Lately, my normal screening tactics have returned very few investment opportunities that satisfy my traditional ‘bargain bin’ value investment philosophy. Because of this, I’ve been doing more and more research on arbitrage opportunities and other special situations to round out my portfolio.

(See analysis example of the PBCI & BCBP merger)

I’m happy to report that I officially completed my first special situations investment last week, when CHDN merged with UBET. For more background, check out my initial writeup on the merger.

Announcement

Filed on Wednesday June 2:

“Churchill Downs Incorporated (“CDI”) (NASDAQ: CHDN) announced today that it has completed its merger with Youbet.com, Inc. (NASDAQ:UBET). As a result of the merger, each share of Youbet.com common stock was converted into the right to receive 0.0591 shares of CDI stock and $0.99 in cash.”

The initial terms of the deal called for a conversion ratio of 0.0598 in CHDN stock and $0.97 in cash.  However, the conversion ratio was open to adjustments in order to limit the number of shares CHDN was required to issue.

Investment Breakdown

Based on my initial entry points, the arbitrage opportunity was offering estimated gains of approx. 12.5%.  I’ve included my timeline below.

1. May 5 – I entered an initial position in UBET at $2.90. At the same time, I entered a corresponding short position in CHDN at $38.29, based on the conversion ratio of 0.0598.
2. May 7 – I added to my position in UBET at $2.80, balanced with a short position in CHDN at $36.51.
3. June 2 – Official merger announcement
4. June 5 – My UBET shares were converted into shares of CHDN at the new conversion ratio and I received cash considerations of $0.99 per share.  Due to the slight difference in the conversion ratio on closing, I ended up with a few extra shares of CHDN which I quickly covered at $32.35.  I then closed out long/short position in CHDN to end the trade.

Return

To wrap my head around the accounting, I considered the two trades as separate positions. Overall, I gained 12.25% and 12.45% respectively, or 308.15% and 317.02% annualized.

Takeways

-This was my first time shorting stock and I was never aware that brokers charge “hard-to-borrow” fees on all but the most liquid stocks. Since most of my investments will be in obscure opportunities, this is definitely something to keep in mind.

BTW, does anyone have brokerage recommendations? I’m using currently Zecco  (the free trades are great) but might need to expand if I continue with these more complicated transactions.

-Merger arbitrage, especially stock & cash mergers, involve much more complicated gain/loss scenarios than standard stock investments. I spent way too much time figuring out my final tally on this position.  In hindsight, it might have been prudent to start with a simpler transaction but I’m happy I forged ahead – the return was too good to pass up!

-As in all investment scenarios, it is important to have a margin of safety in any transaction. Too many things can go wrong with merger arbitrage  – entry points, commissions, market timing, fractional shares, etc. all make the real world outcomes of these types of trades different than how they appear on paper.

-Successful special situations investments have the potential for truly eye-popping annualized gains.

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

Analysis

Background

On June 30th, 2009, BCB Bancorp Inc (BCBP), a small community bank with three branches in NJ, offered to purchase Pamrapo Bancorp (PBCI) in a transaction valued at $46.6m. It was a friendly transaction with both company’s board of directors voting for the merger.
Mark Hogan, Chairman of BCBP –

“We believe the partnership will solidify the combined entity’s Hudson County franchise and presents the opportunity to generate earnings and attractive returns to both groups of shareholders. The combination will greatly assist us in developing a more responsive and efficient institution while holding true to our tenet of customer service.”

Kenneth Walter, CEO of PBCI –

“We believe that this transaction is a great opportunity for our shareholders and will benefit our customers, employees and our community. We can continue with our philosophy of providing a high level of customer service and local decision making in our market area but will now have the added benefits of being part of a larger organization with much greater resources, lending limits and convenience for our customers.”

Terms

PBCI shareholders will receive 1.0 share of BCBP.

Shareholder Complaints

Despite friendly management terms, it has been a rough road since the merger announcement. On Dec 2, 2009, PBCI’s former president and largest shareholder, William J. Campbell, filed a complaint that the bank did not fully disclose the cross-ownership between the two entities by members of the board of directors. This joined another shareholder complaint filed by Keith Kube, who argued that the board of PBCI breached its fiduciary duties to shareholders.

Shareholder complaints seem to be common occurrences in many corporate mergers, but they rarely end up changing the outcome. On Feburary 17, 2010, the court of NJ voted to dissolve its injunction that was blocking the merger, opening the door for the shareholder vote.

Shareholder Approval

BCBP Shareholders voted to approve the merger on Dec 17, 2009. PBCI’s shareholders followed suit and voted to approve the merger on February 17, 2010, with 77% of shareholders voting to approve the transaction.

Investigations

To complicate matters even further, it seems that PBCI has been under investigation for quite some time for various issues. The bank received a Cease and Desist Order from the Office of Thrift Supervision back in September of 2008, and received another on Jan 22, 2010 relating to unresolved deficiencies in management and succession plans. The bank had to submit a 3yr business plan and hire 3 outside independent directors to satisfy OTS’s requirements

To make matters worse, the DOJ had been investigating the bank for several years for lax controls around anti-money laundering laws. On March 29, 2010, the bank pled guilty to the DoJ’s charges and was ordered to pay a $5m civil penalty.

Despite the setbacks, PBCI’s 10-Q on May 17, 2010, reports that the merger has received all necessary regulatory approval.

Discussion

It doesn’t appear like anything is stopping the merger from completing in the near future. Although all of the investigations look terrible for PBCI, BCBP has not given any indication that it will back away from the merger. I’ve read through most of the press releases, and it seems like PBCI’s management a) is incompetent or b) disregarded numerous compliance and regulatory rules that come with owning a financial institution.

Another concern with this arbitrage opportunity is the illiquidity of both stocks. PBCI trades roughly 3000 shares a day, while BCBP trades only 1000. It would be difficult to short BCBP, and the large bid/ask spread could eat into profits when exiting the trade after the completion of the merger.

It seems like many investors have been caught up in the bad press surrounding the merger, while the companies have slowly crept closer to completion by satisfying all of the necessary requirements one-by-one.  The spread is very attractive, but only if investors can successfully pull off the trade.  Thoughts on this opportunity?

Supporting Documents:

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Disclosure

No position in either PBCI or BCBP at the time of this writing.