That’s not $0.60 in cash but $0.60 worth of stock independent of Google’s stock price. The problem is that $0.60 worth of Google stock are a lot fewer shares today than back in August when the merger was announced. Google has since risen from the $450s to the $580s, or 29%. The merger consideration has remained constant $0.60. Had management negotiated a fixed exchange rate of, say 0.0013 shares of GOOG for each ONT, then shareholders would receive $0.77 worth of Google stock for their shares now.

The flipside of a constant merger consideration is that it has become much less dilutive for Google. Instead of issuing roughly 235,000 shares based on Google’s August share price, Google will now have to issue only 182,000 shares (assuming the VWAP for GOOG will be around $580).

Management is in a frenzy to line up enough votes to get the deal approved in the December 18 shareholder meeting. Every day another SEC filing is made extolling the advantages of the deal and threatening the dire consequences if shareholders vote it down. This is a clear sign that they lack votes to close the deal.

Merger arbitrageurs are the joker that will determine the outcome of the shareholder vote on December 18, The arbitrage community holds a significant share of On2. Technologies. We attribute holdings some 15% of the shares to holdings by arbitrageurs, based on our analysis of 13F holdings data collected by Whale Wisdom:

This was per 9/30, a full two months prior to the record date for the meeting. We would not be surprised if their holdings of shares have since doubled. As we pointed out in our book about merger arbitrage, the outcome of many mergers is driven by the arbitrage community whose holdings often reach the 30-50% range during the merger process. A study by Micah S. Officer (“Are Performance-Based Arbitrage Effects Detectable? Evidence from Merger Arbitrage,” Journal of Corporate Finance 15, No. 5 (2007), 793–812) gives examples of the percentages reached historically in some mergers.

Arbitrageurs generally try to take a quick gain and move on. With the current price of On2 Technologies the spread comes to around 20%, depending on your assumptions about commissions and the closing date. So it will be tempting for arbitrageurs to support the deal and take that quick and easy return. However, it is also possible that the arbitrage community has smelled blood and will reject the deal, challenging Google to increase its consideration. Some of the arbitrageurs on the list are of the more aggressive variety and we would not be surprised if they challenged management.

For Google, this is its first purchase of another public company. So they are still learning and probably won’t mind bumping the price, especially not if the transaction is so small that it is a mere rounding error in their financials. They simply have to increase the exchange ratio to the level they were willing to pay back in August. That would boost returns to shareholders significantly and win over the support of the arbitrageurs.

We doubt that the transaction will collapse completely. It makes sense for Google from a strategic point of view. Building their own video compression software is certainly a possibility, but in the typical tradeoff between buy or build they are probably better off acquiring a firm that has a technology that actually works. Not to mention that in acquiring On2 Technologies they can use the technology right away. Time is of the essence if they want to use video as a driver to push their Android operating system into the mobile market. Therefore, we think that Google will eventually increase the exchange ratio to 0.0013 so that investors get as many shares as they would have in August. There remains upside in On2 Technologies beyond $0.60.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which engages in merger arbitrage and owns shares of On2 Technologies. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

The Wilsons and Issac together own 69% of the shares and have the ability to force the deal through, at least in theory. However, we believe that this transaction should be conditioned on an approval by the majority of the unaffiliated shareholders and expect that the vote will be restructured in this way. But even that would do nothing to appease shareholders who are forced to sell their shares along with the Wilsons in a fire sale.

Going private was not the only option available to the company. The proxy statement reveals that going private was an outcome that came about almost incidentally. ACPT is unable to qualify for taxation as a REIT because of the large number of shares held by the Wilson family. The IRS requires a more diversified investor base before it grants REIT status. The company tried to get outsiders to invest in ACPT. No takers. Given the control exercised by the Wilson’s over the company nobody was willing to become a minority shareholder. Then the Wilson family offered to sell its stake. Three bidders emerged at prices between $6 and $7.75 per share. FCP bid $7.15 under the condition that it could acquire the entire firm, not just the Wilson interest. Here is where it gets interesting: the Wilson’s accepted the proposal if FCP were to pay $7.50/share. The Wilson’s effectively closed the deal on behalf of the company. When the special committee was formed, it more or less rubber stamped the Wilson’s deal and as a token gesture to shareholders negotiated a $0.25 increase to $7.75 per share.

It should be noted that another buyer had made a preliminary offer for $8 per share; it is not clear to us why this buyer did not perform additional due diligence. This could have been caused by a genuine lack of interest or by a realization that the deal with FCP was more or less done and that the Wilson’s were seeking speed over price.

One of the alternatives considered by the board was quite dumb: “going dark.” This refers to the company deregistering from the SEC with the stock continuing to be traded over-the-counter. It is an option often pursued by small companies but mostly ends with the stock loosing value due to the lack of trust by public investors in non-reporting companies whose financial statements, if available, are not subject to the strict Sarbanes-Oxley requirements. Fortunately, some minority investors the board spoke to rejected this proposal outright.

FBR acted as the investment banker for ACPT, so we are not surprised by the low merger price. FBR also acted as adviser to Wilshire Enterprises (WOC), a long and painful story that we covered previously and which led to a significant destruction of shareholder value. Their repeatedly poor performance make us think that they are probably not the best choice for small real estate companies seeking an investment banker.

It is an irony that Paul J Isaac is now part of the problem. Initially, the firm’s representative on the board, Ross Levin, resigned citing the unfair nature of ACPT’s sales process. We think that Isaac’s desire to join the buyout group rather than fight it demonstrates how much value is left in ACPT. We continue to believe that the transaction undervalues the shares of ACPT and believe that shareholders may end up with more than $7.75. The strongest indication that the shares are worth more comes from one of the participants in the buyout, Paul J Issac: his firm bought additional shares above $8 prior to announcing that he was going to join the buyout group.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of American Community Properties Trust and is in litigation with the firm. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

The first thought is, of course, you get what you pay for. If this line of thinking has some validity, then alpha-generating talent is well worth paying 2/20 for. The counterargument of the indexers is, of course, that what looked like alpha in the boom turned out to be in many instances either an illiquidity premium or simply leverage. Who wants to pay a performance fee on leverage?

On our second thought, we looked a little more closely at one of the upcoming IQ Arb Merger Arbitrage ETF. We were not impressed by what we saw.

The ETF is based on the IQ Merger Arbitrage Index, a monthly rebalanced index that is long the target companies and short – no, not short the acquirer like every merger arbitrageur in the world. They are short index ETFs (or long inverse and ultra inverse index ETFs). So the “arbitrage” and “ARB” in the fund name are really quite misleading and we are surprised that they got through the SEC. Then again, the SEC is busy looking for the next Madoff so they probably didn’t notice this naming inconsistency.

We see a number of issues with the MNA ETF:

• Monthly rebalancing: The index and ETF are rebalanced monthly. In the fast-moving world of merger arbitrage, a month is an eternity. The average merger of U.S. targets closes in 145 days (for details and industry breakdowns see Chapter 3 of our book about Merger Arbitrage), so that monthly rebalancing is sub-optimal.
• Cash holdings: 22.93% of the fund were held in cash. We don’t think that cash holdings are a problem in actively managed funds, but if you acquire a passive fund you want it to be fully invested. Then again, merger arb is a strategy that tends to have higher cash balances than other strategies due to the involuntary nature of the closing of the mergers the fund is invested in. Nevertheless, 22.93% strikes us as a high number for any passive strategy.
• No arbitrage: The MNA ETF does not short the acquirer. It takes long only positions in companies that get acquired. To the extent that they invest in cash deals (Sun Microsystem [JAVA] is a top holding with 7.55% of the fund) there clearly are no acquirers to short. We wouldn’t mind a cash deal-only merger arb fund. But if you do stock deals you really should short the acquirer if you want to call yourself an “arbitrage” fund and give your investors that risk profile.
• Index shorting: Rather than going short the acquirer in stock-for-stock deals the ETF and its index short index ETFs. Other than shorting, they can also buy inverse and leveraged inverse ETFs. It appears that these positions are also rebalanced monthly. At least there is nothing contrary in the prospectus or publicly available index documentation. If holdings of leveraged ETFs are rebalanced only once per month then they can lead to significant underperformance because the leveraged ETFs themselves are rebalanced daily. Much has been written about the problem with leveraged ETFs elsewhere and we refer readers to those sources.
• Risk profile: Despite its misleading name this ETF is not an arbitrage ETF and does not have an arbitrage risk profile. It is a fund that invests in stocks that go through mergers and also shorts indices. Again, this is not an event-driven risk profile. It is more similar to a run-of-the-mill equity long/short fund. The risk profile is different from a fund that actually shorts the acquirer and therefore has deal risk as its major uncorrelated risk driver. The MNA ETF has general market risk through the long positions in the target companies with an overlay of deal risk, and hopes that statistically some of the market risk is hedged. We are not sure what sort of risk profile that is, but we would expect it to be much more correlated than a fund that provides investors with real deal risk by shorting the acquirer.
• Speculative deals: There is nothing wrong with investing in slightly speculative mergers. If done carefully it can provide significant upside. However, the key word here is “carefully”. There is no way that a passive rules-based index can invest in speculative mergers and do well. It requires good judgment, not mechanical rules. Consider, for example, the index holding of Cadbury plc (ticker CBY). Until Monday there wasn’t even a deal, yet the index has 6.26% in Cadbury, its 4^th largest holding excluding cash. The Cadbury/Kraft deal announced on Monday is a hostile takeover at a slight discount to Cadbury’s market price. Clearly, it is not a deal without risks, and many arbitrageurs do not even touch speculative or hostile deals. In our opinion a deal with this risk profile deserves an allocation much lower than 6.26%. Again, these deals introduce more market risk into the fund than you would expect from a genuine arbitrage fund.

We are not quite sure what the implication is of replacing the short of the acquirer with a generic index short position. The implicit assumption is that the acquiring companies outperform the index while the merger is pending. We do not believe that is true but do not have data in our hands to back this up. The other question is what it does for volatility, and here the answer is more obvious: an index has a lower volatility than individual stocks, so if you replace a relatively small number of acquirers by a broad index you will have higher volatility than if you short the acquirers. In addition, the acquirer correlates very closely with the target while the merger is pending, so that an index hedge is not only second second but third of fourth choice.

Overall, we do not think that this ETF has much value to investors. There are no doubt some index fanatics who will buy anything that comes in an ETF format, but serious investors who look for low correlation should stay away from this ETF. And with the absence of real arbitrage we think this ETF should not be allowed to include “merger arbitrage” in its name.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of Sun Microsystems as part of its merger arbitrage strategy. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).
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Hedge funds have high water marks so that managers do not receive the 20% performance fee until the fund has reached its prior high. That is one of the reasons why so many managers simply shut down their funds and launch new ones not subject to that constraint. But it also leads to difficulties with the reporting of returns. Performance fees are assessed not at the fund level but on each investor’s capital account. In other words, if you invest on December 30 you do not have to pay the performance fee for the whole year.

And that’s where the bias in return reporting comes in. Returns are shown for an investor who has been in the fund since its beginning. After last year’s carnage most hedge funds are still underwater and therefore do not charge performance fees this year to their investors who have been with them for some time. A new investor, however, who entered this year will have to pay performance fees for this year.

This now leads to the absurd situation that hedge funds generate two different after-fee returns this year, a higher one for longer investors and a lower performance for newer investors. The number reported to the major databases is, of course, the better one.

The problem is not just theoretical. Hedge Fund Alert reports that 77% of all hedge funds tracked by hedgefund.net were underwater at the end of August. As a result most hedge fund indices report inflated return numbers for this year.

Startup hedge funds are likely to suffer as a result of the bias. Typically they are above water and report their performance for this year net of performance fees. Therefore, they appear to do worse than more established managers even though the discrepancy has nothing to do with actual performance but is only due to the skew in reporting. Many investors, including supposedly sophisticated institutions, do not understand this subtlety and are likely to make decisions based on data that compares apples to oranges.

To make matters worse, the performance skew that results from the high watermark and performance fees is not the only issue. The good old survivorship and backfill biases also contribute to an overstatement of returns this year. Through August, HedgeFund.net reports an average performance of 13.7% for hedge funds, whereas funds of hedge funds returned only 6.7%. The difference can not be explained by fee layering but is an indication that many poorly performing hedge funds have simply stopped reporting their numbers to the databases. Fund of funds are still invested in them and therefore provide a better guide to the real performance of hedge funds as an asset class than the indices.

All this proves what we have been thinking for some time: data is nice to have, but its usefulness is often limited and even simple figures can have so much devil in the details that they are a clear and present danger in most investors’ hands.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which does not charge performance fees. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

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In our recent Hiland posting we speculated that oil magnate Harold Hamm, the acquirer, would not obtain sufficient votes at the October 20 shareholder meeting to close the transaction. We think the only way to get shareholder to buy into the deal is to follow the recent example of Black Stone Minerals bid for Eagle Rock Energy’s (EROC) minerals business and increase the price.

Hamm should look closely at the bidding war that is unfolding at Eagle Rock (EROC) over its minerals business. It began on September 18 when Natural Gas Partners (NGP), which controls the general partner of Eagle Rock, proposed to acquire the minerals business for $135 million. While EROC was evaluating the proposal, NGP raised its bid to $145 million on October 13. Less than a week later Black Stone Minerals Company joined the bidding with a $157.5 million bid. Both proposals include support for an equity raise.

As we pointed out in our last post about Hiland, natural gas trades higher now than when the original buyouts at $9.50 (for HLND) and $3.20 (for HPGP) were announced. Nevertheless, Hamm sticks to prices that value the firm at a level when natural gas was some 30% lower. We believe that the strong performance of natural gas is the principal driver of the pending bidding war at Eagle Rock, and we do not see why Hiland should be stuck at a gas price from a different economic environment.

Performance of the Hiland Companies and Natural Gas

The trick is the interaction between the shareholder meetings at HLND and HPGP. Both buyouts must be approved by the public shareholders (other than Harold Hamm) before the transaction can close. At the last meeting only 43% of the public shareholders supported the transaction. Since the adjournment of the meeting to allow Hamm to solicit more votes HLND has moved above the $7.75 acquisition price. This indicates clearly that the market believes that the deal will not get done at $7.75. HPGP still trades at a small discount to the $2.40 acquisition price.

Two outcomes are possible if Hamm can not get enough votes:

1. Hamm will increase the price of the merger. We think that a price that is closer to the initial January 15 bid of $9.50 for HLND and $3.20 for HPGP could sway sufficient shareholders to vote in favor. In our opinion this is the most likely scenario.
2. If the deal collapses then HLND and HPGP would probably trade above the acquisition price in light of the dramatic improvement of the gas price over the last two months. Gas has more than doubled from its September lows, trades about 40% higher than when Hamm lowered his acquisition price to the current levels, and is 10% higher than it was when Hamm lowered the price. As a result, HLND and HPGP should restore their profitability. One concern that triggered the acquisition was Hamm’s support of the company in light of its covenant violations. We believe that Hamm, as a 50% shareholder, has more to lose than anyone else if Hiland suffers as a result of covenant violations. He should be willing to provide support even if he were to withdraw his acquisition proposal.

We think the first scenario is the most likely one. Hiland’s shares are held widely by retail investors who typically do not vote. They are even less likely to vote if they get a bad deal such as this buyout, which is priced at roughly two years worth of dividend payments (prior to their suspension).

Some shareholders who initially voted for the deal might try to change their vote to a “no” when they see the shares trading above the deal level. Such changes in votes would offset any additional “yes” votes that the proxy solicitors collect. Changing the vote is not easy, though: most shareholders hold their shares through a brokerage account and vote at proxyvote.com or via telephone at the 800 number that comes with the voting materials. However, when we did a test the other day the control number no longer worked, so that shareholders can not change their vote in the normal way. The trick to work around this issue may not be known to many shareholders: rather than using the materials the company sent out, the shareholders must call the proxy solicitor D. F. King (1-800-967-4612). However, this also means that the only “yes” votes that can come in at this point are those that are collected by the proxy solicitor. On balance, the chances for a “yes” vote on Tuesday are not high.

Whether or not the transaction goes through, we believe the risk/return profile of the two Hiland companies is attractive. The market prices the probability of an upside into HLND at Friday’s 5 cent premium to Hamm’s acquisition price. We think that probability is much higher than that premium suggests.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of HLND and HPGP. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).
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Peter started by noting the difference in the type of question asked today of emerging markets and the developed world. For emerging markets, the discussion is about how well they will do over the next 20 years. For the developed world, the concern is whether the entire system will collapse within the next six months. Thiel wants to take a different approach and think about the developed world in 20 years. He believes that the growth of science and technology will drive the developed world and will offset the economic headwinds that we are facing, including inflation. His overall thought is that science and technology are broken because there is not enough innovation. He contrasts three facts with the bullishness of VCs, startup companies and scientists

1. VCs made no money in 11 years. (We wonder whether this is really an issue because the nature of venture capital has changed so much in the 1990s. Venture capital is no longer pools of entrepreneurs who invest in other business with a profit motive but has become an asset class where financial products are structured to be sold to institutions with a goal of generating a management fee. If there is a 20% payday at the end, that’s great, but in the meantime the managers collect a cushy 2% management fee. We believe these incentives make venture capital today less of an indicator for innovation than in the past.)

2. There is a disconnect between the exponential technological growth and progress on one side and the stagnant median wage on the other. (he acknowledges that the question of progress of the median wage depends on whether you believe that the government over- or understates inflation)

3. The demographic development does not favor innovation

Thiel then steps back to the 1960s and how commentators then saw the year 2000. Back then, the year 2000 promised permanent bases on the moon as well as manned missions to Mars. Increased productivity would lead to seven hour workdays and 13 weeks of paid vacation. But none of these forecasts came true.

Thiel fast forwards to 2009 and claims that the credit crisis is primarily a technology crisis, or a crisis of innovation. Credit is a claim on the future, and if there is no progress, you will not get paid on your claims. The technology bubble was a sign of hope in the power of innovation. When that bubble burst in 2000 we added leverage to the system to offset the effects of the bursting. When still no growth materialized by 2008, markets collapsed.

Over the last 200 years growth has averaged 8% per year. This was driven primarily by innovation. If you look back at other time periods like the 1300s to 1500s there was no growth at all. Thiel wonders what would happen if we were suddenly to enter a long no-growth zone. This would have catastrophic effects. In order to meet retirement needs everyone would have to work to 80 and the savings rate would have to approach 40%.

To top off his bearish forecast, Thiel suggests that investments in large cap tech companies are actually bets against technological progress. Microsoft (MSFT) will do well if there is no disruption from technology. Therefore, investments are actually stacked against innovation.

During the Q&A session a Bloomberg reporter asked the inevitable question about Clarium’s YTD 10% loss. Thiel responds that he was mistaken to focus on the real economy and overweight equities. Clarium did not expect the financial economy to read the real economy in a bullish way. The decoupling occurred because volatility declined, mostly through the help of the government which took risk out of the system, and because the Chinese stimulus was big enough to actually have an effect which percolated to the rest of the world. For the near future, he sees little prospect for volatility to decline more and thinks that China will begin to reign in growth.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX). He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

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Billionaire Harold Hamm controls both HLND and HPGP and is squeezing out the public shareholders. He made his initial acquisition proposal of $9.50 for HLND and $3.20 for HPGP on January 15 when natural gas closed at $4.81. As natural gas continued to slide throughout the first quarter of the year, Hamm revised his price to $7.75 (HLND) and $2.40 (HPGP) on April 20, when natural gas traded at $3.67. Today, natural gas trades above $5, or about 5% higher than when the first acquisition proposal was made. Since the decline of natural gas prices was specifically mentioned as a reason for the reduced merger consideration, it is no wonder that shareholders are reluctant to support the deal.

Performance of Hiland compared to Natural Gas (NYMEX front month) since Harold Hamm's first proposal

Hiland is a small MLP that has the typical GP/LP setup: Hiland Partners (HLND) owns the assets, whereas Hiland Holdings GP (HPGP) acts as general partner and manages HLND. Billionaire Harold Hamm, directly and through trusts as well as through Continental Gas, controls the GP and thereby also Hiland Partners. A diagram in the proxy statement illustrates the complex ownership structure:

Ownership Structure of Harold Hamm's Highland Partners and Highland Holdings

HLND went public in February 2005 at $22.50, whereas HPGP had its IPO in September 2006 at $18.50. After doubling from their IPO prices, both stocks crashed last year. HPGP and HPND are now off 65 to 85% from their IPO prices.

Harold Hamm, Continental CEO and majority shareholder of the Hiland companies (HLND, HPGP)

Harold Hamm is #164 on the Forbes list of the world’s richest people with an estimated net worth of $3.5 billion. We are not quite sure why exactly he is pinching pennies on taking the Hiland companies private, but it is clear that he did not become a billionaire by buying high and selling low.

Both companies are acquired simultaneously. The merger agreement is conditioned upon approval by a majority of the minority of each HLND and HPGP. In addition, each of the mergers is conditioned upon the other being approved. And this is where the problem lies for Hamm. After revising his acquisition price down when gas prices were falling and valuations were at a trough, shareholders are now questioning whether price adjustments need to be one way streets only. Getting one bad deal approved is tough, but two at the same time will be a real challenge. The problem is compounded by the absence of large holders of the stock, which means that Hamm has to convince a large heterogeneous base of retail shareholders to vote. Institutions wisely stayed away from owning stock in which a controlling shareholder is dominant. We described in our book about merger arbitrage how minority shareholders get squeezed out again and again at low prices, and the Hiland companies follow the script quite closely: an IPO, a tough external event (fall in gas prices), suspension of dividends, and finally a squeeze out at a fraction of the IPO so that the controlling shareholder essentially received free money from investors.

Most shareholders bought the Hiland stocks for their rich dividends. The squeeze-out is scheduled at prices that are equivalent to two annual dividend payments. We expect that the closing of the merger will be delayed because not enough votes will be cast in favor by the October 20 meeting. Whether shareholders can expect an increase in the merger consideration is a tough call that we will pass on. Considering the discount to the proposed squeeze-out prices that the shares are trading at we consider it a risk worth taking on.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of HLND. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).
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The sudden sale at a discount to the market price comes out of the blue for shareholders who still remember the failed attempt by the Wilson family, the 50.68% owners, to take the company private in 2007. The Wilsons had engaged a financial adviser, Granite Partners, which was ultimately unable to raise the funds for the buyout. The stock has since underperformed REITs. Since the July 17, 2007 announcement the Dow Jones REIT index has fallen 45%, whereas ACTP shares have lost 60% of their value.

American Communities Properties Trust underperforms the Dow Jones Equity REIT Index

The buyer of ACPT is a fund run by Federal Capital Partners, a Washington, D.C. based private equity firm founded by two alumni of the Carlyle Group, Esko I. Korhonen and Lacy I. Rice. The firm managed to raise $230 million for its first fund, FCP Fund I, in 2008 just before the market imploded. The firm focuses on the Washington, D.C. area and Maryland, so ACPT is right on its home turf.

The big question is why the Wilson’s are selling in a depressed market for $7.75 even though they were willing to take the firm private at top prices during the boom. After all, there are alternatives to selling: other options the firm was looking at include a breakup of the firm and a restructuring of some of its assets into a REIT. We suspect that the sudden sale at a discount may have more to do with the Wilson’s own need for liquidity rather than anything else.

We are not alone with our suspicion. On September 2, the company suddenly formed a special committee to explore its sale. The formation of the committee was disclosed only on September 14 after Ross Levin, one of the independent trustees and representative of Arbiter Partners/Paul J. Isaac, a 6.5% shareholder, resigned from the board. Justifying his resignation he sent a letter to the company that shows that the Wilsons wanted to sell their shares but were unable to find a buyer. So they had to sell the whole firm to obtain liquidity:

“ACPT is under no particular pressure to sell itself […] the Wilson process excluded a particular identifiable potential bidder and excluded the universe of potential bidders for the whole company uninterested in bidding on only the Wilson family stockholding” Levin’s letter, 8-K on September 14

Investors waiting for some help from the two activists who have been circling ACPT may be in for a disappointment. Chapman Capital, which has been invested for a decade, began selling its stake in 2008. Leeward Capital recently suffered a setback when Eric Van Der Porten passed away. So any hopes of pressure from activists are likely to be dashed.

Nevertheless, we believe that outside shareholders have a good case to make about the legality of the sale. Levin’s resignation was triggered by his dissatisfaction with the sales process:

“I have been troubled by the current strategic process of the company and I do not believe that it is in the best interest of the company’s shareholders. […] I believe that the company should be marketed as widely as is practicable. The board seems to be relying on the fact of a preceding Wilson family stake sale process as a de facto marketing of the whole company justifying a less than exhaustive company process. […] I believe that a higher price would be realized for the company’s shareholders if the company were marketed as a whole in a more open process.” Levin’s letter, 8-K on September 14

Clearly, the board has failed to do its job and a higher price should be achievable. A 2/3 majority is required to approve the merger agreement, and the Wilson’s themselves have almost 51% of the votes. We recognize that this is not a management buyout but wonder whether a vote of the majority of the minority would not be appropriate here since the sales process was driven primarily by the Wilson’s desire to sell. In addition, the special committee seems to be a farce: the decision to sell had been taken before the committee was established, and it only served to rubber-stamp the sale. The record speed between the establishment of the committee (September 2) and the signing of a term sheet (September 14) that gave FCP exclusivity precluded any real effort to shop the company. The public only found out that the company was for sale when FCP was given exclusivity. The 30-day go shop period, during which other potential buyers can make bids, is too short and no more than a cosmetic exercise to pretend others could buy it. Unfortunately, appraisal rights are not available to shareholders of publicly traded Maryland companies. If ACPT were a Delaware company, the Netsmart ruling would apply (shopping a small or micro cap company to only a limited set of buyers is a breach of fiduciary duty); unfortunately, it is a Maryland trust, where it is more difficult for shareholders to seek legal recourse.

We anticipate that we have not yet heard the last of ACPT’s sale. The market clearly agrees with us, trading 5-6% above the acquisition price. The only question is what the trigger for a higher bid will be.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of American Community Properties Trust and is in litigation with the company. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

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The tender offer is the result of a settlement of a proxy fight with Philip Goldstein’s Bulldog Investors/Full Value Partners. Bulldog agreed not to run its slate of directors, and management agreed to provide Bulldog and all other investors with a liquidity event that allows them to sell roughly three quarters of their shares. Unfortunately, Bulldog’s desire to exit their investment will leave everybody in the position of minority shareholders. Even worse, due to the last minute timing of the settlement prior to the shareholder meeting, Bulldog did not vote the proxies that shareholders had entrusted them with and two shareholder proposals, including ours to eliminate the poison pill, were defeated by management’s votes.

The good news is that management ditched FBR as its financial advisor, after they charged exorbitant fees and yielded little results other than bringing in a buyer who could not get financing. Wilshire’s new financial advisor is TM Capital Corp which works for a bargain basement rate of $500,000. Apparently that is a price level at which TM Capital is not prepared to do too a good job. Data in the Stock Ownership Summary (slide 7) of their board presentation is simply copied and pasted from Bloomberg, along with the errors in the Bloomberg data base. Bloomberg attributes the shares held by our fund (PAEDX) to the Georgetowne Funds. Never mind that the Georgetowne Funds shut down last fall. We spoke to the manager when we first noticed their holdings on Bloomberg and he assured us that he had never even heard of Wilshire Enterprises. So we wonder where else in their opinion TM Capital took sloppy shortcuts without checking their information. If we were Wilshire’s management we would ask for a partial refund of the half a million dollar fee due to poor quality work.

The bad news is that public shareholders will become minority owners of a small illiquid company. Currently officers control 900,925 shares of Wilshire directly, representing 11.2% (TM Capital’s opinion ignores COO Kevin Swill’s 127,200 unvested shares as well as some in-the money stock options and shows a smaller percentage of only 8.5%). In addition, the Wilzig estate owns 1,660,792 shares, which we can count as being under the control of management. Therefore, management has control over 2,561,717 shares, or 31.8%. If 4 million shares from outside shareholders are acquired by the company, then management will have absolute control over the company: 63.25%. We see two problems with that:

• Management has avoided so far the payment of a control premium to shareholders by distinguishing between the shares held by management and those held by the estate. If Sherry Wilzig were to obtain formal control over the shares in her father’s estate, how would the remaining public shareholders obtain a control premium? They would not.
• As we pointed out in our book about merger arbitrage, shareholders are largely powerless against creeping takeovers of companies. Sherry Wilzig’s slow takeover of the company reminds us of what was about to happen at infoUSA, now renamed infoGroup (IUSA) when Vinod Gupta was slowly approaching the 50% threshold.

Shareholders will be in a tough spot once management exercises absolute control. If all shareholders tender, the proration factor will be about 73%. Not all shareholders will tender, so that the tendering shareholders should expect to be left holding about one quarter of their current holdings. We expect that the shares will descend back to penny levels once the tender offer is completed. At some point in the next year or two, management will take the company private through another tender offer, which will cost them less than a dollar per share. Sherry Wilzig was willing earlier in the year to acquire shares for $1.10 from distressed sellers in private transactions, so we would expect that this will be a level at which a going private deal could be consummated. If proration of the current offer is taken into account, the average payout for shareholders in a $1.10 squeeze-out will be $1.76, roughly current cash on hand and no value for the going concern.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of Wilshire Enterprises. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

SPACs represented a great liquidation arbitrage late last and early this year when they traded well below their cash value at double-digit annualized yields. Other companies trade occasionally below cash, usually when they are running operating losses. SPACs and other cash shells, however, trade below cash without much operations other than minimal corporate activity to keep them going. SPACs have the added advantage of a built-in deadline at which they will be liquidated. Spreads on SPACs have narrowed to small single digit annualized returns, but opportunities abound in other cash shells.

Some SPACs have actually been able to pull off reverse mergers rather than liquidate in their entirety. According to data collected by Paul Larosa and Andrew Rosen of Maxim Group since their invention 47 SPACs have liquidated and 71 have completed an acquisition. Currently 12 SPACs have announced acquisitions, 2 are liquidating and 29 continue to seek acquisition targets. Of the SPACs that completed acquisitions, all are now in the red from their IPO price, sometimes by as much as 98% or 99%, with only a handful of exceptions shown in the table below:

Source: Morgan Joseph. Excludes SPACs that have been acquired since their business combination.

So fewer than 10% of all SPACs show gains from their IPO price.

Today, more interesting than SPACs are shells that are the successors of former operating companies. These firms have wound down their business and are sitting on large hoards of cash. The natural reflex of investors is to scream “liquidation” and have the cash distributed to shareholders. However, unlike SPACs, these shells have a hidden asset: net operating losses. In many instances, the NOLs are worth a multiple of the cash on the balance sheet. Therefore, it makes sense not to liquidate but buy another business that is very profitable so that these profits can accumulate tax-free. This is not easy because the IRS limits the use of losses after business combinations; however, it is possible to structure transactions in a way that the NOLs are preserved.

MathStar has been the object of a number of acquisition proposals. Management has been trying for about a year to effect a reverse merger. As the SPAC experience shows, the environment has not been particularly favorable for such deals over the last year, and therefore calls for liquidation multiply. 10.5% holder Salvatore Muoio called in a December 13D filing for the liquidation of the company. Later, Muoio proposed taking control of MathStar in order to liquidate it. Building software maker PureChoice has made proposals to acquire MathStar for $1.04 per share, increased to $1.28 in June. At the same time, Tiberius Capital entered the bidding with a $1.15 per share proposal to acquire half of MathStar, bidding a lot less than PureChoice. The Tiberius bid has since been increased to $1.25, still below that of PureChoice. Considering that MathStar has about $1.40 in cash and NOL carryforwards worth almost ten times that amount, all of these proposals look rather cheap.

Despite all the propaganda by Tiberius, its intentions for the future of MathStar do not differ substantially from what management is planning to do. Tiberius proposed

an extraordinary cash dividend; a stock repurchase program or an issuer self-tender; selling or licensing MathStar’s technology assets; a “restart” in which MathStar would hire programmers and other personnel to improve and to commercially exploit MathStar’s technology assets; and/or a merger or other combination with another company [Source: Schedule TO by Tiberius]

in its original bid. Tiberius also recognizes the value of the NOL carryforwards:

We attempted to propose to MathStar’s management a structure that would preserve its NOL carryforwards, in order to offset taxable income when and if its business is restarted or a suitable merger partner is identified. [Source: Schedule TO by Tiberius]

We believe that both PureChoice and Tiberius would simply liquidate the company and make a quick and easy 12% profit at shareholder expense ($0.15 per share profit: cash per share minus purchase price). The NOLs would be lost. Not only would shareholders give up the value of the NOLs but they would not even receive all of the cash that MathStar holds. Even a liquidation would be more favorable than these proposals. However, shareholders rejected a liquidation proposal at the recent annual meeting. We take that as a clear mandate for MathStar’s board to engage into a reverse merger, something they have since done by announcing the potential acquisition of a translation service and technology firm.

Tiberius Capital is an opportunistic liquidator that pursues a similar goal at PetroSearch Energy Corporation (PTSG). It seeks to acquire only 51% of the company for $0.33 per shares, potentially leaving everyone, after proration, with half of their shares in an illiquid firm under the absolute control of a majority shareholder. As we point out in our Merger Arbitrage book, this is an awful position to be in. So what looks like premium to the current trading price of $0.21 can quickly turn into a loss when the remaining shares of PetroSearch fall back to below $0.16.

Tiberius freely admits in its filings for both PetroSearch and MathStar that NOL carryfowards will probably be lost if the transaction closes. This is a strong suggestion that shareholders in both deals are better off with a reverse merger that has at least the potential to realize some of the value of the NOLs than selling to Tiberius below cash and loosing the NOL value for sure.

Cadus Inc (KDUS) is another cash shell that is looking for a reverse merger candidate. Cadus has about $24 million of cash and $37 million of loss carry forwards. Its roughly $800,000 royalty and interest income for 2008 matches the current run rate of expenses. Therefore, Cadus can afford to wait and see until a good reverse merger candidate pops up that can make use of the losses. The only drawback is that the board appears to be too passive. We tried to introduce a company to them last year but our phone calls were not returned by the board member who is supposed to look at candidates. Moab Capital, an event-driven hedge fund run by former Perry Capital managers Michael Rothenberg and David Sackler with approx. $120 million under management, bought its 12.5% stake in the hope of a reverse merger last year above $1.80. Cadus now trades in the $1.50s. But with Carl Icahn and GlaxoSmithKline together owning almost half the shares, it will difficult to get Cadus out of the benign neglect mode. Icahn and GlaxoSmithKline have better things to do than spend time on a $25 million company, which is a mere rounding error in their portfolios.

We believe that cash shells are attractive vehicles if their NOLs are utilized properly. We understand that it can be difficult to find a suitable reverse merger target that will qualify as a continuing business and that is also has the right size for a merger structure in which less than 50% of the shares change hands. Both are criteria under IRS rules for the preservation of NOLs. However, if management can find a suitable company and minimize expenses during the search, then shareholders can enjoy a much more significant upside than in a simple liquidation.

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

The cancellation of the shareholder meeting coupled with an increase in the buyout price was caused by insufficient shareholder votes in support of the $1.85 deal. Entrust has adopted high pressure sales tactics otherwise characteristic of pump and dump schemes to force through the Thoma Bravo deal. It claims that the increased $2 proposal is the final offer. However, Thoma Bravo has pursued Entrust since September 2007 with the intention of “using the Company as a platform to make further strategic acquisitions”(DEFM14A). So there is value in Entrust not just as a going concern but also as the core of a roll-up strategy. In addition to Thoma Bravo, there are three other potential buyers who have submitted higher bids during the go-shop period.

Adding to the high pressure tactics is the unchanged record date for the meeting. Anyone who bought shares after May 11 will not be eligible to vote on the revised deal. Not changing the record date is a trick to convince a few marginal investors to back the deal. The strategy of maintaining the old record date is consistent with our view that the vote fell just short of the required 2/3 majority. Management has postponed the meeting twice now: first by one month to July 10^th, and now again by another month to the 28^th coupled with an increase in the consideration. They seem to feel that they are close to the requisite number of votes. As we pointed out in our last post, almost 22 million shares have traded since the record date at levels of up to $2.10. In the meantime, another 6 million shares have changed hands. Shareholders who have voted already for the deal are unlikely to change their vote if they have since sold their shares, and those who bought shares will not be able to vote.

The lack of detail about the go-shop period continues to irk us. Management has not disclosed the prices at which the three higher priced proposals were made. Were they made at just a cent or two over Thoma Bravo’s? If so, the price levels would probably have been disclosed as shareholders would probably agree that it’s not worth chasing an extra cent or two. However, the lack of disclosure suggests that the prices came at a substantial premium to Thoma Bravo’s $1.85. We also believe that they were made at levels well above the revised $2 deal. Were Thoma Bravo the highest priced bidder at $2, the Company would have made that clear in its extensive pro-buyout propaganda.

It is also odd that the board accepts a higher price without going through a new market check. Clearly, there was interest during the go-shop period at higher prices. If the buyer now voluntarily suggests a higher price, then maybe there has been a fundamental change in the market that has increased the value of Entrust not only to Thoma Bravo, but also to other potential acquirers, including the three that came forward during the go-shop period.

Proxy advisory firms were split on the original $1.85 transaction: RiskMetrics (formerly ISS) opposed it, where as the smaller firm Glass, Lewis & Co and Proxy Governance recommended a vote in favor. We hope that in light of the sudden increase in price, the two supporting proxy advisers finally come to their senses and see how flawed Entrust’s sales process is.

Entrust’s board continues to be split over the buyout. Independent director Douglas Schloss abstained from the revised $2 proposal. We think that shareholders should remain skeptical about the buyout and hold out for a higher price that comes from a proper market check of Entrust’s current value.

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).

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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.

And by the way, why does management not 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).

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).

But first an overview over the universe’s demographics. Emerging managers encompass a wide range of firms. Joanne Infantino of the CFA Institute gave a brief overview over the emerging manager demographic. Historically, the term has been applied to minority and women-owned money management firms with a high degree of employee ownership and have less than $1 bn in assets under management. In the Altura database, the current average AUM is $257 million and average number of employees is 10.3. As a group, they employ over 8,000. Total assets held by emerging managers are $200 bn, representing a mere 1.6% of tax-exempt institutional assets. Michael Moy of Pension Consulting Alliance quotes numbers from Pension & Investments whereby only 100 mega asset management firms control 86% of global institutional assets. The Deal Sleuth believes that such a concentration of market power among so few decision makers should alarm all investors who build asset allocation models under the assumption of efficient markets with atomistic participants. As an aside, attrition rates between established and emerging firms are similar for equity managers, but emerging manager attrition is higher for fixed income.

What counts in the end are risk and return, and by most metrics, emerging managers beat their larger competitors. Even though the margins may seem small, we assume that readers of this space are familiar with the power of compounding over long periods and will not go deeper into this question. Michael Moy shows that even in the over-researched large cap core style box, emerging managers outperform mainline managers and achieve slightly lower standard deviation (see figure below). He also showed that in terms of skewness, emerging managers match mainline institutions. However, they beat mainline managers on kurtosis, where larger firms tend to exhibit long tails, whereas emerging firms have no statistically significant tails.

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Mainline managers achieve a return of only -0.72%/year compared to +0.93% for emerging managers. The respective standard deviations are 16.50% and 15.97%.Source: Michael Moy, PCA. Based on Altura data.

A similar case as for large cap core can be made for fixed income, except that the advantage of emerging managers on kurtosis is no longer present.

Cesar Gonzales of Progress Investment Management underlined the outperformance with whole range of statistics, of which we can repeat only a few here. Cesar based his analysis on firms in the database of eVestment Alliance. His breakdown of large cap core performance by managers’ firm size show the clear outperformance of small firms:

The information ratio is also much better for smaller firms than the large managers. As a reminder, the information ratio measures a manager’s risk-adjusted outperformance. It is the active return (manager return minus index) divided by the active return’s standard error.

Click to enlarge.Source: Cesar Gonzales, Progress Investment Management

Readers who are still not convinced should consider the down market capture ratio of emerging managers. Anyone who lost a bundle in the recent crash with a large brand name firm would have fared much better with an emerging manager. Firms with more than $1 billion of AUM have captured almost 100% of the downside, whereas niche player with less than $100 AUM have not even captured three quarters of the downside.

Click to enlarge.Source: Cesar Gonzales, Progress Investment Management

These are the statistics for large cap equity managers, and we can extrapolate that the small firm effect should be even more pronounced when we look at smaller market capitalizations. For small caps in particular, where smaller firms can have an edge over big ones, we would expect that the statistics look even more favorable for emerging managers. Cynthia Tusan quoted a 2007 study by Gregory C. Allen of separate account managers that shows that although smaller managers have an edge over mainline firms across the entire capitalization spectrum, the effect is most pronounced for small caps.

Source: Cynthia Tusan. Based on “Does Size Matter?” by Gregory C. Allen, Journal of Portfolio Management, Spring 2007.

The successes of emerging managers are not limited to traditional asset classes and hedge funds. Mary Kelley of Invesco Private Capital pointed out that 21% of all private equity funds between 2005 and 2008 were raised by emerging managers, representing only 6.5% of the committed dollars. Invesco’s Emerging Manager Partnership Index has outperformed the Venture Economics All Private Equity Index, with 60% of all funds achieving first or second quartile performance.

Acceptance of emerging managers by institutional investors is increasing slowly. Mandates continue to be awarded for the most part to the largest 85 firms that each control at least $50 billion in assets, and have grown to a size where they no longer are capable of adding value. Nevertheless, a number of plans have adopted specific mandates to allocate small stakes to emerging managers, and some firms have even rolled out emerging manager funds. Even investment banks are capturing the trend, with Morgan Stanley (MS) reportedly planning to roll out an emerging manager platform. As a result, emerging managers themselves have changed. It is not uncommon today to see small firms backed by larger sponsors, that act effectively like venture capitalists or incubators.

Investors’ motivation for hiring emerging managers goes deeper than mere performance and the quest for alpha. It is now accepted that the high percentage of employee ownership serves as a better incentive for performance than the indirect bonus structure of large firms. In addition, concentration risk of ideas from mainline firms is best countered by diversification of ideas that goes far beyond the top 100 firms. As a result, we expect to see more interest in emerging managers and the development of many more emerging manager programs over the next few years.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which engages in merger arbitrage, capital structure arbitrage, proxy fight and distressed securities investments. 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).

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 that their exercise is coming up on June 19^th. Options on 23% of outstanding VW shares will expire that day, representing almost half the free float. Currently, Porsche owns 50.8% of the common. Most of the outstanding options are likely to be held by Porsche, which has announced that it controls some 75% of VW shares through direct ownership and OTC options. Many of the options are cash settled. The banks that sold Porsche the options are likely to have hedged themselves through exchange-traded options and also by acquiring underlying shares and hedging them with puts. This would explain the large number of outstanding puts with strike prices between Eur 100 and 800.

The risk is that the unwinding of the hedges on cash settled options will lead to massive selling of the VW shares. This would depress the value of Porsche’s holdings of VW, and flow through the income statement. Much of last year’s gains by Porsche were realized through the appreciation of VW shares during the short squeeze. Upon the expiration of the options, the opposite effect may happen, and Porsche will face losses of billions of Euros.

Porsche has debt of Eur 10bn, much of it incurred in the acquisition of VW shares. Porsche needs an additional Eur 2.5 billion in working capital to keep its business going. So far, only Bank of Tokyo has committed Eur 750 million.

It has now been made public that Porsche was already skirting insolvency in late March, when Eur 10bn of debt came due. Porsche was saved only when government-owned banks agreed to extend credit, and Volkswagen chipped in an Eur 700 million bridge loan that will mature in September. The Porsche/Piëch families owns large stakes in both VW and Porsche. The Porsche family hypothecated parts of its Austrian dealership network for some of the loans. Although the seriousness of Porsche’s situation was not known at the time, the market did see an increased default risk for Porsche.

The question is whether Porsche will be able to raise sufficient capital in the next three weeks, and how large its cash needs will be upon the expiration of the options. Not all VW options are cash settled, so that Porsche will have to buy some VW shares at the strike price. There have been rumors that a middle Eastern investor might acquire a stake in Porsche. No names have been mentioned, but with Dubai having troubles of its own, we think it could be the KIA (Kuwait Investment Authority), which has owned a large stake in Daimler(DAI) since 1970.

VW’s CEO Piëch talked about a potential “insolvency” of Porsche as a result of its trading in VW shares. It is ironic that the engineers of one of the largest short squeezes now find themselves begging for liquidity only months after squeezing hedge funds by removing liquidity from VW’s common stock. Porsche is unlikely to find much sympathy for its plight.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which holds long and short positions in different Volkswagen securities. 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).

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Welcome, AQR. Seriously.

Welcome to the most exciting and important marketplace since the hedge fund revolution began with Alfred Winslow Jones 50years ago.

And congratulations on your first mutual fund.

Putting real investment power in the hands of the individual is already improving the way people invest, think, build portfolios, and will spend their retirement years.

Financial literacy is fast becoming as fundamental a skill as reading and writing.

When we launched the first event-driven mutual fund, we estimated that millions of investors worldwide could justify the investment in alternative strategies, if only they understood the benefits.

Next year alone, we project that many more will come to that understanding. Over the next decade, the growth of alternative strategies mutual funds will continue in logarithmic leaps.

We look forward to responsible competition in the massive effort to distribute these strategies to the investment world.

And we appreciate the magnitude of your commitment. Because what we are doing is increasing financial capital by reducing portfolio volatility.

Welcome to the task.

Cliff Asness’ AQR gathered some press when it launched a mutual fund earlier this year. It has since been followed by Permal, which runs a tactical allocation fund under Legg Mason’s umbrella, and GLG with a U.K.-based retail fund. So the move by hedge fund managers to mutate from performance generators to classic asset gatherers is in full swing.

One of the absurdities of the hedge fund bubble is how little emphasis was put on longevity, and how pedigree came to replace longevity as a predictor of success. Anyone who has been in the investment business for some time knows that longevity is the most important predictor of long-term success. If pedigree were important, then George Soros should have never gotten anywhere: he started his career as a traveling salesman in Wales. Longevity will get you Morningstar and Lipper ratings, and AQR will have to wait three years to get there. Which shows that there is such a thing as an early mover advantage in mutual funds.

It is unfortunate that it is completely lost on most commentators that these hedgies are not the first mutual funds running hedge fund strategies. There has been a sizable minority of mutual funds that has managed alternative strategies for years, including yours truly. And what seems also lost on commentators is that the expense ratios of all these funds – between 1.50% and 2.0% – are well below those of typical hedge funds. Management fees alone run 2% in a hedge fund, and other expenses come on top. Not to mention the performance fee. A typical hedge fund has a 2.3% expense ratio plus a 20% performance fee. So a fixed expense ratio of less than two percent is a real bargain and evidence that the market for raising hedge funds is pretty much saturated, so hedge fund managers seek growth from lower-margin products. Commentators should stop calling mutual funds with alternative strategies “expensive”. They are bargains compared to hedge funds.

So let’s look briefly at the portfolio of the AQR Diversified Arbitrage Fund ADANX. It has almost half of its assets in SPACs. For readers unfamiliar with this acronym, we have written about SPAC arbitrage elsewhere in this space before. The problem is that the opportunities in SPACs existed mostly last fall, when we (or rather, our event-driven fund PAEDX) first got involved with them; by the beginning of this year, when AQR’s fund became active, they had disappeared for the most part. At the moment, we don’t expect much return from the SPACs held by AQR. The following table shows a list of annualized returns that can be achieved from the SPACs that AQR’s fund held on March 31^st:With these annualized returns on half of the fund’s assets, we would not expect any stellar returns, especially not after deduction of the 1.5% expense ratio. We think that they hold SPACs mostly as a marketing gimmick, as they have received quite a bit of press lately. The other large positions in the portfolio are mostly convertible bonds. We did not see any merger arbitrage positions among the top 25 holdings, although that is the specialty of two of the four managers, Todd Pulvino and Mark Mitchell.

So again, we welcome AQR, GLG and Permal to the mutual fund world. We welcome you to your transformation to asset gatherers. We wish you all the best with not cannibalizing your high cost hedge funds. And any other hedge fund manager who wants to follow the lead of AQR and launch a mutual fund with an alternative strategy, give us a call. We have been running one for more than five years, and got the star rating to prove it.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which engages in merger arbitrage, capital structure arbitrage, proxy fight and distressed securities investments. 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).

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.

Needless to say, we were at first a little nervous about the adjournment. The trick is that because the meeting had been scheduled, it had to be opened and immediately adjourned by a vote of the shareholders. So we were nervous that some other business potentially could be transacted in our absence (we didn’t bother trekking to Delaware just to observe an adjournment). Fortunately, the only business conducted was the adjournment.

The adjournment was only possible through a vote of the majority of shareholders. So in addition to the votes controlled by management, other shareholders had to support the adjournment, too. We understand that Full Value Partners/Bulldog voted their shares in support of the adjournment. Which raises the question of why Bulldog would support an adjournment. Normally, shareholder meeting are procrastinated when management needs extra time to solicit votes in its support. If this were the case with this Wilshire meeting, Bulldog obviously would not have supported the adjournment. We do not know exactly what happened behind the scenes, but the circumstances suggest that something important is brewing.

We doubt that Bulldog cut a deal with management for some board representation, as someone who called us suggested. This contentious election will have an all-or-nothing outcome: either Bulldog gains two seats, or management does. Neither side has a motive to compromise if it can win.

Similarly, we cannot see Bulldog agreeing to adjourn the shareholder meeting to allow management to solicit additional votes in its favor. If Bulldog supports the adjournment, the most likely scenario is an event that makes the fight over control of Wilshire moot. The only event we can think of is a sale of the company. If Bulldog wins two seats at the current meeting, they will win another two at the next one in August, and Sherry Wilzig will lose control. A sale would give the current CEO Sherry Wilzig Izak a face-saving way out.

Last year, a similar chain of events unfolded when Nick Jekogian’s NWJ made its ill-fated attempt to acquire Wilshire for a bargain-basement $3.88/share. Wilshire first amended its 10-K filing with information that would normally be included in the proxy statement, because the special meeting to approve the acquisition was likely to be held after the deadline for the annual meeting, and there was no point in having two meetings in a single year. Of course, management did not reveal that it was working on a sale when it amended its 10-K. This left us to speculate about its real intentions.

We feel that we are now going through a similar scenario. Management is, of course, tight-lipped, and so is Bulldog. We just hope that management will find a more serious buyer than the last one. How about a buyer who actually has the money to pay for Wilshire? We would advocate a sale of the assets rather than a sale of the entire firm, if only because real estate is a local business, especially for a small firm like Wilshire, and buyers for multifamily properties tend to be local operators. They are familiar with acquiring properties in their local area and have no expertise in dealing with a publicly traded company with properties in four States. We believe that a sale of the assets followed by a liquidation would achieve more value for shareholders than a sale of the entire company. Wilshire’s investment banker, FBR, has been chasing the wrong type of buyer. Inexplicably, the proxy during the NWJ acquisition shows that management had rejected a prospective buyer who wanted to buy the assets rather than the whole company, so we suspect that shareholders will not get maximum proceeds this time, either.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of Wilshire Enterprises and has submitted a proposal to abolish the poison pill. 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).
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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).

After management rejected Mercury Real Estate’s acquisition proposal as “undervalued”, Wilshire traded for $5.50 per share and dropped to the $3.80 level when Nick Jekogian attempted to buy it. That changed dramatically when management announced its new value enhancing strategy. The market assigns a negative value to that strategy: with cash on the balance sheet of over $2 per share, Wilshire trades slightly over $1.

We believe that the market’s skepticism is right. CEO Sherry Wilzig Izak has failed to show her ability to manage Wilshire profitably. Despite owning 950 rental units and 200,000 sf of office space, Wilshire is not profitable. A new COO, Kevin Swill, was hired in late 2008 to implement a new strategy: optimize rental income and gamble the cash hoard on distressed real estate. We are not convinced that Mr. Swill has the background to work on distressed real estate or manage a small publicly traded firm like Wilshire. He has no background in distressed real estate; according to Bulldog, he arranged the speculative acquisition of the most expensive office building in Manhattan ever, 666 Fifth Avenue, for $1.8 billion, or a meager cap rate of only 3.2%, marking the peak of the market.

666 Fifth Avenue

That’s a tad more expensive than what Wilshire can hope to play in. In addition, running a small business like Wilshire requires a different skill set than managing acquisitions for one of the world’s largest real estate holders during boom times. Wilshire’s spending is profligate already, and it risks becoming even more so under the new strategy if consultants and advisers are hired to help with acquisitions, as is typical for large investors like Kushner. Shareholders will have to pay expensive tuition to get Swill up to speed on small public company management.

Wilshire’s management and Bulldog have been bombarding shareholders with proxy materials ahead of the vote. Management’s materials are printed in color on high quality glossy coated paper to give shareholders the feel of a billion dollar company. Bulldog’s mailings are more frugal and more appropriate for a small firm. This detail is symptomatic for the entire proxy campaign: we expect Bulldog to spend around $20,000 of its own money, whereas management will spend more than $150,000 of shareholder funds – other people’s money.

Shareholders are at risk of finding themselves holding shares of a defunct company if management’s candidates win this election. Shares will drop to penny levels and Wilshire will be delisted. Maybe that is the intention – it would allow management to acquire the firm on the cheap. We continue to bet that Sherry Wilzig Izak will do anything necessary to maintain control and anticipate litigation between management and Bulldog.

Shareholders can vote until the cutoff time, which is Monday at midnight Eastern time. And those of you who make the trip to Delaware, we look forward to meeting you on Tuesday at 8:30.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of Wilshire Enterprises and has submitted a proposal to abolish the poison pill. 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).
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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.

Inevitably, the stock reacted by dropping to penny levels, as it did after the collapse of Bergstein’s acquisition. However, Image has since improved its financial condition significantly: in the last quarter its earnings improved by $0.10/share from a loss to a small profit, and its top line grew by a whopping 43.2%. Given these achievements, we have confidence in the capabilities of Image’s management.

Image Entertainment CEO David Borshell

Management’s proven ability to deliver differentiates Image Entertainment from the other collapsed buyout that we blog about: Wilshire Enterprises (WOC), where management changes were purely cosmetic and Sherry Wilzig Izak is still in charge despite years of failing to make money on rental real estate.

Image stands to collect a business interruption fee of $1.8 million from the failed deal. We would anticipate that the buyer Nyx/Q-Black will follow Bergstein’s lead and litigate in order to avoid paying, or get a reduction. Fortunately, management learned from the last deal and insisted on pre-funding of the business interruption fee, so it is in a stronger position this time. Merger-related expenses were $0.6 million last quarter, and we would expect a little less for the current quarter, leaving Image with a small profit. Maybe Image should change its business model and make business interruption fees its main source of revenue?

We thought $2.75 was a low price for Image Entertainment, but given where the market is were willing to go along with it. In light of the growth Image has experienced, in particular in its digital Egami division (read our last post about DISK) with no less than 68%. We think that a higher price target than $2.75 should be achievable for patient investors. Maybe Image’s management should give Carl Icahn a call to revive talks with Lionsgate once he takes control of that board. We wouldn’t mind selling at a discount to its last proposed price.

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

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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:

• Litigation to block the sale of shares to Bulldog;
• Acquisition of shares in the open market by CEO Sherry Wilzig with voting rights attached, although the record date has passed;
• Splitting the annual meeting into two;
• Expanding the board with an unelected director.

There was a brief period in late 2008 where Wilshire’s poison pill had expired and the board had not yet adopted a new one. It should be noted that the adoption of a new poison pill during a battle for control of a firm is a highly questionable maneuver that has little chance of being upheld in court, but the board adopted the pill anyway. Just before the new pill was adopted Bulldog acquired a block of shares that had previously been owned by a former business associate of Sherry’s late father Siggi Wilzig. The seller is said to be also Sherry’s godfather. They seem to have fallen out, if the scathing letter posted on the internet shortly after the sale by someone claiming to be related to the seller is authentic. Management has since been busy suing the brokerage firm that arranged the sale trying to void it. The goal of the lawsuit was to prevent Bulldog to vote its shares. The judge, probably annoyed by this case, ruled that the case would be decided after the shareholder meeting and only if the vote of these shares had made a difference. A partial defeat for management.

In a desperate attempt to gather the votes CEO Sherry Wilzig needs to keep her job at the upcoming shareholder meeting, she has been buying up shares in the open market. The record date for the meeting has long passed, so she had to resort to a trick to get the votes: she acquired the shares with voting rights attached through an irrevocable proxy. We are not making this up. We were approached ourselves by a broker from Gilford Securities, who informed us that

if you check the tape you will see that we found a seller of 279k WOC yesterday. The seller sold us this block @ $1.10 and executed an irrevocable proxy so that the voting rights transferred to my buyer. I have a limited amount of buying power left and others that I am in negotiations with, but I will bid you the same for all of your piece as long as you are willing to execute the irrevocable proxy so that your voting rights come with the piece. That would be enough to clean me up, and for that we are willing to pay the premium.

The Wilzig estate owns some 21% of Wilshire and one would have thought that the purchase by Sherry Wilzig bringing her holdings to more than 5% would trigger the poison pill and dilute her stake and that of the estate. However, since Sherry Wilzig bought the shares in her own name, she can probably get away with it as long as she does not form a formal group with the estate. We are sure that her lawyers have ring fenced the estate carefully to ensure that estate will vote for management without forming a group. Whether or not this would hold up to a test of facts and circumstances if it came to litigation is a different question. If management adopt such a high risk strategy where the poison pill could backfire, it shows that they are extremely desperate. And we won’t even discuss whether a CEO should be allowed to drive the share price to penny stock level through neglicence and then buy it up on the cheap, while clinging to the poison pill to block Bulldog from its good faith attempt to launch a tender offer.

Management also split the annual meeting into two. Rather than saving costs and holding a single meeting in 2009 to catch up for the 2008 meeting and hold the 2009 meeting both at once, management decided to hold two meetings in one year. It is a waste of shareholder money, but if management loses one election, maybe they can win the other. Due to the confusion over the shareholder meeting, Bulldog had to litigate to get its nominees on the proxy for the first meeting. The company settled the litigation and agreed to hold the second meeting no later than August 18^th.

Finally, management has expanded the board from six to seven members with one unelected board member serving an unspecified term. Since Bulldog will win four seats in this year’s proxy contests, two in March and two in August, the expansion of the board will not make much of a difference.

Wilshire owns 950 rental units, some 200,000 sqft of office space, plus some land, yet is unable to turn a profit. It also has a cash hoard of some $13 million, yet its market capitalization is only $8 million, reflecting lack of confidence in the CEO and her recently announced long term strategic plan for creating value. Even though management is unable to turn a profit with the real estate owned, it plans to add to its real estate holdings and become a major industry player. Good luck competing with Sam Zell’s Equity Residential or the Pritzkers with your paltry $13 million, much of which sits in unaccessible auction rate securities. We may have some confidence in that strategy if management had been able to at least make the current rental real estate profitable to market yields. One can argue whether or not it is the right time to sell now, but one can not argue that management should stay in place after so many years of failing to get the rent roll to grow at the same rate as expenses. The same CEO who drove the stock price down while real estate values were soaring now wants to create long-term value.

A friend of ours recently performed a valuation of Wilshire and found that the company should be worth a multiple of its current stock price if you make reasonable assumptions about the value of the apartments. The current management has been unable to run the firm profitably and there is nothing to suggest that they will ever get the firm anywhere near its intrinsic value.

So what is the likelihood that Bulldog will prevail at the two shareholder meetings? The last contested election was decided very narrowly by 2% in favor of management. There has been some change in the shareholder base in the meantime, and anyone who gave CEO Sherry Wilzig the benefit of the doubt (“initial bids are in”) is unlikely to do so again. We predict that the election will be close again, if only because of management’s dirty tricks to accumulate voting shares by skirting the poison pill and and sterilizing those likely to vote against them. The election may well be decided in court.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of Wilshire Enterprises. 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).
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