Risk arbitrage (merger arbitrage) is an investment strategy that speculates on the successful completion of M&A (mergers and acquisitions) transactions that have already been announced. The operative word in the previous sentence is “speculates,” as there is no such thing as a free lunch. In most cases, there’s an inverse relationship between the magnitude of an arbitrage opportunity and the level of risk that the arbitrageur will have to assume. To be more specific, when the closing of a transaction is all but certain, the profit potential is invariably nominal. On the flip side, when the outcome is highly uncertain, the investor (or speculator) stands to earn outsized returns. That said, the risks and uncertainties inherent in each announced transaction aren’t necessary accurately reflected in deal stocks, allowing for astute investors to exploit pricing inefficiencies. Indeed, as a class, marriages involving Chinese players have frequently afforded substantial opportunities, reflecting the mindset among many that they’re all too risky. The subject of this Event Driven Special Situation recommendation represents one of those inefficiently priced situations, we think, giving the intrepid speculator a chance to make a substantial near-term profit. At today’s closing price of $4.10, buyers of U.S.-based Genworth Financial, Inc. (NYSE: GNW) stands to earn a return of 32.4% within a few months. Moreover, we detail a very simple option strategy below that would allow the investor to more than double his capital investment while limiting his downside risk considerably. As always, though, we remind readers to limit financial allocations to each individual special situation recommendation to a relative small proportion of overall risk capital. (Note: The company is scheduled to announce March-quarter results on May 2nd, which could trigger some price volatility.)
The Terms of the Merger Agreement
On October 21, 2016, Genworth Financial, Inc. entered into a merger agreement with China Oceanwide (OTC:HHRBF) in a transaction worth $2.7 billion in cash, or $5.43 per GNW share. The vehicles to be utilized to consummate the deal will be indirect subsidiaries Asia Pacific and Asia Pacific Global Capital USA Corporation, but Genworth will ultimately survive the merger as an indirect subsidiary of China Oceanside, maintaining its current appellation and corporate headquarters. In addition to the $2.7 billion in cash payable to shareholders, the acquirer has committed to invest $1.125 billion in cash, $600 million to address debt maturing in 2018 and $525 million to essentially fortify Genworth’s troubled U.S. life insurance businesses. The transaction is subject to the approval of Genworth’s stockholders, as well those of myriad financial and insurance regulatory bodies, both in the United States and elsewhere around the world, including China, Canada, Australia, and New Zealand. It will also need to pass muster with CIFIUS, the Committee on Foreign Investment in the United States.
In connection with the execution of the merger agreement, Genworth and Asia Pacific entered into an escrow deposit agreement on October 21, 2016, pursuant to which Asia Pacific paid to Genworth a cash amount of $210 million, equal to the termination penalty that Genworth would be entitled to if the merger failed to go through for some very specific reasons. On the other hand, if Genworth were responsible for the deal being scuttled, because it had agreed to a superior offer, for example, China Oceanwide would be entitled to receive $105 million. In accordance with the agreement, the $210 million was deposited in an escrow account at Citibank (NYSE:C) on October 26, 2016
Additionally, concurrent with the execution of the merger agreement, the three related parties – China Oceanwide, Oceanwide Capital and Wuhan – that will fund both the $2.7 billion acquisition and the aforementioned $1.125 billion cash infusion delivered to Genworth equity commitment letters, dated October 21, 2016, pursuant to which they committed to provide immediately available cash as soon as all the conditions spelled out in the merger agreement had been satisfied.
The merger is expected to close by the middle of 2017. The deadline for the merger agreement, meantime, is August 31, 2017, subject to extension(s).
Genworth Financial, Inc. is a Richmond, Virginia (U.S.)-headquartered financial services company, focused on helping meet the homeownership and long-term care needs of its customers. It is the largest individual provider of long-term care insurance in the country and one of the largest providers of private mortgage insurance outside the United States, based on new insurance written. The company operates its business through the following five operating segments: U.S. Mortgage Insurance; Canada Mortgage Insurance; Australia Mortgage Insurance; U.S. Life Insurance; and Runoff.
All three mortgage insurance segments were profitable in each of the past four years. The small Runoff segment, which includes the results of non-strategic products that are no longer actively sold (but serviced by Genworth), was profitable in three of those four years, with a small $5 million operating loss in 2015. Unfortunately, however, the mainstay U.S. Life Insurance segment generated substantial losses in each of the past three years – totaling $1.8 billion. This segment, which includes the long-term-care business, is struggling from the combination of a prolonged period of low interest rates, lower-than-anticipated mortality rates, and rising healthcare costs. As a result, Genworth reported a net loss of $1.5 billion for those three years, or $4.31 a share, much of the losses stemming from the need to boost reserves to take into consideration diminishing interest income and rising costs. Significantly, too, the deteriorating results forced the debt rating agencies to downgrade the company’s papers, lifting its cost of doing business. (See 2016 Form 10k for detailed financials.)
As of December 31, 2016, the financial services concern’s balance sheet showed a cash balance of $2.8 billion, long-term debt of $4.2 billion, shareholder equity of $12.6 billion, and total assets of $104.7 billion; total assets and shareholder equity were $106.4 billion and $12.8 billion at the end of 2015, respectively. Last year equity totaled equates to $25.39 per share. At year’s end, there were 498 million shares outstanding. Of note, too, both the Canada Mortgage Insurance and Australia Mortgage Insurance businesses are separate publicly traded entities, with Genworth owning 57.2% of the former and 52.0% of the latter.
Asia Pacific Global Capital Co., Ltd. (or “Asia Pacific”) is a newly formed limited liability company incorporated in July 2016 in Tianjin, the People’s Republic of China. Asia Pacific is a subsidiary of China Oceanwide Holdings Group Co., Ltd. (or “China Oceanwide”). It currently has no operations and was created simply to China Oceanwide’s investment in Genworth. China Oceanwide, meantime, which for all intents and purposes is the acquiring company, is a well-established, well-diversified conglomerate, with substantial real estate assets globally, including in the United States, and insurance operations in the China. In addition to the vast real estate holdings and insurance operations, China Oceanwide has investments in banking, energy, media, and technology. It is the third-largest shareholder in Legend Holdings Corp., the controlling shareholder of the world’s biggest personal-computer maker Lenovo Group Ltd. (OTCPK:LNVGF) (OTCPK:LNVGY). The privately owned company was founded in 1985 by Lu Zhiqiang who is reported to be the ninth-richest person in China, worth some $13 billion. Mr. Lu, 64, is known as a philanthropist, doing charity work in China and donating money to aid programs in the country to fight poverty.
The acquirer has assets in excess of $20 billion, representing to Genworth early in the negotiations to have over $20 billion in cash, cash equivalents, and available-for-sale assets to fund the marriage.
Risks and Uncertainties
Genworth shares traded in the mid-$30 neighborhood in 2007 as the real estate boom of that era was approaching its end. They sunk to almost $1 the following year, swooning along with all financial assets, before recovering to almost $18 by the spring of 2014. With the U.S. Life Insurance business starting to fray in 2014, however, GNW began to fall again, despite all of management’s efforts to “enhance shareholder value” through all means possible. Even the announcement of the China Oceanwide deal didn’t help. In fact, the price of the stock fell on the day of the announcement and has never come even close to the takeout price since.
Given Genworth’s sharply higher book value, some shareholders were undoubtedly disappointed with the terms of the deal. Investors are also concerned about the following:
- A relatively large number of M&A transactions involving Chinese acquirers have failed over the last several years so that reality is clearly on the minds of many on Wall Street.
- There is always the risk that an acquirer could reconsider and either try to renegotiate price or pull out entirely.
- The pending transaction will need to get the approval of more than a dozen regulatory bodies, so there is that risk, especially since it involves a Chinese buyer and an American seller.
- Some fear the possibility that the Chinese government will not provide the foreign currency, i.e., U.S. dollars, necessary to consummate the transaction.
- The possibility of a freefall in the stock price if the deal fails to go through.
Needless to say, investors also have to contend with all sorts of ill-informed fear mongering in the Internet, including the notion that Genworth would have trouble collecting the termination penalty and that the deal couldn’t get regulatory clearance because China Oceanwide is connected to that country’s government.
First Hurdle Cleared Handily
On March 7, 2017, Genworth Financial held a special meeting of stockholders to consider the merger detailed above. At the meeting, a total of 368,739,713 shares of Genworth’s common stock, representing approximately 74% of the shares issued and outstanding, were present in person or represented by proxy, which constituted a quorum. Of that total, 352,454,507 voted in favor of the merger, representing 95.6% of the votes cast. Only a majority vote was necessary. Following the vote, both Genworth and China Oceanwide reiterated their expectation that the deal would be completed by the middle of this year.
In a subsequent interview with the Richmond Times, Mr. McInerney, chief executive of Genworth, indicated that the expects to remain with the company after the deal closes, saying “I have told Oceanwide that we are three to five years away from finishing the fixing of long-term care, so I am prepared to do that.” He also said there are opportunities to build a long-term care insurance business in China.
In addition to getting the nod from shareholders, the parties filed the required notifications with the Antitrust Division and the Federal Trade Commission on December 7, 2016 and early termination of the applicable waiting period was granted on December 16, 2016.
Other Concerns Probably Overblown
China Oceanwide initially notified Genworth of its interest in an extraordinary transaction in May 2015. Over the subsequent 17 months, the two companies and their respective financial, legal, and accounting advisors – including heavyweights Goldman Sachs, Lazard, Citigroup, PricewaterhouseCoopers, and Sullivan & Cromwell – conducted substantial due diligence and extensive negotiations. That’s not all, Genworth did the rounds, introducing China Oceanwide executives to many of the pertinent financial and insurance regulators and keeping that apprised of all ongoing negotiations. The financial services concern’s executive also made multiple trips to China to meet with Mr. Lu and his management team. It should be noted, too, the troubled Life Insurance segment was the subject of intense discussion and the final deal terms were set with the full knowledge of the charge taken in the third quarter. The extended negotiations, the extensive due diligence, and the shareholder approval strongly suggests both that China Oceanwide is committed to the transaction and a price reduction is unlikely. (See Proxy Statement – Merger or Acquisition for all the events that ultimately led to the merger announcement.)
The groundwork laid by the two companies multiple meetings with the various regulators also augur well for getting clearance, as does the fact that the $1.125 billion cash infusion will strengthen Genworth’s financial underpinnings, to the benefit of all constituents, certainly including the company’s customers. A favorable CFIUS review also seems likely since there aren’t likely to be any national security issues with this transaction, and China Oceanwide had no state-related or governmental ownership.
Significantly, too, China Oceanwide and Mr. Lu has a solid history of closing their deals, including one earlier this year, with no problems getting the foreign currency necessary to effect payment. The $210 million in the Citi escrow account also obviates any concern of collecting the termination penalty if events so dictate.
As to what might happen to the price of GNW if the deal collapses, it’s certainly difficult to know with any meaningful level of confidence. It is worth keeping the following in mind, though:
1. Genworth was in negotiations with a handful of interested parties for either parts or all of the company before ultimately deciding to sell to China Oceanwide. There’s no guarantee that any would return to the negotiating table, but there’s always that possibility.
2. The issuance of additional stock to fortify finances may not prove to be the worst thing in the long run, giving management time to unlock value in the life insurance business; interest rates are rising.
3. Taking into consideration the two publicly traded mortgage insurance subsidiaries, the profitable U.S. Mortgage Insurance segment, the large, albeit troubled, life insurance business, and the incredibly large discount to book value, breaking up the company could yield more than the $5.43 takeover price.
Meantime, the 6.515% debt maturing next year are selling at a slight premium, showing no fear on the part of bond investors when it comes to Genworth’s ability to meet its obligations in 2018.
A High Return Low Risk Strategy
As always, simply buying the stock would be the easiest way to play this arbitrage opportunity. Purchasing 1,000 shares would cost $4,100 at today’s closing price of $4.10. If the deal closes, the investor would earn a return of 32.4% ($5.43/$4.10), or $1,330. In the worst-case scenario, however, which is highly unlikely, he could lose the entire investment.
Alternatively, the investor could buy the September $4.00 calls. Today’s closing bid/ask spread was $0.55/$0.75, and the last trade was at $0.70. Important, too, this particular option series has a relatively large open interest, suggesting substantial liquidity. So, 10 contracts, which would give the buyer control of 1,000 shares would cost some $700, assuming a purchase price of $0.70. If the deal were to close as anticipated, this investor would earn 104% within a matter of months, or $730. Also of importance, the most that could be lost with this strategy would be $700. Investors should bear in mind, though, that the entire amount would be lost if the stock closed at $4 or less on option expiration day, whereas the buyer of the stock would only lose $70 if the stock fell to $4.00.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GNW over the next 72 hours.
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.
Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.