Sallie Mae Merger-Arb: There's No Such Thing as a Free Lunch

On April 16, 2007, Sallie Mae (SLM) announced that an investor group ("Investor Group") led by J.C. Flowers & Co. ("J.C. Flowers") signed a definitive agreement ("Merger Agreement") to acquire the Company for approximately $25.3 billion or $60.00 per share of common stock. When the transaction is complete, J.C. Flowers and certain other private equity investors, including Friedman Fleischer & Lowe, will invest approximately $4.4 billion and own 50.2 percent, and Bank of America (NYSE: BAC) and JPMorgan Chase (NYSE: JPM) each will invest approximately $2.2 billion and each will own 24.9 percent. The remainder of the purchase price is anticipated to be funded by debt.

Any enterprising young man looks at the current share price of SLM and $46.90 and sees a $13.10 discount to the announced take over price of $60 a share of SLM and he says to himself, “Free Money”. Yet, the Contrary Investor remembers his finance professor telling him something like “There’s no such thing as a free lunch”. Alas, the poking around of the new congress in regards to the excessive profit of the student loan industry as made Chris Flowers a bit less than enthusiastic about his trophy deal. The Senate and House voted to reduce education-loan subsidies by $18.3 to $19 billion during the next five years. Certainly this decreases the value of SLM to Chris Flowers by lets say $6.0bn ($19.0bn/5 (per year) discounted back at 20% (assumed general private equity fund hurdle rate) adjusted for cash taxes of $528mn on $1.07bn in pre-tax income for the first 6 months of 2007). However, Sallie Mae’s shareholders certainly are not going to just hand this value over to J.C. Flowers. I really don’t think they have any incentive to do this deal at a lower price now that $60 has been set as the price. So the question Chris has to ask him self is if he is willing to give up his $25bn deal.

Personally, I don’t think J.C. Flowers is very likely to pack it in over legislation that hasn’t even passed yet. Certainly his old boss Hank Paulson (now secretary of the treasury) could help him lobby to lower this figure. Maybe J.C. Flowers really has the discipline to walk away from this deal. But they also have to ask them selves when they’ll be able finance another deal of this size. $25bn, though not the size of TXU Corp (TXU), HCA or EOP, is still a HUGE deal and two years a go would have been unheard of.

It is far more likely that either the deal will get done at $60 per share original price or not done at all. If the deal doesn’t get done at all the shares should return to their April 12th pricing of $40.75, if not lower given SLM’s deteriorating fundamentals and the over all tumult in the credit markets. In oder to properly take advantage of these events I’ll be buying the $55 Jan 08 calls and the $40 Jan 08 puts. I’m long volatility in SLM shares, though I ultimately think the deal will get done but maybe it won’t. Either way deal is due to close by October 2007 leaving time to deal with the January options. This technique is known as a strangle.

Disclosure: Author has a long position in SLM

SLM 1-yr chart

Comments

[davidjmarcus:]

CI,

Your estimate of the impact of legislation on the value of SLM is <b> way overblown <b>. First, SLM represents only a portion of the student loan market and will bear an impact related to its pro-rata share of the industry. Second, while the legislation will have an impact on lender profitability, its focus is not to directly transfer wealth from lenders to taxpayers (or, more accurately, to stem the flow from taxpayers to lenders). There is not a 1:1 ratio of subsidy cuts to lost profitability. So, the $19bn headline figure you are using may be an order of magnitude larger than the actual impact on SLM.

Finally, you are comparing a scenario of today's status quo versus $19bn in cuts. It was well known that cuts in government subsidies for student loans were coming at the time JC Flowers agreed to acquire SLM. In fact, JC Flowers agreed on the $25.3 billion price tag so long as the pending legislation is not materially worse than already disclosed by SLM in its filings. Don't hold me to it, but I think that figure was around $16bn. Therefore, the decline in value in SLM from what JC Flowers is willing to pay for the company should probably only be on the delta between the legislation as previously disclosed by SLM and the current drafts in the House and Congress ($3bn at most). Once taking into consideration my first two points, the difference to SLM's value should be below $250mm.

2007 Aug 20 11:38 AM