Taubman Centers Cap Structure Arb: Heads I Win; Tails I Don't Lose (Much)

Summary

• Simon Property Group is taking Taubman Centers private at $52.50.
• Taubman's capital structure is pricing in different probabilities of deal closing.
• Long Taubman Preferred Share vs. Common Stock at a 0.5 hedge ratio can lock in positive return regardless of the outcome of the take-private deal.
• The hedge ratio can be modified depending on one's view on the deal.

Situation Overview

The largest shopping mall REIT, Simon Property Group (NYSE:SPG) is buying its smaller competitor, Taubman Centers (NYSE:TCO) at $52.50 per share. The J (TCO.PJ) and K (TCO.PK) series of TCO's preferred shares will be redeemed at $25 face value. Common and preferred stocks will continue to pay dividend until the closing date of the transaction. The total required cash consideration from SPG is ~$3.6 billion, and this is expected to come from SPG's working capital and existing credit facilities. For reference, that's about 8.6% of SPG's enterprise value of $42.0 billion.

Probability of Closing

The calculation of the probability of closing being priced in by the different parts of the same capital structure looks more complicated than it really is. See below for a graphic illustration.

For illustration purpose

The only caveat is that the TCO's preferred shares aren't the most liquid securities in the world, so the probability is probably not priced in accurately. In fact, this is probably why this capital structure arbitrage exists - there isn't enough liquidity for large players to price the preferred shares accurately.

The "prices if Deal Breaks" requires some clarification. For the TCO.PJ, I'm assuming the preferred share is going to trade at 8.5% dividend yield ($1.63 / 8.5% = $19.12). SPG also has a preferred stock outstanding, and it's trading at ~6.5% dividend yield. Given that TCO is smaller and more levered, I just arbitrarily added 2.0% premium. Also, it seems like the TCO.PJ snaps back once it dips below $20.

For TCO, $30 is about the 20-day average price before the deal was announced (a.k.a. the unaffected price).

As one can see, the preferred share is implying a 57.5% probability of deal closing, while the common stock is priced in a higher probability at 62.1%.

Capital Structure Arbitrage

Since the implied probability of closing is different for different part of the capital structure, you can put together a hedged trade such that positive results are achieved regardless of the deal outcome.

This is basically an arithmetic exercise, with some detailed nuances to capture all upside and costs of the trade:

• Dividend: since both securities are paying dividend until the deal is closed, we need to take the carry of the trade into consideration.
• Borrow Fee: I assume a 1.0% cost of borrow for shorting TCO.
• Timing: all of these cost of carry considerations (dividend and borrow fee) are a function of time, i.e. these are scaled by the fraction of the year that the positions remain open. I assume the deal closes at the end of November.

The dividend yield for TCO is negative because you need to pay the dividend when shorting the stock. In the example above, the hedge ratio is 0.50, which means for every dollar value of long TCO.PJ, short 50% of the dollar value with TCO. Note that the Net Carry is the same in both scenarios since the net carry is a function of time. With a 0.50 hedge ratio, this is a net positive carry, and therefore a longer deal process benefits the trade.

In the scenario that the deal completes, the long TCO.PJ position will gain 11.1% while the short TCO position will lose 9.7%. The 3.2% total return is made up of 1.4% net capital gain and 1.8% net positive carry.

In the scenario that the deal breaks, the long TCO.PJ position will lose 15%, but the TCO short position will gain 15.9% to offset the loss on the long position. The 2.7% total return is made up of 0.9% net capital gain and, still 1.8% net positive carry.

The hedge ratio can be modified depending on one's view on the deal. A 0.40 and 0.60 hedge ratio examples are shown below:

Conclusion

I believe this is a low-risk capital structure arbitrage trade to play the TCO/SPG transaction. You can structure the trade to produce positive return regardless of the outcome. You can also play around with hedge ratio depending on your analysis of the deal risk. Patient execution is the key as TCO preferred shares aren't very liquid.

Analyst’s Disclosure: I am/we are long TCO.PJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.