Quick Pitch: Battalion Oil (BATL) – Why I’m Not Involved

Merger Arbitrage – 43% Spread (Too Risky)

Over the past week, I’ve received a flurry of messages from members regarding this situation. Given the surge in interest, I thought it would be helpful to address all of these inquiries and provide a concise overview of the situation in a single post. This is a rather curious setup, marked by a merger spread that has recently skyrocketed from zero to 43%. Additionally, reputable parties like Oaktree Capital (led by Howard Marks) are involved and have committed to rolling over their stakes. It’s quite unusual to see prominent investors entangled in a such a convoluted situation, so the setup warrants a deeper look. However, the risk of deal termination is significant and I have no position at the moment.

 

The situation

Battalion Oil is a pure-play E&P (oil and gas exploration and production) company operating in the Delaware Basin. It holds approximately 40,000 acres of exploration area and around 100 wells. The quality of its assets is far from great, and overall, it’s a highly capital-intensive business that demands continuous capital expenditures to drill new wells to offset the ongoing natural decline in the production of its existing wells. Daily production averages 12k-16k boe.

In December, Battalion signed an agreement to be acquired by Ruckus Energy for $9.80/share. $200m in debt financing has already been secured, yet the merger remains conditioned on raising the additional $200m in equity financing. The market viewed this as essentially a “done deal,” and the merger spread remained negligible until January 24, when the parties announced an amendment to the merger agreement, causing the spread to skyrocket to over 40%.

So, what exactly transpired? The initial agreement stipulated that the buyer would deposit $10m into escrow before signing the merger agreement (completed) and then another $10m by January 23. This $20m in escrow effectively served as BATL’s termination fee in the event the deal fell through. On January 24, the escrow funding terms were modified as follows:

• The $10m that had already been deposited was distributed to BATL.
• The second deposit size was increased from $10m to $15m, while the deadline was extended from January 23 to February 5.
• Merger termination date extended from April 12 to June 12.

Apparently, these changes scared the market into thinking that if buyer couldn’t even cough up the second $10m escrow payment, there could be serious roadblocks ahead in securing the $200m in equity financing.

 

Arguments in favor of successful closing

It’s possible to argue that the market has overreacted to these news, and that such widening of the spread was excessive. There are some compelling arguments to back that up.

• BATL has a very concentrated investor base that includes highly credible firms, particularly Oaktree Capital, which owns around 40% of diluted shares. The three largest shareholders also control BATL’s board. Surely, you’d think Oaktree and other major shareholders would’ve done their due diligence on the buyer, making sure it had the capacity to get the financing. Especially, when Oaktree and another largest shareholder (Luminus Management, $1bn+ AUM) have even agreed to roll over their stakes in the merger.
• Ruckus Energy is already on board, putting their money where their mouth is by depositing the initial $10m into escrow. This money will be lost if the merger falls apart, so it must show the buyer is pretty confident that the financing can be secured.
• As a further boost for its credibility, the buyer has also secured $200m in debt financing from reputable institutions, albeit subject to the completion of equity financing.
• Plus, the former CEO of Battalion Oil (who left in April 2023) has joined the buyer’s group.
• And let’s not forget the man behind Ruckus Energy, Avi Mirman, who’s bio says he has a track record of restructuring and growing distressed E&P assets:

Despite all of that, I’m not buying it. This whole situation is riddled with red flags, and when you take a closer look, it makes you wonder why anyone ever thought this merger arb was supposed to trade at a negligible spread in the first place.

 

The red flags

The buyer is very shady and has a history of fraud. Avi Mirman was charged by the SEC for involvement in a penny stock pump-and-dump scheme, and the SEC even barred him from the financial services industry. Before running public companies Mirman was a financial broker and during that part of his carreer, also received multiple allegations of fraud/breach of fiduciary duty, unauthorized trading, manipulation, misrepresentation, etc.

The sale negotiations were quite messy, with Avi Mirman constantly changing the deal terms and throwing curveballs at BATL’s management. For example, initially, Ruckus made an attractive offer of $12/share, with Mirman assuring Battalion Oil that he had “significant confidence” in securing $250m in debt financing and $250m in equity financing. But then, suddenly it appeared that debt financing was no longer on the table and instead, Mirman presented two unappealing alternatives: either enter into a merger agreement with no firm financing commitments and no termination fee, or abandon the merger and agree to an $200m equity financing with Mirman at only $6/share. To salvage the deal and increase the chances of securing financing, Battalion Oil’s three major shareholders, including Oaktree Capital, were forced to agree to rollover their common equity and most of their preferred equity stakes. However, the goalposts kept shifting until the third largest holder LS Power Equity Advisors (around 17% diluted stake) said it’s had enough and would no longer agree to rollover its stake. Instead, LSP opted to get cashed out in the merger at a lower price than minority shareholders.

Availability of merger financing has always been a very big “if”. Eventually, the board, desperate to keep the merger on track, agreed to sign the agreement even though the funding wasn’t finalized. However, the board insisted on one thing: Ruckus had to provide a guarantee that they could at least cover the $16m termination fee and deposit it into an escrow account upon signing. Mirman agreed and kept assuring of imminent escrow funding, yet the money never showed up. Then, the board had to concede once again and in order to “assist” Mirman with getting the termination fee financing agreed to the two-deposit structure described above. The idea was that if Ruckus failed to deposit the second $10m by January 23, BATL would get to keep the first $10m as compensation. If the merger fell apart, BATL would be on the hook for a total of $20m.

The board’s determination to push through this merger with a questionable figure like Mirman, even making multiple concessions and signing the agreement without secured financing, raises a crucial question: why? Well, the answer is that BATL is basically one step away from bankruptcy. The company has a ton of debt with short term maturities – $200m in total, $50m of which it will have to pay this year and $150m by the end of next year. Massive capex spending in 2021-2022 failed to yield any significant results and cashflow has dried up last year. The company is no longer able to finance new drilling, whereas natural production decline as well as certain other operational issues kicked in. BATL has been kept afloat by three preferred equity issuances last year, totaling over $100m, funded by the three major shareholders. These preferred shares have conversion prices ranging from $7.03 to $9.03 per share. If the merger falls apart, a significant amount of additional funding will be required to meet debt obligations (BATL had $61m of cash at the end of Jan versus $200m of debt and $100m+ of preferred equity), and if the major shareholders are unwilling to throw more money, bankruptcy would be imminent. The proxy statement bluntly states the same (taken from the part on why major shareholders agreed with this merger):

One might argue that the $100m in preferred equity investment from the major shareholders is a positive sign, indicating their belief in BATL’s value. However, a closer look at the merger’s background and BATL’s financials suggests that this investment might have been more a desperate attempt to keep the company afloat until the sale process concluded. When the first preferred equity round was announced in March 2023, the sale process was just getting started, and BATL had a dozen of interested parties, including a few non-binding bids on the table. As the process continued, Mirman even promised to buy back all of the preferred equity at closing. Yet eventually, other potential bidders either walked away or failed to provide concrete financing details and disappeared. Management also considered a partial asset sale or third-party financings, but came to a conclusion that it won’t be able to sell anything at attractive prices and no other party would fund BATL with it’s current debt burden. Thus, it sort of looks like management was left with a choice between bankruptcy or a risky gamble on a company sale. Another thing is that pref. equity also has a pretty hefty 16% PIK rate, so in case of a buyout this gamble could’ve turned out quite lucrative for the three major shareholders. I must note that I’m purely speculating here and it’s definitely worth mentioning that Oaktree is a very conservative investor and a distressed asset specialist. Maybe my speculations are completely wrong and they do see value in here. Yet so far, proxy materials and BATL’s financials speaks otherwise.

Another red flag is that the buyer seems to be massively overpaying for BATL. The offer premium comes at 86% to pre-announcement levels. What’s more perplexing, is that the financial advisor has estimated the fair value of BATL at a $1.71-$6.30/share, a 35%-82% discount to the offer price of $9.80/share. That’s very unusual. Normally, financial advisors are hired to sweeten the deal for both sides, ensuring that everyone feels like they’ve got a fair shake. With BATL, a valuation gap of this size raises questions about the buyer’s motives and the overall viability of the merger.

 

Conclusion

Betting on the successful merger closing seems way too risky at the moment and there’s a decent chance that if the merger eventually breaks, the stock price would drop below pre-announcement levels (30%+ downside). To be fair, short thesis would sound more convincing to me, however, the situation is hairy enough that, given my lack of expertise in the E&P field (and particularly BATL’s assets), I am hesitant to risk a potential 50% loss if the merger miraculously materializes.

Any insights or comments would be highly appreciated.