Is There A Merger Arbitrage Opportunity In Cleco?
Summary Cleco agreed to be acquired by a group of North American infrastructure investors led by Macquarie Infrastructure and Real Assets (MIRA). We believe the likelihood of the deal closing is high. The deal is expected to close in the first quarter of 2016. Shares look appealing with a weighted return profile of 22.87%. This article discusses the potential merger arbitrage opportunity in Cleco (NYSE: CNL ). On October 20, 2014, a group of North American infrastructure investors, led by Macquarie Infrastructure and Real Assets (MIRA) and British Columbia Investment Management Corporation (bcIMC) (Group), entered into a definitive agreement to acquire Cleco for $55.37 per share in cash. The deal is valued at $4.7 billion, which includes ~$1.3 billion of CNL’s debt. Cleco is a public utility company and owner of regulated electric utility Cleco Power LLC. It has served residents and businesses in Louisiana for almost 80 years. It owns 11 generating units with total capacity of 3,340 megawatts. This partnership will allow the company to operate as an independent and local business, which will help it stay focused on keeping its strong culture. Cleco is a well-run utility with a dearth of knowledge, experience, and expertise. It’s a very attractive infrastructure business, which just so happens to operate in a regulated, but stable industry. These attributes should help the company grow long term. Here’s what Bruce Williamson, Cleco’s chairman, president and CEO, had to day about the deal: “With this agreement, Cleco’s existing investors will receive an exceptional value for their shares to top off a superior total shareholder return of the past few years, and our customers and employees can expect us to retain our strong commitment to service and reliability. The board and management worked together in structuring this transaction to deliver a premium valuation to our public shareholders and ensure a continued local presence in the communities Cleco serves. This agreement is the right transaction for our shareholders, employees, retirees, and customers of all types. The new owners understand the value Cleco brings to the region and are committed to Cleco’s strategy as a safe, reliable electricity provider positioned to meet Louisiana’s long-term power needs.” So is there opportunity as a merger arbitrage candidate? Let’s dive in and find out. Despite the drop in commodity prices, this group led by Macquarie has very deep pockets. The new owners plan on refinancing Cleco’s debt at closing. The group of investors includes Macquarie, British Columbia Investment Management Corporation, and John Hancock Financial. We do not see a high probability of failure given the group’s strong capital position. The deal is said to close in Q1 of 2016 (three months); both sides appear to be excited about the deal and the synergies involved. Final stages of the state regulatory approval process have pushed the initial timeline back to Q1 2016. Initially, the deal was supposed to be finalized in Q4 2015, but utility deals always seem to take longer than expected. The Louisiana Public Service Commission (LPSC) stated that it was “recommending strong commitments” from the investor group. The investor group filed testimony with more than 70 commitments addressing concerns raised by the LPSC. The commitments appear to be more than adequate, and management expects the deal to go through in Q1 2016. Cleco is currently priced at ~14x FCF, which gives an implied yield of 7.26%. In addition, the company sports an EV/EBIT of 14.85. Although shares are not significantly undervalued at current levels, we would be surprised by a takeover either. However, the current commodity depression may hamper and potential bidders. There are many uncertainties around potential mergers, such as anti-trust approvals, multiple government reviews, changes in market conditions, shareholder approval, and due diligence. If the deal was not completed, we would expect prices to drop to the pre-deal price of $48.50, or a loss of $3.55. We give the deal a 95% chance of being complete based on the parties and terms of the buyout offer. If we look at the recent quote, the stock is trading at $52.05 per share, $3.32 below the announced cash offer of $55.37 per share by the investor Group. We calculate our expected return with the probability of a successful deal ($3.32 x .95 = $3.15). And we subtract that from our expected loss with the probability of that loss occurring (3.55 x .05 = $0.18). This is the expected weighted return, which gives us a potential return of 5.72%, or $2.98 per share. To calculate our annualized expected return, we divide that by the expected time of holding in years (three months = .25). This gives us an annualized expected return of 22.87%. Bottom Line The Cleco acquisition is an interesting deal. And we do not see a high probability of failure given the investor Group’s strong capital position. The regulatory interference concerns us some; however, it appears that the recent commitments from the investor Group may be more than adequate for a state regulatory approval. This appears to be an interesting opportunity at current levels with a potential 22.87% annualized return profile. The return appears to justify the risk in this case. Notable Shareholders: Abrams Capital Andromeda Capital Bryn Mawr Capital LMR Partners Adage Capital GAMCO Diamond Hill Capital Please share your thoughts in the comments section below, as I learn just as much from you as you do from me. It can be a time-consuming endeavor, but I answer all of your comments and questions myself. Your patience and understanding are greatly appreciated. Disclaimer: Merger-arb can be tempting for investors to use leverage to increase their annualized return on high probability events…Resist the urge! Many Wall Street firms conduct merger-arb as their main business and they will normally have 50 or more merger-arbitrage investments at any one time. They understand that if a couple of deals go bad, the winners will more than take care of the loses. Merger-arb can be a very crowded strategy at times. Similar to value investing, it can be cyclical and go in and out of favor over time. The key to merger-arb is to focus on the few deals that are highly probable (ideally ALL cash deals) with minimal regulatory hurdles and an acquirer with a great capital base. And if you’re new to merger-arb, watch a few deals play-out over various industries to get an understanding of the deals. If you do invest in merger-arb situations conduct proper due diligence and make sure to spread your risk appropriately. If you are so inclined to learn more about these types of special situation, I highly recommend Graham’s writing on arbitrage in his Security Analysis book.