At the end of October Heartland Financial USA (NASDAQ:HTLF) announced that it would acquire Founders Bancorp (OTC:FBCP) in a $29.1 million transaction. No details are known yet about the deal since the press release doesn’t contain any, and the proxy statement isn’t yet available. This could very well be the reason why there is an opportunity, although the low liquidity of Founders Bancorp might be an even bigger reason. The stock trades on the pink sheets, and for some reason it is impossible to buy it using Interactive Brokers, TD Ameritrade or SogoTrade. In the end I managed to buy it using Binck, a small Dutch broker.
At first sight the deal doesn’t look super attractive. The press release mentions a $21.87/share consideration while the stock is now trading at $21.40: a spread of just 2.2%. What makes it interesting is that the deal is a 70% stock and 30% cash transaction. While the proxy statement for this deal hasn’t been released we can simply look at earlier deals that Heartland Financial has done to figure out what are likely the most important terms. In previous deals the amount of HTLF stock to be issued was based on the 20-day VWAP of the stock in the days preceding the close of the merger. So while HTLF is up 16% since the deal was announced this doesn’t increase the per share consideration.
What does offer an opportunity is that in previous deals there was a cap and floor on the VWAP price used by Heartland Financial to compute the number of shares that will be issued in the merger. For CIC Bancshares deal the cap was +15% and -15% compared to the price the day the deal was announced, and the Premier Valley Bank deal had the same cap and floor. With Heartland Financial up 16% since the Founders Bancorp deal was announced this cap has most likely been reached, and offers at this point an unique opportunity. When Heartland Financial drops from the current level we get more HTLF shares so the consideration remains effectively $21.87/share, while if HTLF goes up more we profit directly. In other words: we are getting a free call option on HTLF by purchasing FBCP.
We can make a rough approximation of the value of this option by throwing the following variables in a Black-Scholes option calculator:
- Spot price: 43.30
- Strike price: 43.01 ($37.40 price before merger announcement + 15%)
- Volatility: 30% (historical volatility for the past year is 30.5%)
- Interest rate: 0.50% (yield 3-month US government bond)
- Dividend yield: 0.92% (current yield HTLF)
- Expiry date: 2-28-2017 (merger is expected to close in Q1 2017)
If we feed this to the calculator it spits out an option value of $2.75. Since the merger is 70% stock the same percentage of the option value accrues to one Founders Bancorp share. So the value of the merger consideration is $21.87 + $2.75 * 0.70 = $23.81. This implies a spread of 11.2% which is quite juicy.
A final complexity is that the press release mentions that the payment per share is subject to certain adjustments, without mentioning what kind of adjustments these are. Based on previous deals this is probably an adjustment if tangible equity of Founders Bancorp suddenly drops below a certain level. I don’t think this is a big deal. If book value suddenly ends up a lot lower it means there are some hidden cockroaches in the bank, and if it wouldn’t result in a lower takeover price it would otherwise probably result in a failed deal. It’s the kind of tail risk that is almost always there in a merger arbitrage.
So I think that what we have here is simply a merger that is just being ignored by the market, not a merger that is exceptionally risky. Therefor I think the current spread is way too high, and Founders Bancorp is an attractive addition to my special situations portfolio.
Author is long Founders Bancorp