Bringing merger arbitrage into the mainstream

We recently discussed a takeover transaction in Vitalharvest Freehold Trust (ASX: VTH) that offered a favourable risk/reward scenario that has since gone on to deliver returns far in excess of what was anticipated at the outset. At times throughout that transaction, shares have traded in the market at a premium to the highest consideration offered and yet, with the benefit of hindsight, has made sense to do so. It seems counter-intuitive to think of purchasing shares only to tender them into a lower offer as a winning strategy, but key to any merger arbitrage strategy is assessing risk. Sometimes that risk remains to the upside, even if it means paying a premium today.

The last twelve months has seen a wave of consolidation in the financial services industry. IRESS Limited acquired Oneview Holdings Limited (ASX: OVH), Praemium Limited (ASX: PPS) and Powerwrap Limited (ASX: PWL) merged to better compete against the likes of Netwealth Group Limited (ASX: NWL) and HUB24 Limited (ASX: HUB), that latter of which themselves were busy acquiring Xplore Wealth (ASX: XPL) and taking an interest in Easton Investments Limited (ASX: EAS).

And so it was that Mainstream Group Holdings Limited (ASX: MAI) joined in the fun, at probably no surprise to the small-cap fund managers who had followed the story throughout its listed history. Mainstream announced a scheme of arrangement with Vistra Group Holdings at $1.20 cash per share in early March, and there were a couple of details about the offer that were highly intriguing at the outset.

First was a call option granted to Vistra over 19.9% of the total register from friendly directors. Secondly, and probably most importantly, was the insertion of a “go shop” clause within the scheme documentation, essentially a free licence to go out and find a better offer. Schemes of arrangement typically carry exclusivity conditions, so a “go shop” clause is certainly a rarity (last seen in 2019 when KKR acquired MYOB Group Limited).

In the context of Vistra’s skinny 12% equity premium offered, the combined call option and “go shop” clause worked like a pay to play incentive. Either take control of the company without stumping up a full control premium (the average is closer to 30%) or exercise the call option and vend into a higher bidder. Vistra had thrown down the gauntlet - the theoretical exercise of what an adequate control premium might look like was jolted into the real world, and shareholders would find out one way or another.

Valuation wise the EV/EBITDA multiple implied by Vistra’s offer was 17.4x forward EV/EBITDA – not exactly cheap but not necessarily a nosebleed valuation either. The likely implications were that any counterbid would come from a trade buyer than a financial buyer, where some synergies could be stripped out of the cost base to make the upfront valuation more palatable.

The well-communicated intention to solicit a higher offer meant that a favourable entry on the existing terms, like we saw in the Vitalharvest transaction, was most likely off the cards, and logically so. Trading in the shares during the “go shop” period saw very limited opportunity to purchase shares at a discount to terms:

The basic shorthand to assess implied probability of a deal completing is to set a baseline against the undisturbed price (pre-announcement) through to the consideration offered; the closer the share price to the consideration, the higher the market’s expectations of a deal completing and vice versa. In the Mainstream transaction, this basic shorthand was immediately thrown out the window. Not only was it necessary to get comfortable around the downside in the event of a deal break, but also attempt to price the likelihood of a counterbidder emerging and at what price. Investors were forced to pay above terms to take on the risk and faced losing money even if the original Vistra deal completed.

On assessing the downside, the conditions were not punitive. The most likely reason the deal would not proceed was due to a Material Adverse Change (MAC) in the business, either triggered by a 10% decrease in net assets or a 10% decrease in forward EBITDA. A material settlement for a US subsidiary was specifically excluded in the MAC clause, and long term service contracts with the client base were grounds enough to get comfort on both asset and earnings tests.

On the upside, putting an estimate on where a counterbid would land is more art than science, however we looked to the incentives of those involved as a guide. A deferred exercise price adjustment clause was included in the call option deed between Vistra and certain Mainstream directors. If a counterbid came in up to $1.35, Vistra retained the upside on the call options should it decline to take up its matching right, a bonus in addition to a break fee payable (they would walk away with an equivalent 3.5% of the MAI equity value for tipping their hat in the ring!). Indeed, a $1.35 offer would reflect a more appropriate 26% control premium from the undisturbed price.

However, above $1.35, Vistra was liable to pay away 50% of the upside on the option shares. Herein lied the incentive for the directors – giving away the call option may have been a necessary evil to get the ball rolling on the corporate activity, but there was still an embedded mechanism to secure the best price possible for shareholders.

All of this suggested to us there was a decent probability Mainstream would not sell for $1.20 per share, and so purchases above terms could be justified. Suffice to say, it was the right decision.

There was not a peep from the company right up until the “go shop” period expired.

Enter SS&C at expiry with an agreed deal at $2.00 per share. A huge premium.

From here, the activity has become a little frenetic. All eyes were back on Vistra to see whether they would take up their matching right. Vistra were up almost $15m with both a break fee payable and the call option deed, and thus the assumption was that they would take the money and run rather than chase SS&C higher, leading the shares to trade in market at a discount to the offer price. Vistra’s decision to take the cash and walk was subsequently confirmed a week later.

It is worth mentioning that while Mainstream were prevented from soliciting higher offers, the private equity backed Vistra were not and even had the economic incentive to do so. Additionally, the data room had been open under the “go shop” period for four weeks and likely shopped far and wide, however such a small window of time makes it quite difficult develop a binding proposal from a standing start. There is nothing guaranteed in M&A but there was a non-zero probability the process had not been sufficiently exhausted at that point. Indeed, one only need look at Tilt Renewables Limited (ASX: TLT) who did recently run an exhaustive process and still received a counter offer after the fact. 

With Mainstream shares now trading at a discount to terms, investors could pay for a right to any further bids but also make money in the event one was not forthcoming. They wouldn't have to wait long. 

Two weeks after the SS&C bid was first announced, and six weeks from the start of the “go shop” period, an undisclosed third party made a non-binding, indicative offer at $2.20 per share. SS&C were notified and offered their matching rights, and they agreed to lift to $2.25 per share.

Two days later, Mainstream announced receipt of a $2.35 offer from global fund administrator Apex Group, and again SS&C took up their matching right. The next day, Apex would return at $2.55. SS&C lifted to $2.56.

Apex then offered $2.60.

SS&C matched and lifted at $2.61.

Apex came back at $2.65.

SS&C matched and lifted to $2.66

Apex returned with $2.75

SS&C matched and lifted to $2.76, and this is where the contest currently stands.

It's been an incredible outcome for shareholders up until this point, but for the vast majority of time since the corporate activity was announced it has not reflected a classic merger arbitrage opportunity of buying at a discount to terms. Since the emergence of the threat to SS&C, the market has consistently priced the shares higher than the best offer tabled on the expectation a better offer emerges, and rightly so. The idea of paying through terms can seem counter intuitive but evidently has been the correct option throughout the course of the transaction. Paying up in situations like this is not always going to work, but a successful merger arbitrage strategy not only needs to assess the risks but price them correctly.

Before winding this up, I should mention that neither the SS&C scheme or Apex offer have completed. It’s never over until it’s over in M&A, and we’re well past the takeout valuation making sense from a traditional perspective. From a strategic perspective though, it’s a vastly different proposition. There may yet be more to play out from here. 

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