Following is a guest post from ninad kunder. I have been working with ninad and arpit on arbitrage deals for some time and we exchange notes and ideas. In the post below ninad has explained the framework we follow for an arbitrage or a special situation.

In addition, I have upoaded a template which I use to track such opportunities (look for file – arbitrage delisting template).
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My friend Rohit had in his earlier posts detailed out the Elantas Beck opportunity and the various milestones associated with the special situation opportunity.

The objective of this post, taking the example of Elantas Beck, is to list down the framework (in our limited intelligence 🙂 for managing a special situation opportunity and the thought process associated with it.
Before I run thru the framework and the thought process, let me just run thru a brief background about Elantas Beck.

About Elantas Beck
Elantas Beck is the subsidiary of Altana AG which is a specialty chemical major based out of Germany with operations spread across the world. Altana historically had a pharma business and a specialty chemical business. The company divested its pharma business and transformed itself into its current form.

Altana has four key divisions
1) ECKART
2) BYK
3) ACTEGA
4) ELANTAS

Elantas beck India is a 88% owned subsidiary of Altana and is aligned to the Elantas division globally. The other divisions at present have a marginal presence in the Indian market.

Process Framework
In any delisting opportunity and the same framework can broadly be applied across other special opportunities, there are 3 risk points in the transaction
1) Time Risk
2) Price Risk
3) Deal Risk

Let me address each of these risks with respect to the Elantas opportunity.

1) Time Risk
In any arbitrage opportunity even though the deal might go thru and at the price that we had defined, there could always be time delay involved in the deal which will shave off potential returns. This is especially true in the Indian context when there are court approvals required in certain special situation opportunities like mergers.
In the Elantas beck deal time risk was eliminated by constantly monitoring the milestones achieved in the deal. The entry point was timed only post the shareholder approval and once the company had filed with the BSE for the delisting process.

2) Price Risk – There were 2-3 ways to handle price risk in this transaction. This of course would be different for every transaction.

a) Valuation – As Rohit pointed out step 1 was to ascertain the fundamentals of the company and Rohit & Arpit (They are good at this :-)) arrived at a fair value of Rs 600 for the Elantas stock.

b) Ability / Inclination of the parent company -The interesting point is that the largest shareholder of Altana is taking Altana private and Elantas was the only listed subsidiary in the world. Market cap of elantas was 360 crores. So the parent would have had to cough up about 40-50 crores to do the delisting. It wouldn’t have been a big amount considering their balance sheet and 15-20% more wouldn’t have been difficult to stretch. Also having run their global balance sheet and other communication, it was clear that India was a high focus area for Altana and the other divisions were waiting to enter the country.

c) Expectation of market participants – When the delisting was announced ICICI emerging star had about 2.25% stake of the 11.5% public holding. They exited at around the 460-470 mark post the delisting announcement. So market participants who bought that 2.25% holding, at that price clearly bought it with an intent to tender it at a higher price in the delisting process.
Factoring in all the above variables Rs 600 was a reasonable estimate that was arrived for the delisting price.

3) Deal Risk – which brings us to the most imp variable in this transaction. We saw a high deal risk because of the dispersed nature of shareholding and out of the 8 lac outstanding shares there were 2 lac shares in the physical form. Though the current SEBI amendment has allowed physical holders to tender in the delisting process, we saw not too many shares getting tendered on this front.

Factoring in a high deal risk we defined 2 clear exit points which ever came earlier.
1) Price point – 520-525 levels (my comment: take advantage of the 10-15% pop in the prices)
2) Time point – Exit midway thru the book building process.

The call was clear not to wait till the reverse book building process closes and take whatever money was available on the table and not live with the deal risk. There is of course the behavioral angle to the transaction where the dopamine kicks in when one is actually in the thick of action and tends to not necessarily follow what was defined at the start of the transaction :-).

The special situation discussed in the previous post was a delisting announcement by Elantas beck. The plan was to benefit from the price appreciation between the deal announcement and the actual delisting.

A few Comments and some emails on the previous post made me realize that understanding delisting norms is really not everyone’s idea of fun. So let me try to explain it in brief (while omitting some details)

If you hear a thud sound while reading this post, it is likely you have fallen asleep and hit your keyboard while reading this post 🙂

Delisting process
You can find the delisting norms here. In brief, the rules for delisting apply when a company wants to delist all its shares from the exchanges (i.e go private with no public shareholding). It needs to go through a prescribed process which can be described in short as follows

1. Board approves delisting
2. Company seeks shareholder approval for delisting the shares. For the delisting to be successful, the company has to buyback atleast 50% of the publicly held shares. So if the public holding is 11.5 % (as in case of elantas), then the minimum buyback has to be 5.75% of the total shares for the company to delist from the exchange.
3. Shareholders approve the buyback.
4. The company launches reverse book building to discover the price at which it can buy 50% of the outstanding shares. The shareholders tender their shares to the company at their desired price. If the company finds that more than the outstanding number of shares have been tendered and the price for the 50% of the shares tendered is within their target price, then they can declare the offer successful. The company is then obliged to buy all the shares that have been tendered at or below the declared price.

Let’s try to understand this with an example. For simplicity, let look at the case of elantas beck.

Elantas announced a delisting and the share price jumped from 250 levels to around 450 levels in response to it. Finally the company announced on 7-dec, that the board has approved a buyback with a floor price of 219 which is the minimum price based on the delisting norms. In addition the board approved a price of 330 as the offer price. This would be the minimum price paid to the shareholders, if the discovered price turns out to be at or lower than 330 during the reverse book building process.

The price was steady around 470-480 levels and as the reverse book building date approached, it crept upto around 500 levels. Finally after the first two days into the book building process, only .5% of the shares had been tendered and the price in the open market was around 525. As the probability of the success of the offer was low, I exited the stock completely booking around 7-8% gain over the deal.

At the end of the tendering period (around 6-7 days), the company received about 25-30% of the outstanding shares and hence irrespective of the price tendered (which ranged from 210-1100), the offer was not successful (as less than 50% of the shares had been tendered).

About the company
It is not crucial to know about the company in detail in an arbitrage or special situation such as delisting. However when analyzing such a deal, it is important to have a look at the fundamentals of the company and evaluate if the company is overvalued by a large margin at the current price.
Elantas beck is into specialty chemicals for insulation and construction industry. It has performed well in the last few years with an ROE in excess of 20%, zero debt and a 10% growth in bottom line. The company has cash equivalents of around 35 crs which is almost 10% of the market cap. At the time of delisting the company was selling at around 16-17 times earnings which is right around fair value of the company.
If the valuation at the time of the announcement is high, the downside risk of the deal is high if it fails.

The calculations
The matrix in the previous post is the expected value analysis. The formulae for expected value is gain*probability of gain+loss*probability of loss.

I estimated that the delisting price would be around 580-600 and hence there was an upside of around 100 Rs. On the downside I expected the price to drop to around 360-370 levels and hence a possible loss of around 110-120 Rs. The probability estimates for each of the events was a subjective number and it depends on one’s experience and guess.

All this work for a measly 7%?
The return was around 7% for 1.5 months, which works out to 56% annualized. My return expectations are 20% per annum from arbitrage over the course of the next few years. There will be some deals which will work out well and some where I will lose money. In aggregate i am targeting 20% or more. I don’t expect too much from myself 🙂

The advantage of arbitrage is that the returns are not correlated to market returns. If you can evaluate the deals well, the returns are independent of the market. This helps in reducing the volatility of the portfolio and it is always a better to have an additional tool to invest and make decent returns.