The merger between Paramount and Coeur was completed last Friday without any issues. When I entered the trade I paid next to nothing for the spin-off that would occur simultaneously with the merger, and today I sold the shares of the SpinCo for $1.70/share. When measured against the value of the PZG leg the merger arb returned 8.1% in just a month. That’s an awesome result! At the same time, I could be penny wise and pound foolish by purely focusing on the merger arb, and not on the spin-off itself.

Spin-offs are known to outperform because people often sell them indiscriminately, and that’s exactly what I have done… SpinCo appears to be cheap at $1.70/share since it’s trading barely above its cash balance of $10 million while it also owns an undeveloped gold project that could be worth hundreds of millions if gold prices go up. So why sell? I have two reasons:

1. I know next to nothing about mining
2. I think exploration stage mining companies as a group are usually a terrible investment

Investing in something that you don’t know anything about doesn’t seem smart and if I didn’t already own SpinCo I wouldn’t have bought it, so I think it makes sense to sell if you get some shares as a by-product from another trade. It’s just that selling the position feels like a different decision that not buying it, although logically it’s equivalent.

Disclosure

No position in PZG and/or CDE anymore

At the end of last year, Coeur Mining announced that it would acquire Paramount Gold & Silver in an all-stock transaction. It’s a strategic transaction that makes sense: Paramount owns silver and gold deposits in Mexico that are adjacent to Coeur’s properties. Because of this there are significant synergies that can be realized:

The transaction is expected to close on April 17 when shareholders at both companies have to vote on the transaction. The company has obtained the required regulatory approval for this deal from the Mexican government and it doesn’t need to obtain financing. I think that this is a deal that is almost certain to go through. Usually when this is the case the spread between the two stocks is so small that there is little money to be made in the merger arb.

But this is no ordinary deal, as already hinted in the title of this post there is at the same time also a spin-off. Paramount not only owns assets in Mexico, but it also owns a gold deposit in Nevada that Coeur doesn’t want. This asset will be spun-off before the merger together with $10 million dollar in cash that Coeur will contribute to the new company. How valuable SpinCo will be is an unknown, but today you can get it almost for free and at a big discount to its future cash balance. Current Paramount shareholders will not get 100% of SpinCo, Coeur also obtains a small interest. The deal is structured as follows:

When we value SpinCo at only its cash/share value the current spread is roughly 4%. That’s in my opinion already pretty attractive, and their gold deposit is presumably worth something as well. Perhaps a hint of its value can be extracted from the price that Coeur will pay for its 4.9% interest: $1.47 million. This implies a valuation of $30 million for SpinCo or $0.1761per PZG share which would imply a spread of ~14%. While Coeur and Paramount could have structured the deal to arrive at almost any valuation I think that it is probably a pretty decent estimate of value: I bet their accountants would like to see that a related party transaction occurs at something that resembles fair value. As long as the number is in the right ballpark I’m happy.

Chris DeMuth Jr. has a more optimistic take on the valuation in this Seeking Alpha blog post. The value of the gold deposit in Nevada is very leveraged to the price of gold, and if you model a small probability of significant higher gold prices in a few years the value of the deposit increases greatly. I wouldn’t want to bet on that, but optionality is worth something.

An additional sweetener to the deal is the fact that a long PZG, short CDE position has a significant positive carry. Borrowing the CDE shares costs around 1% while you can lend your PZG shares at 35%. If you are able to fully capture the high lending fees on the PZG leg you could make an additional return of 1.4% in the 15 days that it will take before the merger closes. Capturing the full spread will be difficult for most, but it should be a nice bonus.

The high borrow fee for PZG is at the same time also a risk factor because you have to ask what the shorts know what you don’t. In this case, I think the high borrow fee can be partly explained by an inefficient lending market. Just 7.4% of the PZG shares have been sold short, and this percentage has been declining since last year. CDE has actually 12% of the float sold short, but probably because it’s a bigger and more liquid company it also has a more efficient lending market. I think it’s reassuring to know that the shorts aren’t betting against the merger. The company might not be great, but that’s to be expected when you look at an exploration stage mining company. Betting against that group was (is?) a pretty decent trade.

Disclosure

Long PZG, short CDE