Using Corporate Actions to create Value Investing opportunities, Delhi

Contributed by: Manan Agrawal CFA, IAIP Volunteer

The Delhi chapter of IAIP organized this Speaker Event on 9th June 2013. Ashish Kila, head Perfect Research, a proprietary fund that follows the Value Investing approach to investing in Indian listed Equities and Special situations, spoke about Value Investing opportunities generated by corporate actions such as open offers, de-listings, demergers etc.  Ashish discussed Open offers in depth,  offered practical insight with live examples and case studies from his own Investing experience. The event was well attended by both IAIP members and non-members. This event qualified for 1.0 CE credit hours.

Special Situations are opportunities arising from publicly announced corporate activities. The gross profits in such a situation appear quite small, but their predictability coupled with a short holding period produces quite decent average annual rate of return (20%+) after allowance for the occasional substantial loss.  The list of special situations includes spinoffs, mergers, restructurings, rights offerings, bankruptcies, liquidations, asset sales, de-listings, de-mergers, tender offers, open offers.

Open offer is an offer from either the promoters or a big investor to buy shares from the open market at a fixed price (which is mostly at a premium to the prevailing market price). Open offers result from increasing stake and takeover situations.  Open offers are preferable to other special situations because they have well defined timelines, very low failure rate, and they can be used as an opportunity to create cheap shares. Many open offer opportunities are available throughout the year.

SEBI regulates open offers via SEBI’s SAST regulations 2011 – Regulation 3(1) and 3(2). Open offers can be voluntary or mandatory.  The minimum open offer size is 26% of total shares of target company in case of acquisitions, and 10% in case of voluntary open offer.

Open offers are publicly announced on BSE website under Corporate announcements. Open offer process takes around 3 months to complete. The process starts with a Public announcement followed by Detailed Public statement, filing of Draft letter of offer with SEBI, SEBI’s comments on DLOF, dispatch of DLOF to shareholders, opening of open offer, closing of open offer, and finally, a post open offer announcement.  Open offers remain open for 10 working days. Delays can happen while SEBI is giving its comments on DLOF while SEBI is questioning the merchant banker.

Ashish shared a checklist listing points to check while considering any open offer.  One should watch out for things like Acquirer background and Financial strength, Any previous violation under takeover regulation, statutory approvals (from RBI, CCI, FIPB), deal structure (preferential allotment, SPA, SHA details), whether the acquisition give any synergy or not, chances of price revision of open offer,  retail shareholding.

The risks in open offers are twofold – Deal risk (deal may not go through from regulatory side), Time Risk (delay in getting various regulatory approvals). It is extremely difficult to withdraw Open offers once made. Open offers once made cannot be withdrawn except when statutory approvals are refused, or when the board decides to withdraw due to some event, and SEBI also approves this request. SEBI often disapproves withdrawal requests. For example, Nirma Industries made a mandatory open offer for acquiring shares of Shreerama multitech ltd. in July 2005. Later, Nirma found discrepancies in financial accounts of the target company. Nirma filed a withdrawal application with SEBI but SEBI disallowed.

As for taxes, there is no STT for selling shares in Open offer. Due to this, the concessional tax rate on long term Capital gains is not available.

Ashish viewed open offers from two different perspectives – 1) from a long term Value Investing standpoint (as an opportunity to create cheap shares), and, 2) short term Arbitrage.  Ashish gave two examples of open offers made by RHI and Tube Investments in 2012 for Orient Refractories, and Shanthi Gears respectively. Ashish discussed the analysis one needs to do given the shareholding pattern before the offer and considering various scenarios assuming tender from various categories of shareholders. Because of the limited size of an open offer, less than 100% of the tendered shares get accepted. The effective cost of the remaining shares (shares which are not accepted) works out to be cheaper (than the market price of the shares of the target company at the time when  the open offer was announced).

From a long term Value investing perspective, in case of open offer involving Orient Refractories, the open offer price was Rs 43. The market price of Orient’s shares when open offer was announced was Rs. 37.5. The acceptance ratio was 74% (i.e. only 74% of the tendered shares got accepted). So, if one had purchased 100 shares at Rs 37.5 (the market price of Orient’s shares when open offer was announced), one would have been able to sell only 74 shares in the open offer at Rs 43 a share. The cost per share of the remaining 26 shares works out to Rs. 22 a share. [This is much lower than Rs. 37.5 a share]. Hence, one was able to create shares in Orient Refractories at a substantial discount to current price.

From a short term arbitrage perspective, an arbitrageur can hope to exit the remaining shares at a price equal to the market price of shares when there was no open offer announcement.  For example, On 13 July 2012, Tube Investments came up with an open offer for Shanthi Gears at Rs 81 a share. A week after this announcement, market price of Shanthi Gears was Rs 68 a share. Based upon an analysis of market price of Shanthi Gears before the open offer announcement, one could have estimated an exit price of Rs 52 a share for shares left after the open offer. The actual acceptance ratio was 74%. Open offer ended on Nov 2012. So, if one had bought a 100 shares at Rs 68 a share, 74 shares would have been accepted at Rs 81 a share, and the 26 shares remaining after the open offer could have been sold in the market at Rs 54 a share. Having done this, one could have generated a 9% return in just 5 months (which is equivalent to 21.6% annualized return).

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