A good portion of special situation investing, or ‘workouts’, involve transactions with limited upside and tight spreads, yet significant downside risk if the transaction is called off.

The drawn out situation with the Emmis Communications (EMMS) going private transaction is a prime example of the risks with these transactions.

Last week, the deal fell apart after the company failed to negotiate a deal with a group of preferred lockout holders and the company’s original financier, Alden Global Capital.

Transaction Background

As I originally wrote back in back in June, the company’s CEO and Chairman, Jeff Smulyan, was trying to take EMMS private in a cash offer for $2.40/shr.

At the time, the deal was offering a spread of nearly 5%, with most conditions for the transaction all but guaranteed since Smulyan owned a controlling interest in the radio operator.

Preferred Shareholder Lockout

However, as I wrote several weeks later, the EMMS transaction was derailed when a group of preferred shareholders came together to collectively vote against the deal.

While the intentions were never disclosed, it is likely that lockout group was trying to get better terms as part of the transaction, as the company’s original offer priced the preferred shares at only 60% of face value.

After the lockout was announced on July 9, the parties engaged in a back and forth round of negotiations over the next two months.

Vote Delayed – Again and again and again…

EMMS’s stock varied widely during the time period, generally falling during periods of no news before leaping back up after another extension.

On August 4th, the company put out a positive press release, saying that the company was seeking an alternative structure for the transaction, only to extend the offer again.

On August 30th, another extension was announced, but with new and dire language:

“Emmis, JS Parent, JS Acquisition, Mr. Smulyan, Alden and the representatives of the group of holders of Preferred Stock negotiated and agreed in principle on revised economic terms for the contemplated transactions that each indicated it would support. Subsequently, Alden has informed Emmis, JS Parent, JS Acquisition and Mr. Smulyan that it would no longer support the negotiated terms. Accordingly, although discussions are continuing, JS Acquisition believes it is unlikely that an agreement will be reached with either Alden or the group of holders of Preferred Stock.”

In total, the shareholder vote was delayed a staggering 9 times, as it looked increasingly unlikely that the transaction would be completed.

Deal Falls Apart

On Sept 9th, EMMS’s going private transaction officially collapsed. According to the company’s COO,

“I think Jeff and the entire Emmis team are bitterly disappointed that the transaction didn’t conclude successfully,” Patrick M. Walsh, Emmis’ chief operating officer, said Thursday morning. “We thought we had a deal, and it’s unfortunate that Alden backed away from the deal.”

The stock market reacted swiftly, and the stock dropped more the 33% over the ensuing week.

Exiting my Position

I held onto my stock through most of the long ordeal, counting on the fact it would be very difficult for Smulyan to walk away from the deal again if there was any way possible to complete the transaction.

In addition to the negative press release on August 30th, strange trading in the preferred shares caught my eye as well. I’d been closely monitoring the preferred shares throughout the ordeal, figuring they would give a better picture about the odds of success.

On Thurs, Sep 2, the preferred shares (EMMSP) dropped more than 14%, with a large sale of 8.1k shares. This was by far the largest sale in the previous 2 months, and significantly below the original purchase price of many of the lockout holders.

Combined with an increase in the common price (the common & preferred had traded mostly in sync since the lockout), it appeared that someone ‘in-the-know’ had sold out.

I sold my shares on Friday, August 30, at $1.70, for a loss of 26%.

Lessons Learned

These special situations investments are designed to supplement an existing portfolio, with many ‘easy’ transactions for small but guaranteed profits.

With these investments, it is very easy to feel committed to a position, even though the circumstances surrounding the deal can change drastically.

In hindsight, I should have sold my shares for a small loss as soon as the lockout was announced (knowing I could probably buy back in if a deal was reached again.)

I’m sure a similar situation will occur in the future, and next time I’ll be disciplined enough to sell when the guarantee is no longer there.  No sense in being too risky while picking up nickels in front of a steamroller!

Disclosure

None

In workouts and special situations, the goal is to invest in ‘sure-things,’ where all or most of the conditions for the transaction are satisfied, but yet the market still offers an attractive spread.

In the case of the EMMS going private transaction, it appears I jumped the gun with my initial investment, as recent news has substantially changed the details of this investment.

Shareholder Approval

The deal is subject to both common and preferred shareholder approval. The common share vote is assured, as the Company’s Chairman & CEO, Jeff Smulyan, already owns 60% of outstanding shares.

For the preferred vote, a 2/3 majority was needed. Since Alden Capital Management, the company providing the financing for the transaction, owned 41% of preferred shares, I thought that preferred vote was likely as well.

Turns out I was wrong.

Preferred Shareholder Lockout

On July 9, a group of preferred shareholders led by Geoffrey Raynor and Daniel Loeb filed a lock-out agreement to vote against the proposal. In total, the group holds more than 33% of outstanding shares, effectively blocking the transaction.

Under the current agreement, preferred shareholders are being offered new bonds at a 60% discount to the face value of $50 per share.

Based on the 13-D filings, Loeb and other investors recently picked up preferred shares around $20 – from my reading, they do have upside under the current offer already.

Although the purpose of the lockout has not been disclosed, it seems that the group of investors sees additional upside in the preferred shares, and will likely lobby for Smulyan to sweeten the conversion ratio.

The lockout is expected to expire on September 30 unless an agreement is reached.

Common Shareholder Lawsuits

Also troubling, is that an Indiana court judge still needs to rule on the common shareholder lawsuits that have been filed regarding the transaction. On Monday July 19, the judge heard arguments for a preliminary injunction to block the transaction. According to the plaintiff’s lawyers:

“We’re not arguing the price. What we’re saying is that people should have the right to make a fully informed decision on whether they like the price.”

On the other side, EMMS’s lawyers argued that Indiana state law prohibits common shareholders from blocking these type of transactions.

The judge expects to make a ruling by the end of this week.

Another lawsuit suggests that the Company, despite several amendments to the proxy filing, still hasn’t fully disclosed all material information about the transaction.

Lessons Learned

From an investing standpoint, one big lesson is to be aware of shareholder lawsuits. The legal world can be tough to understand, and it brings along a great deal of uncertainty and roadblocks to any transaction.

These types of lawsuits seem to pop up at the beginning of every merger, but are usually quickly settled – in this case, the transaction has continued to linger.

Although it would be difficult to anticipate the preferred lockout, lawsuit problems can be avoided by just waiting for the final ruling before making an investment.

Conclusions

In reality, if common shareholders are forbidden to block these types of transactions under Indiana law, the lawsuit doesn’t seem to have much merit, and should hopefully be dismissed this week – although some risk certainly remains.

Positive Spin

I don’t think Loeb and the other preferred investors are trying to block the transaction outright, as it appears like EMMS has few other options for restructuring or unlocking value.

In addition, Smulyan has a heavy financial interest (since he owns 60% of common shares) in this merger, and has already tried and failed to take the Company public back in 2006 – meaning he has a vested interest in seeing this merger go through.

Negative Spin

The Indiana judge could rule that common shareholders are allowed to block the transaction (a setback, even though the preferred lockout has accomplished pretty much the same task).

Preferred shareholders demand the higher payout, but Smulyan cannot get approval from Alden Capital to raise the price.

With the deep decline in other radio stocks over the last few months, Smulyan might decide the price is too high and walk away from the transaction – again.

Discussion

-Do you think the transaction will go through by August 3?  At all?

-What outcome are the preferred shareholders hoping for?

-Sell or hold?

At the time of this writing, I still hold a small position in EMMS.  I will be closely monitoring the results of the shareholder lawsuits, along with the negotiations with the preferred shareholders – if there is a substantial change on either front, I’ll have to sell at a loss.

Links

Lockout Agreement

Jeff Smulyan Facing Emmis Options

Judge Hears Arguments Challenging Emmis Sale

Another Lawsuit over Emmis

*Update – 7/27/10

The Indianapolis Star is reporting that the honorable Judge Robyn Moberly has decided to deny the petition from common shareholders to block the proposed going private transaction.

Smulyan still faces a class action lawsuit in NY and must work out a deal with the preferred shareholder lockout group, but this is a definite step in the right direction.

*Update – 08/04/10

The EMMS tender offer was supposed to wrap up yesterday.  With no news from management as it neared the deadline, the market grew increasingly concerned, with the stock dropping more than 15% on Monday and Tuesday.

However, EMMS jumped more than 30% today on news that the tender offer would be extended until close of business on Friday, August 6.

Smulyan and the preferred shareholder group are still negotiating a deal to end the lockout, including a possible alternative structure:

“that would still allow a tender offer for the Class A Common Stock to proceed without any changes to the terms of the Preferred Stock and without an offer by Emmis to exchange the New Notes for the Preferred Stock”

This looks to be extremely positive news for Common shareholders.  If an alternative structure is approved, the common offer can proceed as planned, while also removing the risk of having to refinance the deal due to increased financial consideration.

Also, a two day extension seems to indicate that the negotiations are close to completion.  It would be a little embarrassing for Smulyan to postpone the date again after only two days, especially since the outside date for the transaction is set for Sept 24.

I think it’s highly likely that shareholders will receive a decision on Friday.

Disclosure

Long EMMS

Analysis

Background

On May 25, 2010, Emmis Communications Corporation announced that it signed a merger agreement with JS Acquisition, LLC, a company owned by EMMS’s Chairman and CEO, Jeffrey Smulyan, effectively taking the company private. Common stock holders will be cashed out at $2.40 per share in a deal worth approx. $90.2m. The deal has been in the works since late April, when the company received a letter of intent regarding the going private transaction.

Terms

Holders of Class A common stock will receive $2.40 for each share tendered. Other considerations are due to preferred stock holders.

Shareholder Complaint

As often happens in these transactions, several lawfirms are investing whether the board of directors breached its fiduciary duties to shareholders by accepting the going private offer. These lawsuits allege that the closing price of $2.40 is only 11% above the most recent closing price of $2.38.

However, I do not see this as being a major roadblock to the transaction. The only reason for the small premium was that a letter of intent was signed back in April. The $2.40 offer is 74% above the 30-day average trading price and 118% above the 180-day average trading price, a significant premium.

Board Approval

The board approved the transaction in conjunction with the merger announcement.

Shareholder Approval

In order to approve the transaction, a majority of common shareholders must tender their shares in favor of the merger. Since Jeffrey Smulyan owns 60% of outstanding Common Shares, this part of the approval is already assured.

In addition to the common shareholder approval, 2/3 of Preferred Stock holders must also vote to tender their shares. Alden Global Capital, the asset management company that is providing financing for the transaction, holds 41% of outstanding preferred shares and has voted to approve the merger.

This means only 25% of preferred stock holders must vote to approve the merger in order for the transaction to go through.

Timeline

The tender offer will commence on June 3, 2010 and will last at least 20 business days. Assuming preferred shareholders promptly tender their shares, the going private transaction should commence sometime around July 1, 2010.

Discussion

Unless something falls through with the financing, I don’t see very many risks with this transaction. Jeff Smulyan controls the majority of the company and seems to have the backing of the board and the largest preferred shareholder. I’m anticipating the merger will go through in July.

Shares can be picked up for $2.29 per share, resulting in a quick ~5% return in just over 30 days

Supporting Documents

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Disclosure

Long EMMS