Transalta (TA-PD.TO) – Exchange Offer – 2.7% upside

Arbitrage Trade

Upside – 2.7%

Expiration Date - Q1 2017

 

This idea was suggested to me by one reader of the site – it’s an arbitrage trade in Canadian preferred shares. Upside is tiny, but the deal itself is interesting – so I decided to write it up. I have a small position mainly to track how this transaction plays out.

Sedar Filling

 

Background

TransAlta is offering to exchange all 5 Series of its preferred stock into a single type of preferred stock. Company is doing this to simplify the capital structure and to reduce accounting value of its preferred capital. All series of preferred stock would be getting higher dividend as a result.

“Pursuant to the Arrangement, (i) holders of series A shares will receive 0.503 of a New Preferred Share; (ii) holders of series B shares will receive 0.550 of a New Preferred Share; (iii) holders of series C shares will receive 0.705 of a New Preferred Share; (iv) holders of series E shares will receive 0.790 of a New Preferred Share; and (v) holders of series G shares will receive 0.820 of a New Preferred Share. The New Preferred Shares will pay fixed cumulative dividends of $1.625 per share per annum, yielding 6.5% per annum”

BoD has already approved this transaction, and shareholder vote is set for the 16th of February. If shareholders approve, the exchange is expected to close during Q1 2017.

Where is the trade?

The table below indicates the implied prices of the ‘New Preferred Shares’ for each Series of the current preferred.

.Implied Price

All of these securities will be converted into the same single security, however they trade at different implied prices currently. Series A particularly stands out as being priced above the rest. So the trade is to sell the most expensive and to buy the cheapest one, taking into account different conversion factors. Current spread between Series A and Series C is 2.7%. These spreads vary on a daily basis, but for some reason Series A is always more expensive than the others. After the exchange is completed, short and long positions will annul each other.

Will shareholders approve this?

This exchange transaction will need to be approved by 2/3 of preferred holders of each Series. I believe shareholder approval is very likely. All series have traded up after the announcement on the 19th of December.

Preferred listings

Also all shareholders will be getting higher (or the same) dividends than they receive currently.

Dividends

So if the vote is rejected, the prices of preferreds will drop and dividends will remain unchanged – probably not something the preferred holders will be fond of.

The only things the current holders of preferreds will be giving up are par value and liquidation preference (i.e. Series A priority vs Series C and etc). These items would matter only in liquidation scenario, but Transalta seems to be far away from liquidation (at least for the moment being) – it is an electricity utility company that generates sufficient operating cash to for capex, to cover common and preferred dividends as well as to pay down debt.

Taking all of this into account, I believe ‘yes’ vote is likely, but as these are semi-fixed income securities I might be underestimating the importance of liquidation scenario for preferred holders.

Risks

The main risk is that the transaction gets rejected by shareholders. If preferreds trade back to the pre-announcement levels upon this, then Series A (short part of the trade) would drop less than the other Series (long part of trade) – by my estimates the loss would be around 10%. So the downside vs upside clearly does not look favorable here.

Also I still do not understand why Series A is constantly trading above the rest. I might be missing some piece of the puzzle.

18 COMMENTS

  1. Joe Ern

    A few other things to consider:

    1. Dividend that has already been declared will need to be paid out on any short position on March 31, 2017 unless something changes at the special meeting of shareholders.
    2. TA.pr.D is convertible into TA.pr.E in 2021 so if the deal crashes, these two will eventually go back to being the equal in price (albeit I wouldn’t want to be in this transaction that long, the preservation of capital is there for only this pair in a true Arbitrage but you will have to collect and pay the different dividend rates on each and the TA.pr.E is a floating rate so its dividend regularly changes with the Canadian T-Bill rate)
    3. Shareholders may reject the transaction because they may perceive that the company is stealing their long term capital gain cause they would expect at some time in the future that the company will pay them back $25 for their existing shares
    4. The shareholders of the TA.pr.E just recently converted into a floating rate preferrred based on changing T-Bill rates from the TA.pr.D fixed rate reset (all the others are fixed rate resets at different dates based on Government of Canada 5 year bonds). If they (TA.pr.E) alone decide not to convert into the new share because they believe in rising interest / tbill rates over the next 5 years, does the entire deal get killed?

    Those are a few other things that I am currently contemplating. If anything I would have expected the floating rate shae to be the one that would have traded differently from the rest and not its twin fixed rate share. If the spread is still there after the vote is ratified, I would say this becomes a no brainer.

    1. dt

      Joe, thanks for comment:
      1) Dividends – next dividend is not due till the end of Feb (last year was 26th of Feb), so will be after the vote. So do not think it is very relevant. And in any case Series A have the smallest dividend of all, so by paying dividend on the short side and receiving dividend on the long side, one would still be above breakeven.
      2) Series A and Series B although convertable to each other have not traded at the same price prior to the announcement, so would not expect them to trade at the same level if the deal gets cancelled. If I recall correctly they are convertible to each other only on certain dates, which makes
      3) Agree – this is the reduction in par value that I mentioned in the write-up. Series A and B would be the most exposed to this. As they will get only $0.5+ of par for every $1 of par they held so far.
      4) Valid point with regards to higher rate expectation on floating securities. However, if that was indeed expectation of preferred holders, this should have been already reflected in the preferred price pre-announcement. But now Series B (floating) were trading cheaper than Series A (fixed) pre-announcement suggesting that investor did not attach much value to higher future rates. In any case if there are some who want exposure to floating rates, they can always cash out at higher prices (i.e. prices at which the preferred are trading currently) and invest in some other type of floating securities. I do not see much rationale in rejecting the deal and higher preferred prices, just for the sake of continuing to have floating rate exposure specifically in TransAlta securities. But anything can happen, including lack of rational behavior.

        1. dt

          Joe, this is in line with what I wrote above. Dividends on the short side will be smaller than dividends on the long side, and record day is 1st of March, whereas shareholder meeting is on the 16th of Feb.

  2. Benjamin Shannon

    Interesting. The other potential downside is, you could get forced out of your short position at an inopportune time. Or might have to start paying borrow fees.

    1. dt

      Benjamin, there seems to be plenty of shares to borrow and borrow fees are currently at 1% annually. Although what you described is always a risk with shorting, I think the spread is to narrow to get many parties interested in this and to exhaust the borrow pool.

  3. Paul Lee

    From a simple math perspective if each vote is independent and necessary, then you would need a greater than 87% chance of success in each class to have at least a 50% chance of the transaction going through (0.87^5=0.5). This is without knowing any details (ie overlapping shareholder registers). Seems like a high hurdle

    1. dt

      Paul, although mathematically correct, I do not think this type of calculation is very useful in assessing likelihood of shareholder approval.

  4. wayne liu

    Hi,thanks for share .The another risk is the company did not give the guaranteed commitment price, if the transaction is closed at a price lower than the current price of 2.7%, this is the failure of arbitrage. Is my opinion right?

    1. dt

      Wayne, not sure what you mean exactly by ‘commitment price’. This arbitrage involves being long one Series of preferred and shorting another Series. So the 2.7% spread is locked in at the time of purchase/sale, and after when preferred will be converted into single name security, the long and short position will cancel each other out.

  5. Fabrice Evangelista

    Hi,

    When will this deal be 100% sure to be implemented?

    Thanks a lot

    Regards

  6. Fabrice Evangelista

    Do you mean that the shares will merge right after Feb16th or once the decision is made, it will take a couple of weeks to be implemented?

    Thanks a lot

    1. dt

      Shareholder vote will take place on the 16th. I do not know how long will it take then till the actual transaction. However, i would expect the spread to close if it is approved.

  7. LEYI ZHANG

    Hi Dt,

    I am a new subscriber, if i buy stock after vote, will the offer still valid to me ?

    Thanks

    1. dt

      The offer should be valid as long as the existing Series of preferred are not yet converted. However, the remaining spread is only 1%, so probably the transaction is not worth it at current prices.

  8. dt

    Transalta issued information circular:

    http://www.transalta.com/newsroom/news-releases/2017-01-16/transalta-corporation-files-management-information-circular-relati

    And here came the piece of the puzzle that I was missing before – exchange factor for Series A (the short hand of the trade) was increased and subsequently the shares traded up. That was probably the reason why Series A were more expensive compared to the rest.

    I did not foresee that exchange factors could be adjusted. Now the spread is only 1% – with Series A still standing out as slightly more expensive than the rest (implied price of $24.43 vs $24.13 for others) – maybe market is expecting another upwards adjustment.

    I have closed the position with 3.7% loss.

Comments are closed.