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Patriot’s Risk Arbitrage Prospect



August 03, 2009 – Comments (1) | RELATED TICKERS: PSEC

This morning, Prospect Capital (PSEC) announced a deal to acquire Patriot Capital Funding (PCAP) for $197 million.  PSEC will pay down $110 million of PCAP debt and exchange 0.3992 PSEC shares for each PCAP share.

Deals frequently set up an arbitrage opportunity; selling one stock while purchasing the other to take advantage of a spread in the adjusted share prices.  In this deal it’s fairly simple because it’s a straight share swap.

At the 3 Aug close, PSEC’s $10 share price implies a value of $3.99 per PCAP share.  But PCAP closed at $3.84, so an arbitrage trader could sell PSEC and buy PCAP to capture that spread.  The trader’s risk is that something happens to upset the deal.  In this case there’s also a dividend risk.  PSEC has a very high yield and PCAP suspended their dividend; if the deal drags on too long, the trader has to make good on those juicy PSEC payouts while getting no income from the PCAP shares.

I’m a PSEC shareholder.  When I checked prices at lunchtime, the spread between the two prices was over 13% and I decided to make an arb trade with part of my position.  I didn’t trade the whole position because I wanted to limit the risk of the deal falling apart.  No commissions involved – thumbs up for the 100 free trades a year from WellsTrade.

Sold 120 shares of PSEC at 9.95 netting $1194
Bought 340 shares of PCAP at $3.50 at a cost of $1190

In a pure arb trade, the trader doesn’t really care what the share prices do because the long and short positions cancel each other; the trader is making money off the spread.  In my case, I’m still exposed to market risk with PSEC (and PCAP), since I’m long the shares.  But, I was long anyway so this gave me a chance to capture a few ‘free’ shares.

If the deal goes through as announced, the PCAP shares I bought will turn in to 135 PSEC shares and a fraction that will get cashed out.  I’ll end up with 15 additional PSEC shares and a few dollars.  There are several possible outcomes and some of them would not be good for me.

1.  (most likely) The deal goes through as announced and I get free shares and a few bucks for the risk.

2.  The deal could fall apart entirely and the PCAP shares get cut in half or more.  I don’t think this is likely.  Both boards have approved the deal.  It does require PCAP shareholder approval.  PCAP is in default on some of their debt, so this deal should be more attractive to shareholders than having the debt holders take the company over.

3.  Another company could make a better offer or PCAP might persuade PSEC to up the buyout price.  Very unlikely, but this would be sweet.

4.  Something turns up that gives PSEC grounds to lower the offer.  Unlikely, but would be a bummer.

5.  Deal drags out and I miss a PSEC dividend or two.  I could miss two dividends and still be slightly ahead with this deal.  Missing one dividend is very possible.  The announcement states the deal is expected to close in 60 days.  That would be very close to the likely record date for PSEC’s next dividend.  I don’t think it would drag on long enough to miss two dividends.

I’ll keep an eye on the spread.  At today’s close, I could reverse the trade, take the risk of 2, 4, and 5 off the table and still capture 10 of the 15 ‘free’ shares.  If the narrow spread at the close holds, I’ll probably reverse the trade and capture an 8-10% gain over a day or two.  If only I could do that with all my trades.

Fool on!


1 Comments – Post Your Own

#1) On August 03, 2009 at 8:43 PM, anchak (99.91) wrote:

Recd ! For going the lengths to explain the trade...and the risks involved - which is M&A execution

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