It has been a while since we first reported on SPAC liquidation arbitrage in January. The battles over MathStar (MATH.PK) and PetroSearch [PTSG.OB] has prompted us to follow up, as did our annoyance with the slow progress at Cadus (KDUS.OB).
SPACs represented a great liquidation arbitrage late last and early this year when they traded well below their cash value at double-digit annualized yields. Other companies trade occasionally below cash, usually when they are running operating losses. SPACs and other cash shells, however, trade below cash without much operations other than minimal corporate activity to keep them going. SPACs have the added advantage of a built-in deadline at which they will be liquidated. Spreads on SPACs have narrowed to small single digit annualized returns, but opportunities abound in other cash shells.
Some SPACs have actually been able to pull off reverse mergers rather than liquidate in their entirety. According to data collected by Paul Larosa and Andrew Rosen of Maxim Group since their invention 47 SPACs have liquidated and 71 have completed an acquisition. Currently 12 SPACs have announced acquisitions, 2 are liquidating and 29 continue to seek acquisition targets. Of the SPACs that completed acquisitions, all are now in the red from their IPO price, sometimes by as much as 98% or 99%, with only a handful of exceptions shown in the table below:
(Name At IPO)
|Ticker (Current)||IPO Date||IPO Price |
|Increase vs. IPO |
|Asia Automotive||TXIC||04/11/06|| |
|Chardan North China||HOLI||08/02/05|| |
|Chardan South China||APWR||08/02/05|| |
|Great Wall||CAST||03/19/04|| |
|Spring Creek||AUCLF||02/28/08|| |
Source: Morgan Joseph. Excludes SPACs that have been acquired since their business combination.
So fewer than 10% of all SPACs show gains from their IPO price.
Today, more interesting than SPACs are shells that are the successors of former operating companies. These firms have wound down their business and are sitting on large hoards of cash. The natural reflex of investors is to scream “liquidation” and have the cash distributed to shareholders. However, unlike SPACs, these shells have a hidden asset: net operating losses. In many instances, the NOLs are worth a multiple of the cash on the balance sheet. Therefore, it makes sense not to liquidate but buy another business that is very profitable so that these profits can accumulate tax-free. This is not easy because the IRS limits the use of losses after business combinations; however, it is possible to structure transactions in a way that the NOLs are preserved.
MathStar has been the object of a number of acquisition proposals. Management has been trying for about a year to effect a reverse merger. As the SPAC experience shows, the environment has not been particularly favorable for such deals over the last year, and therefore calls for liquidation multiply. 10.5% holder Salvatore Muoio called in a December 13D filing for the liquidation of the company. Later, Muoio proposed taking control of MathStar in order to liquidate it.
Building software maker PureChoice has made proposals to acquire MathStar for $1.04 per share, increased to $1.28 in June. At the same time, Tiberius Capital entered the bidding with a $1.15 per share proposal to acquire half of MathStar, bidding a lot less than PureChoice. The Tiberius bid has since been increased to $1.25, still below that of PureChoice. Considering that MathStar has about $1.40 in cash and NOL carryforwards worth almost ten times that amount, all of these proposals look rather cheap.
Despite all the propaganda by Tiberius, its intentions for the future of MathStar do not differ substantially from what management is planning to do. Tiberius proposed
an extraordinary cash dividend; a stock repurchase program or an issuer self-tender; selling or licensing MathStar’s technology assets; a “restart” in which MathStar would hire programmers and other personnel to improve and to commercially exploit MathStar’s technology assets; and/or a merger or other combination with another company [Source: Schedule TO by Tiberius]
in its original bid. Tiberius also recognizes the value of the NOL carryforwards:
We attempted to propose to MathStar’s management a structure that would preserve its NOL carryforwards, in order to offset taxable income when and if its business is restarted or a suitable merger partner is identified. [Source: Schedule TO by Tiberius]
We believe that both PureChoice and Tiberius would simply liquidate the company and make a quick and easy 12% profit at shareholder expense ($0.15 per share profit: cash per share minus purchase price). The NOLs would be lost. Not only would shareholders give up the value of the NOLs but they would not even receive all of the cash that MathStar holds. Even a liquidation would be more favorable than these proposals. However, shareholders rejected a liquidation proposal at the recent annual meeting. We take that as a clear mandate for MathStar’s board to engage into a reverse merger, something they have since done by announcing the potential acquisition of a translation service and technology firm.
Tiberius Capital is an opportunistic liquidator that pursues a similar goal at PetroSearch Energy Corporation (PTSG). It seeks to acquire only 51% of the company for $0.33 per shares, potentially leaving everyone, after proration, with half of their shares in an illiquid firm under the absolute control of a majority shareholder. As we point out in our Merger Arbitrage book, this is an awful position to be in. So what looks like premium to the current trading price of $0.21 can quickly turn into a loss when the remaining shares of PetroSearch fall back to below $0.16.
Tiberius freely admits in its filings for both PetroSearch and MathStar that NOL carryforwards will probably be lost if the transaction closes. This is a strong suggestion that shareholders in both deals are better off with a reverse merger that has at least the potential to realize some of the value of the NOLs than selling to Tiberius below cash and loosing the NOL value for sure.
Cadus Inc is another cash shell that is looking for a reverse merger candidate. Cadus has about $24 million of cash and $37 million of loss carry forwards. Its roughly $800,000 royalty and interest income for 2008 matches the current run rate of expenses. Therefore, Cadus can afford to wait and see until a good reverse merger candidate pops up that can make use of the losses. The only drawback is that the board appears to be too passive. We tried to introduce a company to them last year but our phone calls were not returned by the board member who is supposed to look at candidates. Moab Capital, an event-driven hedge fund run by former Perry Capital managers Michael Rothenberg and David Sackler with approx. $120 million under management, bought its 12.5% stake in the hope of a reverse merger last year above $1.80. Cadus now trades in the $1.50s. But with Carl Icahn and GlaxoSmithKline (GSK) together owning almost half the shares, it will difficult to get Cadus out of the benign neglect mode. Icahn and GlaxoSmithKline have better things to do than spend time on a $25 million company, which is a mere rounding error in their portfolios.
We believe that cash shells are attractive vehicles if their NOLs are utilized properly. We understand that it can be difficult to find a suitable reverse merger target that will qualify as a continuing business and that also has the right size for a merger structure in which less than 50% of the shares change hands. Both are criteria under IRS rules for the preservation of NOLs. However, if management can find a suitable company and minimize expenses during the search, then shareholders can enjoy a much more significant upside than in a simple liquidation.
Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which holds shares of MathStar, Cadus and some SPACs. He is the author of an e-book about alternative strategies as well as the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).