On September 13th, 2019 Tencent made a non-binding “take-private” offer for Bitauto at US$16 per share/ADS. This deal looks to have a high probability of closing given Tencent already owns 7.8% of Bitauto and has secured votes from the largest shareholders adding a further 48.5% (JD.com, Li Bin, Cox). As Bitauto is incorporated in the Cayman Island, 2/3 of shareholder votes are required for the proposal to be accepted. Therefore, the proposal only requires another ~10% of the votes to go through.
Currently, this deal offers a ~6% spread, which looks quite attractive in its own right. However, I am more interested in the contingent deal mentioned in the notes of the Bitauto take-private proposal. If Tencent succeeds in the transaction, it will result in a change of control in Hong Kong listed Yixin group, wherein Bitauto holds a 44% ownership stake, triggering an “unconditional mandatory general offer to all shareholders of Yixin.”
I find this second, conditional offer, more interesting because it is more complex, has higher potential upside and seems to have less “priced into” it. Therefore, it has the characteristics of my favourite bet: low downside and potentially very attractive upside.
If my understanding of the takeover code is correct, Tencent will have to offer Yixin shareholders at least HK$1.73 per share (6% above current prices), while if my reading of the “tea leaves” proves accurate, Tencent may offer in excess of HK$2.00 per share (23% above current prices).
Finally, the situation seems to exist due to small size, limited liquidity and it not appearing on any “deal lists” yet, as it is contingent upon the Bitauto deal closing. Therefore, the professional arbitrage community may not be very active in the situation, creating a vacuum of potential buyers and resulting in an unfair coin flip. This theory is supported by the Bitauto spread remaining relatively stable since the announcement, while Yixin’s share price has drifted down substantially (despite their probabilities being exactly the same – i.e. if Tencent acquires Bitauto, they must make an offer for Yixin).
The characters involved
The situation has quite a complex and interesting ownership structure, where the two main characters (Tencent & JD.com) effectively control Bitauto & Yixin through various cross holdings:
Putting it together:
- Tencent effectively owns 24.5% of Yixin
- 21% + (8% x 44%)
- JD.com effectively owns 22% of Yixin
- 11% + (25% x 44%)
This is important, because by agreeing to sell their holding in Bitauto, JD.com is effectively ceding control of Yixin to Tencent:
- If the transaction is approved, Tencent will control >2/3 of Bitauto
- Therefore, they will control Bitauto’s 44% stake in Yixin
- Combined with their existing 21% stake, Tencent will effectively control at least 65% of Yixin – getting them extremely close to the key threshold of 2/3 which would allow them to change the Articles of Association, take the company private etc.
If I were in JD.com’s shoes, I would not want to be stuck with a minority position in a company effectively controlled by Tencent. Therefore, when I (JD.com) agreed to become a “supporting shareholder” and sell my shares in Bitauto, I would have wanted a guarantee that, if the deal goes through and Tencent then has to make an offer to buy out the remaining shareholders in Yixin, we are compensated via a juicy premium.
Funnily enough, there is an allusion to this in the notes of the Bitauto announcement:
“As part of the arrangements between the Consortium and JD Global in support of the Transaction, the Consortium has also entered into a deed of irrevocable undertaking with JD Financial Investment Limited (“JD Financial”) in connection with the Possible Offer pursuant to which JD Financial has undertaken, among other things, not to accept the Possible Offer in respect of any shares of Yixin owned by it or make any such shares available to acceptance under the Possible Offer provided that the offer price per share for the Possible Offer does not exceed HK$2.00.”
Translating it from lawyer speak, I believe it says “JD.com will not sell its holding in Yixin for less than HK2.00 per share.” There is a chance this means that they are happy remaining a minority investor, while handing control to Tencent. But as explained, I believe this would not be a smart move strategically and I cannot see why JD.com would have agreed to a transaction structured this way.
The Hong Kong Code on Takeovers and Mergers
Normally, when a company triggers a change in control, it occurs through them buying shares and breaching some key ownership threshold (i.e. 30%). This makes calculating the “minimum offer price” rather simple, as in the case of a Hong Kong listed entity, it is simply “the highest price paid by the Offeror, during the offer period and within 6 months prior to its commencement.”
However, in the case of Bitauto/Yixin, Tencent would acquire control indirectly through purchasing Bitauto. In such cases, the acquirer triggers what is known as a chain principle offer.
Per Practice Note 19 of the Takeovers Code, “the offer price should be calculated objectively taking into consideration the transacted price for shares in the first company and the relative value of the second company” i.e. how much of the price paid for the first company is attributable to its holding in the second?
To determine what the split in value between the first company and second company is, the Executive often refers to what is known as the Pacpo Formula, so called as it stems from the pricing mechanism used in 1993 when China Strategic Investment Limited made a chain principle offer for the shares of Pacpo Holdings Limited and Hong Kong Building and Loan Agency Limited. The formula is as follows:
Applying this formula to the current situation is a little problematic as calculating the NAV of Yixin is more difficult than a Holding Company that contains more easily valued assets. Therefore, I have performed it two different ways:
- Using the market price of Yixin on the day before the Bitauto announcement (as I think it would be hard to argue the NAV is less than a freely traded market price)
- Using Yixin’s tangible book value as a proxy for NAV
With the stock currently trading for ~HK$1.63 and having closed at HK$1.71 on the day immediately preceding the Bitauto takeover announcement, I find it extremely difficult to envisage a scenario in which Tencent could offer a price for remaining Yixin shareholders less than what we can acquire the shares for today.
As my crude attempt at applying the Pacpo Formula shows, our potential upside could be anywhere from HK$1.76 per share (7%+) to HK$2.14 (30%+). Combined with the data point from the announcement that JD.com will not sell for less than HK$2.00 per share, this gives me confidence that there is a high probability of making 20%+ if the Bitauto transaction occurs.
Having an idea of the potential upside in an investment is only one part of the equation, one also needs to consider the likelihood of being correct and the downside when we are wrong.
From a fundamental perspective, the downside is difficult for me to judge as I am not an expert in Consumer Finance companies. However, at 0.7X tangible book value, with a 33% equity ratio, and not trading much above all-time lows, I think it would be hard to make a case that it’s overvalued.
Looking at the stock price chart, it doesn’t look to me like a high probability of a transaction is being priced in, with the stock declining significantly after an initial pop on the day of the announcement:
One argument I could imagine people making is “well a lot has changed in the last few weeks with the Coronavirus outbreak etc. so the probability of the Bitauto deal going through has declined.”
That was my initial thought too, however, if that were true, one would expect the spread between Bitauto’s market price, and the US$16 takeover price, to have widened over the same period (i.e. pricing in a lower chance of success). However, this is not the case, as Bitauto stock immediately jumped to US$14.95 on the day of the announcement and has remained in a relatively tight band since.
What I think is very illuminating, is comparing the price action of Bitauto and Yixin, since the announcement was made:
While Bitauto’s price (green line) has remained fairly steady, Yixin (blue) has declined ~25% since the announcement pop. This indicates that either a) the market got over-excited on day 1 and misjudged the price or b) the market is placing a lower probability on the Yixin deal completing (which doesn’t make sense because if the Bitauto deal happens, an offer for Yixin must be made).
So, in summary, I don’t know what the downside is. However, as usual I will use a range and cap it at an arbitrary 30% as I believe the lack of arb’s in the stock, and our relatively small position size compared to ADV would allow for this type of exit in a worst-case scenario.
Putting it all together
To work out whether the current ~HK$1.65 price offers an attractive bet or not, we have to run a scenario analysis. The first step being, to work out what the probability of the Bitauto deal closing is. To do that, I revert to the “wisdom of the crowds” and back-solve what the market implied probability is (as I believe the US merger arb market to be pretty efficient):
The key assumptions here are:
- The price one would be able to sell Bitauto for in the event the deal is not accepted
- The fair “required return” on a deal of this type
- For this I have used the current yield to worst on the S&P U.S. High Yield Corporate Bond Index of 5.32%
- An expected duration of 6 months
Plugging in these assumptions and adjusting the probability until the expected IRR roughly equals the High Yield Index, results in a market implied chance of success at 88%
Taking this probability and applying it to my Yixin Scenario Analysis, gives me the following expected value:
An expected return of 13% (if one could make this bet multiple times) and a likely duration of less than 1 year, is an attractive proposition to me. This is especially true because the chance of losing money is somewhere around 10% (Bitauto deal fails (13%) and the stock falls 15-30% (40% & 40%))
The only real risk is the Bitauto deal breaking. Here are my thoughts:
- Concerning points
- The deal is still conditional on DD
- The offer is preliminary and non-binding
- The Board has still not released an opinion on it, despite the announcement occurring 5 months ago
- There has been no real update despite Tencent stating they wish to move quickly
- Relaxing points
- Pre-announcement, Bitauto’s stake in Yixin was worth US$620m or 66% of Bitauto’s market cap – therefore, this deal is clearly focussed on acquiring Yixin
- Tencent already owns 21% of Yixin
- James Mitchell is on the Board of Yixin, he is the Chief Strategy Officer at Tencent and is also on the Board of Tencent Music – therefore, he likely has access to management accounts and knows the business inside and out (reducing DD risk)
Overall, I think the Bitauto transaction has a high probability of succeeding, because Tencent is more interested in Yixin, where they already have a 21% holding and a man on the Board.
Why does the opportunity exist?
I think the opportunity exists for three distinct reasons:
- Hidden from computers
- Because the Yixin deal is contingent upon the Bitauto deal closing, it is technically not a live deal
- Therefore, it will not appear on any M&A deal lists – making it invisible to computers, or traders that rely on similar news feeds
- Limited liquidity
- The free float adjusted market cap is only US$300m
- Trailing 3-month ADV is ~US$800k
- This limits the attraction for larger M&A arbitrage traders
- Less natural buyers
- Given it is listed in Hong Kong, is contingent upon another deal closing and it doesn’t have a definite price, there are very few natural buyers for this type of situation as it doesn’t fit into a typical “arb” bucket
- Therefore, only global special situation investors would be interested, and even then, it takes some digging to find and build the picture
- Bitauto take-private announcement
- Hong Kong takeover code
- Practice Note 19 (PN 19) – Chain principle offer price