Harvest Energy gets taken out
Nelson pointed out to me (earlier than I actually read the headline) that one of my holdings, Harvest Energy, agreed to a CAD$4.1 billion takeover by Korea National Oil Corporation. I do not own equity in Harvest Energy, but I do own debentures. The relevant portion of the press release is the following:
In accordance with the terms of the indentures governing Harvest’s convertible debentures, KNOC will make an offer to purchase all outstanding debentures for a cash consideration equal to 101% of the face value thereof, plus accrued and unpaid interest, within 30 days following the effective date of the Arrangement. Likewise, in accordance with the terms of Harvest’s 7 7/8% U.S. Notes, KNOC will make an offer to purchase all outstanding Notes for a cash consideration equal to 101% of the face value thereof plus accrued and unpaid interest, within 30 days following the effective date of the Arrangement.
Most of the debt of Harvest Energy I have acquired earlier this year was between the prices of 40 to 50 cents on the dollar. My TFSA, for example, has exclusively Harvest Energy debt. I have grown my TFSA from $5,000 to somewhat over $12,000 in less than a year, and I guarantee that this rate of growth will not continue. As I do own Harvest Energy debt outside the TFSA, there are tax considerations for me to examine, and other variables.
The variables are as follows:
1) The actual takeover is subject to government approval, but it is likely the Canadian government will not step in. It is clear that the acquiring company will be investing further into the company, and this will mean jobs will stay in Canada. In addition, the acquirer (a Korean “crown” corporation) is from a country that we have good relations with. The risk of the takeover falling through is minimal.
2) The acquisition will take place in late December, but it could be early next year. What gives the debt security value is that once the change in control takes place, the acquiring company is legally obligated to offer 101 cents on the dollar (cash) to the owners of debt securities within 30 days of the change of control. Of course I will be accepting this offer – I can get my money today, or I can get it in 3-4 years; I will take it today, and the cost of this is that I will not be getting a 6.4% or 7.25% coupon from this particular investment after I sell the debt back to KNOC.
3) It is advantageous for me to hold the securities until at least January 1, 2010, where capital gains taxes can be deferred until April 2011. It is also an income balancing tool – if I sell in 2009, these are capital gains taxes that I will not have to pay in 2010.
4) The debentures will continue to accrue interest until they are bought out, which means that there is a cost to selling them and getting an immediate cash conversion. Right now the debt securities are trading at 98.5. Let’s review the math.
Per $1,000 face value of debt (6.4% coupon), I am locking up about $985 of capital. This is still a current yield of 6.5% on investment. In addition, there will be a $25 increase in capital, which spikes up the absolute reward to 2.5%. Realistically, if the offer to repurchase debt is extended to January 31, 2010, then I would have to wait 3.2 months to obtain $25 in capital appreciation and $17 in additional interest income. Math-wise, this is about 4.3% over 3.2 months, and I would have to find an alternative investment candidate that would yield better than that to make selling at current market prices any sense at all.
In other words, if I do not think merger failure is a risk, I am still being paid quite handsomely to hold onto these debt securities. This is actually better than the equity itself, which is priced at a 2.15% return if the deal is consummated (based off of a share price of CAD$9.79, which will receive CAD$10.00 per unit when the transaction is concluded).
If I were to do some merger arbitrage on this deal, I would borrow some serious amounts of money to purchase the convertible debentures. It is not too efficient – if I borrowed $1,000,000 and used it to buy as much debt at 98.5, I would be able to extract about $32,300 minus financing costs (about $4000) over a 3.2 month period. The second the Canadian government gives approval to the transaction, the debt should trade slightly higher than 101 because of the extreme certainty of investors being paid off.
Unfortunately, I do not have the capacity of borrowing $1,000,000, and also the low probability risk of a merger failure would make such a transaction excessively risky. However, certain portfolio managers specialize in merger arbitrage and undoubtedly will be taking advantage of this pricing.
My main problem at this point will be reinvestment risk, although I now have a huge cash injection coming up early next year, I will have to find a place to invest it. Right now my candidates are marginal at best, and I do not like investing in marginal situations.