson Sonsini Goodrich & Rosati has an agreement whereby its compensation is tied to the completion of a successful transaction which additionally jaundices its independence.
  Source: DEFM14A

Management received three acquisition proposals during the go-shop period at a higher price than Thoma Bravo’s $1.85. It is not clear to us why exactly the board classified did not think they were “superior proposals:”

“Upon the expiration of the Go-Shop Period and as a result of the Company’s solicitations during the Go-Shop Period, the Company received written, non-binding indications of interest from three separate parties, each of which contemplated a per share price payable to Company stockholders higher than the per share price contemplated by the Merger Agreement, but each of which was also subject to significant conditions, including completion of further due diligence, arranging financing and negotiation of definitive agreements. After careful deliberation and consultation with the Company’s financial advisor and legal counsel, the Company qualified each of the three parties from whom the Company received an indication of interest as an “Excluded Party” under the Merger Agreement. Two of the Excluded Parties were modestly-sized operating companies and one was a private equity firm.” Emphasis added. Source: DEFA14A of June 10th

The proposals were non-binding and subject to the negotiation of a definitive agreement. It is to be expected that a potential acquirer take more than 30 days for thorough due diligence. Therefore, the proposals had to be subject to a definitive agreement and further due diligence. The board claims “that extending the negotiating process further would pose significant business risk to the Company, and could place the proposed Merger under the definitive agreement with Thoma Bravo in jeopardy.” Then why is the board procrastinating the vote by a month if time is of the essence? And could that extra month not be used to negotiate with these three parties rather than for soliciting votes on a deal that the market was already trading above? It appears to us that the board has favored a low price by Thoma Bravo over the other contenders. In the absence of appraisal rights under Maryland law, it seems to us that if the deal were to go through, it would be followed by litigation for damages. And given the circumstances the plaintiffs should have a good chance of winning.

An by the way, why does not management disclose which prices exactly these buyers were willing to pay? The absence of this information suggests that they were willing to pay a significant premium to $1.85.

We think that despite Empire Capital’s 19.9% stake, there is a good chance that no-votes and votes against the transaction can kill the Thoma Bravo transaction this Friday. After all, this transaction requires approval by 2/3 of the votes, and with the turnover in the shareholder base coupled with the high level of dissent that reached even into the board, it will be difficult for management to get sufficient votes. The good news is that, in our opinion, the two other strategic buyers and one private equity fund who were interested during the go-shop period stand ready to make bids. This will limit the downside and could even lead to an increase in the stock price if this deal is voted down.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which holds shares of Entrust. He is the author of an e-book about alternative strategies as well as the forthcoming book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

Pershing Square Misleads About General Growth’s Equity Value

Pershing Square Bill Ackman’s presentation about General Growth Properties (GGWPQ) at the Ira Sohn Investment Research conference has us wondering what he is up to. The tone of the presentation clearly targets an audience that is not familiar with bankruptcy investing. At the same time, his financial projections for GGP are overly optimistic and do not square (no pun intended) with current results. We believe that some of his analysis is very misleading.

As anyone who followed the saga knows, General Growth filed for bankruptcy not only because of poor operating performance, but primarily because of the credit crunch that made it impossible for the company to refinance its debt. Repayment also was not an option because it holds only a few hundred million dollars of cash. So the bankruptcy filing was triggered by a liquidity problem and not by losses. In fact, General Growth even made a small $3 million profit last year and has book value of $1.7 billion. But with $3.5 bn of debt coming due this year and another $7 bn next year, there was little the company could do when it did not gain an amicable settlement with creditors. Most of the debt are CMBS secured by properties, but some debt is unsecured corporate bonds. The unsecured bonds are a result of GGP’s acquisition of Rouse Co in 2004, and are still listed under Rouse’s name.

Ackman made headlines in May when his firm failed to become debtor in possession (DIP) lender to bankrupt General Growth Properties. Pershing’s Libor+1200 loan proposal was trumped by a slightly cheaper DIP financing from a group including Farallon, Elliott Associates and others. Pershing’s DIP loan had a 3% Libor floor, whereas Farallon’s has only a 1.5% floor and provides slightly more funds. Had Ackman been successful he would have been both a 25% equity holder (including total return swaps) and a debtor, which would have given him a strong position to wrestle concessions from the creditors in order to maximize the return on his equity holdings.

Ackman’s presentation at the conference attempts to value General Growth’s equity. The key point is that GGP’s assets are worth more than the liabilities, and therefore the equity should have value upon emergence from bankruptcy. We do not question this thesis, but we doubt that the numbers underlying the valuation are correct. For a start, Ackman’s topline assumption is not accurate. He assumes a 2.4% drop in NOI for 2009, excluding the Master Planned Communities segment. However, annualized Q1 performance suggests a 4.4% drop. Minimum rents in Q1 even declined by 4.9% from the prior year’s Q1. So GGP will have to reduce its vacancy aggressively to get to Ackman’s projection. In a difficult retail environment it is unlikely that a mall operator that is in Chapter 11 will find many new renters. We would think that throughout the year some leases will not be renewed, and the tenants on others will end up in Chapter 11 themselves. So the full year NOI may well deteriorate further from the 4.4% drop in Q1. Pershing’s presentation quotes YTD sales growth at GGP’s malls as minus 6.7%, so the outlook for leasing activity clearly is bleak.

Like most valuations, Pershing Square’s lives and dies with its cap rate assumption. Ackman contends that GGP should trade at a 7.5% cap rate, 100 bps better than Simon Property Group (SPG). 7.5% cap rates are not what malls trade at these days, if they trade at all. SPG itself trades at an implied 8.5% cap rate, and Pershing Square thinks that this cap rate discounts the risk of bankruptcy of SPG. Therefore, reasons Pershing Square, GGP should trade at a lower cap rate, resulting in a higher valuation. The problem with this argument is that it can be applied to GGP as well: if the maturity of the debt is extended by 7 years as proposed, the market will discount a potential liquidity squeeze at the new maturity date of the debt. In addition, we believe that an 8.5% cap rate for SPG only shows that SPG is overvalued. If we apply a more realistic cap rate (9%, in our humble opinion) to GGP, then the upside for the equity looks much less appealing. And we haven’t even mentioned dilution yet, which we will address in a moment. After dilution, the equity looks pretty close to fair value to us.

Ackman uses more than 10 slides to explain Bankruptcy 101: how equity holders can retain value in a bankruptcy. He seeks to overcome the perception that equity holders will always be wiped out. Clearly, this part of the presentation is geared to investors who have no knowledge or experience of distressed debt investing or corporate bankruptcies. We are not sure whether he is trying to make investors in his fund feel comfortable, or whether he is trying to entice other investors to jump on his bandwagon. In any case, it is rather odd that he would include such a lecture in a presentation held at a conference full of financial professionals.

Pershing Square offers several solutions to GGP’s exit from bankruptcy. The first involves a simple extension of the debt by seven years. Somehow, Pershing Square assumes that debt holders will grant such an extension without asking for anything in return. The presentation states literally that Pershing Square wants

All Debt maturities extended seven years at current interest rates

A free lunch for shareholders? We would think that such an extension would at a minimum be accompanied by warrants, and more likely by actual equity. We have seen cases where simple consents in connection with minor technical defaults were accompanied by 25bp consent payments. It is highly unlikely that bondholders will simply extend maturities without asking for compensation. And (secured) CMBS holders have even less incentive to extend debt maturities. Since cash consent payments are out of the question, dilution of the existing equity is the only form of payment available. We are at a loss to explain why Ackman simply ignores this pretty fundamental problem in his analysis. We believe that this omission is highly misleading.

Ackman’s other idea for the exit, a “cram down” on debt holders, is completely unrealistic. It would include a cram down on all CMBS debt. We can picture the turmoil in the CMBS market that such a judgment would make. Investors receiving currently ~6.5% suddenly would find themselves getting 4% (prime + 75 bps). This might wipe out some CMBS tranches. We would see years of litigation before a cram down could even occur. Therefore, we believe that the cram down proposal is just a scare tactic to pressure debt holders, albeit not a very credible one.

Finally, Ackman closes his presentation by stating that

The nuisance value of the equity is meaningfully greater than zero

If your equity has real value then you don’t need to rely on its nuisance value. The point of the entire presentation is to underline that the equity will have significant upside in the current bankruptcy proceedings, so if he concludes with the nuisance value, it shows that the remainder of the valuation analysis can not be taken too seriously.

We do agree with Pershing Square that the equity will not be wiped out completely. However, we do believe that it will be diluted and will not be worth as much as in his optimistic projections. We are surprised that Pershing Square seems to address an audience that is not familiar with bankruptcy investing with flawed analysis. We are not quite sure what the goal of that strategy is, but we fear that some people who believe any spreadsheet or powerpoint may end up investing solely based on trust in Ackman’s public persona without realizing how misleading the presentation really is.

At this point, the bankruptcy has become a fight over valuation. Pershing Square will not help its cause by throwing out overly optimistic numbers that are easy to dismiss. We do favor the bonds over the equity and anticipate that equity holders will be appeased through the issuance of warrants with high strike prices between $10-$15. In that case, Ackman will be correct that “inflation is your friend.” We believe that the equity will be worth somewhere in the mid-single digits upon emergence. The shares have rallied to $2.60, so that we do not believe that it is worth assuming the risk of further store closings by cost-cutting retailers in addition to GGP’s bankruptcy risk.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which holds securities of General Growth and/or Rouse. He is the author of an e-book about alternative strategies as well as the forthcoming book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

Looking For Outperformance? Invest With An Emerging Manager!

An ill-advised, persistent and costly error among institutional investors and their consultants is their reliance on large brand name money management firms to look after their assets. We had the privilege of attending and speaking at the recent Emerging Manager 2009 conference, from where we return with some very persuasive statistics that show the outperformance of small money managers over the large mainstream firms.

Porsche At Risk Of Bankruptcy Over VW Option Trades

Porsche CEO Wendelin Wiedeking with CFO Holger Härter

These days, liquidity is in short supply for all hedge funds, and it comes as no surprise the hedge fund wannabe Porsche (POAHF) suffers from the same liquidity squeeze symptoms as many of its hedge fund brethren. The liquidity situation for Porsche will be critical over the next three weeks.

Recall that Porsche engineered a massive short squeeze of Volkswagen common stock (VLKAF) just a few months ago. Volkswagen’s common had been shorted by arbitrageurs who went long the undervalued preferred (VLKPF) at the same time. When Porsche announced that it had acquired 75% of Volkswagen through options and intended to take over the firm, the common stock soared while the preferred didn’t budge. This led to large losses for the hedge funds when they had to cover their short positions in the common.

The flipside of Porsche’s large position in VW option is

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Welcome, AQR. Seriously.

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Is A Sale Of Wilshire Enterprises Imminent?

The shareholder meeting of Wilshire Enterprises (WOC) has been adjourned for the second time. This is actually the third delay of the shareholder meeting, which was originally scheduled for February 26 in Wilshire’s preliminary proxy materials. The meeting was then set for March 24^th and at the last moment adjourned to March 30^th. Today, the meeting was adjourned again to April 20^th.

Wilshire Enterprises’ Future Decided This Tuesday

Wilshire CEO Sherry Wilzig Izak with Mina Otsuka, her brother "Sir Ivan" and friends (left to right)

The end of the first round is approaching in this years most underreported proxy fight, the battle over Wilshire Enterprises (WOC) between Phil Goldstein’s Bulldog Investors and Wilshire’s CEO Sherry Wilzig Izak. Two directors will be elected at Tuesday’s meeting, and shareholders will also vote on proposals to end the staggered board, seek a liquidity event and abolish the poisons pill. We have written extensively about the battle previously (here, here).

Image Entertainment’s Buyout Collapses, Yet Again

Image Entertainment (DISK) went through a change in leadership over the last year with the retirement of Marty Greenwald, who was replaced by ex-COO David Borshell, but one thing hasn’t changed: its bad luck when trying to sell itself.

Readers of this space may recall that producer and entrepreneur David Bergstein, with the financial backing of real estate mogul Ron Tutor, had tried to buy Image early last year for $4.40 per share, beating a $4 bid from Lionsgate (LGF) – which now itself is under attack by Carl Icahn. The deal collapsed when hedge fund D B Zwirn ran into trouble with accounting, valuation and redemption woes and was unable to provide the promised funding.

Dirty War Over Wilshire Enterprises

Wilshire CEO and party girl Sherry Wilzig Izak with her brother "Sir Ivan"

The battle over Wilshire Enterprises between Phil Goldstein’s Bulldog Investors and Wilshire’s (WOC) CEO Sherry Wilzig Izak is gradually growing into a full scale war, if not a jihad. Among a string of litigation, the shareholder meeting was postponed from this week to March 24^th, giving management crucial time to beef up their defenses that ultimately will be futile. We have previously chronicled the battle between Wilshire and Bulldog, which ended in a temporary defeat of Bulldog when management declared that “initial bids are in” for a prompt sale of the company. Almost a year after the initial bids, a buyer emerged for $3.88/share, down from $8.50 a few years ago when management rejected a bid by Mercury Real Estate as “undervalued”. Last year’s buyer didn’t have enough funds to acquire Wilshire, and the stock now trades just over $1.

With the date of the shareholder meeting approaching, the fight over Wilshire is heating up. Wilshire’s management is fighting hard to keep Bulldog out:

Avenue Capital’s Marc Lasry Is In Therapy Over Depressed Asset Prices

Marc Lasry, Avenue Capital

At the first Wharton Hedge Fund Conference keynote speaker Marc Lasry of Avenue Capital declared that he was still in shock over how his firm got to $22 bn in size. Lasry started his firm in 1995 after breaking off from an entity that is affiliated with the Bass family with $7 million, expecting to run a few hundred million dollars if things were to go well. At its peak in 2007, the firm exceeded all targets with $22 billion in assets under management. The wonders done by a decade of liquidity and leverage helped him grow beyond his wildest dreams.

The State Of The Hedge Fund World

Rosy forecasts were in short supply at the first annual Wharton Hedge Fund Conference. The shock of last year’s worst-ever performance still reverberates through the industry. Career plans of students at Wharton are the best indication we have seen to date of how bad things have become for hedgies: one Wharton professor reports that last year, two thirds of his students wanted to get a job in a hedge fund. This year, only one student admitted to hoping for a hedge fund career.

Mark Fisher: Keep It Simple, Stupid

Mark Fisher, inventor of the technical trading method ACD, sees this market as a pure trading market in which analysis does not matter. This was probably not what some of Wharton’s students attending its first annual Wharton Hedge Fund Conference wanted to hear. After all, they have committed to spending a six figure amount on learning how to perform just that analysis. Fisher probably depressed also Wharton’s faculty whose livelihood depends on a steady supply of students willing to pay ever increasing tuition rates. Not to mention that Fisher himself holds a Wharton MBA.