Tuesday, October 7, 2008 9 comments ++[ CLICK TO COMMENT ]++

Purchase: Puget Energy (PSD) - Merger Arbitrage

UPDATE (Oct 27 08): Reader Armen pointed out a mistake with the number. Instead of multiplying by 0.074 (7.4%) an incorrect 0.74 was used. Error has been fixed. The change results in the estimated potential return being better than the originally computed figure... Do note that numbers, especially estimates and guesses, may change as new information becomes available. This is especially true for M&A, where news can be abrupt and the probability should improve as we get closer to close.

I hope this doesn't turn into a dumb move because it was sort of a rash decision. I took a risk arbitrage position in Puget Energy (PSD). I briefly looked at it a few months ago and felt the risk was too much if the deal failed. Now, however, the stock price has collapsed and is almost trading at pre-announcement levels, which is also around the 2 year low (3 or 4 year lows are much further below.)

Old School Value has a brief mention of PSD in this post.

You can also get an up-to-date picture in this news story from the Seattle Times.

Purchase price: $23.77
Time frame: short-term

The details and my thought process follows...

Details of the Proposed Takeover

Puget Sound is a small utility located in Belvue, Washington and is being acquired by a consortium led by Macquarie bank, an Australian bank. The consortium also involves a bunch of pension funds from Canada so funding is only an issue when it comes to the bank. Like almost any financial institution these days, it's not clear if Macquarie is going to have problems or not (the BCE takeover seems to be unraveling due to speculationg that Royal Bank of Scotland, one of the parties in the LBO, won't provide the necessary funds.)

PSD takeover price: $30
Closing Date: 4th quarter of 2008 (Washington Utilities and Transportation Commission should give a ruling within a month)
Current price: $23.77

Gain if deal closes: 26.2%
Loss if deal fails (guess): -7.4% ($22)
Probability of success (guess): 90%
Probability of failure (guess): 10%

Expected Return = 0.9*0.262-0.1*0.74 0.074= 16.2% 23.6%

I place a high probability of success and the overall return seems attractive.

Buffett's Four Key Questions

(1) How likely is it that the promised event will indeed occur?

Seems highly likely. Anti-trust regulators, as well as shareholders, have voted in favour of this deal. A key approval from Washington Utilities and Transportation Commission is all that remains. Some consumer groups are against the takover but it seems to be weak, especially after the consortium agreed to increase the equity portion and lower debt usage.

A failure may also occur if the financing fails, but some of it is being provided by Canadian pension funds so this risk is mitigated somewhat.

(2) How long will your money be tied up?

If everything goes smoothly, between one to three months.

(3) What chance is there that something still better will transpire - a competing takeover bid, for example?

No chance.

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

If the deal fails, the stock will probably drop to $22 (but this can be lower.) I might exit with a small loss (say <4%)>

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9 Response to Purchase: Puget Energy (PSD) - Merger Arbitrage

October 7, 2008 at 8:14 PM

Have you noticed BCE's recent closing price of $30/share? 40% upside now.

October 8, 2008 at 9:04 AM

An M&A (www.maresearch.com) service has a complete free report on the PSD deal.



Good luck!


October 8, 2008 at 10:31 AM

Vlado, I have kept a close eye on BCE and even thought about averaging into that. Financial risk is real but someone sitting on the sidelines should consider BCE.

As for me, I need to diversify and adding to BCE is a bit risky. I don't mind holding BCE if the deal fails but I don't want a huge chunk of my portfolio tied up in that. The same thing with PSD: if it fails, I wouldn't mind owning it as a last resort but don't want most of my capital tied up in a slow-growth, albeit safe, utility.

October 8, 2008 at 12:21 PM

Good point.. a will be taking the plunge soon.

Jae Jun
October 16, 2008 at 12:53 PM

I entered into a position in the low 23's about a month ago but then sold at a tiny profit because I needed the capital for another opportunity.

Now that its down to the 22's with limited downside even if the deal fails, your probabilty of success versus failure is probably true.

All approvals have been acquired, including the antitrust and now all that remains is a reply brief to be submitted by Oct 23.

I believe this to be a very nice short term play.

October 20, 2008 at 10:16 AM

The market is likely implying a probability of less than 90%.

October 20, 2008 at 9:40 PM

BombayAdvisors: "The market is likely implying a probability of less than 90%."

Yes, the market is implying a high probability of failure. But my risk arbitrage strategy involves going against the market. So the probability is what *I* think it is. Who knows how correct it is but that's my stance.

If I used the market probability, then I would not be doing anything advantageous for me. If the market thinks the probability of success if high then the returns are going to be small (often less than 5%, and maybe 3% after commissions/taxes/etc). That case is not worth it to me at all. But if you were running a hedge fund or a specialist mutual fund, I can see someone finding that scenario attractive due to leverage. If you didn't use leverage, like me, then the high probability cases are not worth it.

October 27, 2008 at 1:19 PM

In your expected return formula, why are you factoring in the downside to be ten times larger/more likely than the upside when the percentage of likelihood is already accounted for?

Shouldn't it be 0.1*0.074 instead of 0.1*0.74?

October 27, 2008 at 5:24 PM

Thanks Armen. You caught a mistake. I fixed it and the estimated return improves slightly.

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