TWTR 5% 2030 Bonds – A Credit Merger Arbitrage Play

Recommendation: Buy and hold for Make-Whole.

Right now, it seems like Twitter can’t possibly get more news coverage. Naturally, its equity is the hot topic being discussed in the world of merger arbitrage.

The stock is currently trading at about $44.40, a tick above halfway between the unaffected price (before Elon started buyng) and the implied purchase price if the deal were to go through – implying around a 50/50 chance of the deal closing.  A simple analysis on the equity trade is below:

However, everyone seems to be forgetting about something: the bonds! They seem to be pricing in a much lower probability of the deal closing..

Don't judge the Business Insider bond price chart.

In early April, when Elon Musk had just filed 13D and right around the time of the offer, the bond traded just around par, ranging from 98-100. It touched the 101s in May as the deal was being put together, pricing in a near-certain Change in Control tender, but since Elon has announced his intention to terminate, the bond has dropped below even its “unaffected” levels. Even with the recent announcement of the judge ruling in Twitter’s favor for an expedited trial, it has not rebounded to its unaffected price. As this combined with the debt agreement provides a chance for upside with minimized downside within the trade, I believe the 5% 2030s offer an enticing investment opportunity.

 

The Trade

The concept of the trade is to buy the bonds and profit in the case of a forced close on the deal.

The existing 5% 2030 Senior Unsecured Notes are “non-call” meaning they cannot be “called”, or prematurely paid off, except for in specifically stated circumstances. If the court rules that Elon has to close the deal, the two “call” options are as follows:  

1. The Change-Of-Control (CoC) Repurchase

2. The Make-Whole (MW) Optional Redemption

Change Of Control Repurchase

In the case of a “change of control triggering event” (in this case the sale to Elon), the Change of Control (CoC) repurchase offer must be extended by Twitter. The indenture lays out that the bondholder will have the option for the company to repurchase the bond from them at 101, give or take a few cents for interest. If a bondholder were to accept this tender offer, they would return as follows:

Make-Whole (MW) Premium Redemption

The other option in the bond for a premature call is a make-whole redemption. This optional redemption can be done “at a price equal to 100% of the principal amount”, “plus a make-whole premium and accrued and unpaid interest”. This “premium” is one of the following:

(2) is the greatest, and generates a return for bondholders calculated as follows:

Clearly, the make-whole offers a greater return for bondholders than the CoC. However, the make-whole can really only occur if the bondholder rejects (“holds out” on) the CoC offer.

Additionally, as laid out in the indenture, if >90% of holders in principal amount accept the CoC tender, the company has the right to fully execute the CoC. Therefore, those buying with the intent of achieving the MW should consider this possibility. In the condition that <90% of holders agree to the CoC and the company still tenders the CoC to those who accepted, the risk of getting left holding the debt at undesirable levels comes down to this section in the indenture:

There is a restriction on sharing liens above the basket amount of $5B with these bonds, unless approved by the bondholders. The merger agreement includes raising new senior secured debt of $10B and senior unsecured of $3B. In this LBO, they are raising multiple bridge loans in the neighborhood of $6B to retire current obligations, with $5.1B outstanding debt. Presumably, while the interest rate of existing debt is preferable to the newly raised, these 2030s will almost certainly have to be retired, as holders of this bond (most likely made up of majority institutional investors) would certainly not approve of being shoved down the cap structure, and possibly having up to $5B of the pro forma new unsecured debt share collateral with them. If this were the case, these bonds would trade down significantly. This is possibly the worst downside case – getting left holding the bonds in a much worse-off position in the new capital structure. However, it is very unlikely that the company would let these minority remaining bonds sit un-retired, as they either require bondholder approval if liens are shared, and most likely must pay off the current debt as part of the buyout according to creditor discretion anyways.

Therefore, as long as hold-outs greater than 10% of the principal occur, a make-whole should be in play. In this scenario, however, it should be noted that the company would most likely attempt to negotiate a repurchase price between the CoC at 101 and the make-whole at ~111.4, but holders could try and hold out for the MW for max upside, with the negotiating leverage that the company may likely have no choice but to retire current debt.

The Downside Cases1

Thus, the main downside cases are if the judge rules that the deal doesn’t close:

1. Twitter gets breakup fee ($1bn) – sell at unaffected price

1. Company comes out of the hassle with $1B more cash, minus professional fees. Assuming unaffected price on April 4th, pre-Elon news, at 98.96  

2. Judge rules Elon has to pay Twitter damages at a higher amount – say $10B

1. Cash infusion of $10B would certainly cover the existing debt load, and thus the bond should trade very close to par. Will assume 99.5 for simplicity

Thesis:

Buy the 2030s with the intention of holding out for a make-whole. Depending on other creditors’ sentiment and personal risk tolerance, can also buy with the intent to take the CoC @ 101. Given that the judge has ruled for an expedited trial in which Twitter has sued for “specific performance”, which forces Musk to close the deal, all signs point to Elon being forced to close. I believe that the judge will force Elon to close, but it will ultimately execute at a lower price than the current offer of $54.20/share. This is where the main risk for buying equity in this risk arb trade is, and thus I think the bonds offer an attractive risk to reward ratio, even with a CoC. Regardless of what price Elon pays, this bond will most likely have to be retired in order to meet the lien requirements. At this point, bondholders should be able to leverage for a make-whole based on the company’s need to retire existing debt, and max profit will be realized.

Notes:

1)    These downside cases are built on very simplified estimates. More analysis should be done on whether the 90% majority will be met for the CoC offer if the deal goes through. Even in the worst “likely” case, if Twitter doesn’t close the deal, they still receive $1B.

a.    The absolute worst downside case would be very conditional: 

                                          i.    Deal Closes

                                         ii.    You hold out on the CoC, and the company carries over your debt to the new PF cap structure without negotiating another repurchase. 

                                        iii.    Newly raised debt shares liens with your bonds. Also, new creditors agree to share liens and carry over your debt.

b.    However, this is an extremely conditional case, and highly unlikely 

c.     Details such as which assets are exactly collateralized for the liens are not made public, and so I am making assumptions just to consider this as a worst case.

2)    The Make-Whole case is contingent on a few conditions:

a.    Being able to amass a significant portion (10%?) of the notes without compromising your cost average in order to be able to hold out on the CoC.

                                          i.    To the extent of my analysis, I am not aware of a provision in the credit docs that allows Twitter to execute the tender offer at CoC if a simple majority is reached, nor am I aware of one that obliges the bondholders to accept a change of control offer.  

b.    Once successfully “held-out” of the CoC, the holders have to also hold out through negotiation that would be between the CoC and MW. 

c.     After this, it depends on how badly Twitter/new debt want to retire the 2030s: 

                                          i.    If Twitter wants to retire the current 2030s and not have them carry over into the new PF capital structure

1.    They have to make the MW offer/repurchase negotiate

                                         ii.    OR: If new creditors refuse to share security with the existing debt, or don’t want them to carry over old debt

1.    Twitter has to retire the debt w/ MW 

References:

1. TWTR 5% 2030 Bond Indenture

2. 13D/Merger Agreement

3. Merger Debt Agreement

4. Bond Price Chart

 

There's Levels To This

A followup to my Overton Window post – see here.

In video games, such as my favorite, Super Mario Bros, there are levels: stages of incrementally increasing difficulty you must chronologically pass through in order to progress in the game.

In investing, specifically in company valuation metrics, there similarly exist these “levels”. In recent years, as Silicon Valley startup darlings have taken over markets, it seems as if the game creators have updated the game with more levels. Long gone, it seems, are the days of simply searching for “Intrinsic Value” and investing in companies that generate “Free Cash Flow”. To be fair, Old Man Buffett is probably on the more conservative side. But still, when was the last time you heard the words “P/E ratio”? 

See above: Lucid Group, Inc. ($LCID), an EV startup. What is a good P/E ratio for an electric car company, one might ask? Many such cases. 

At the time Amazon was founded, a main gripe of its detractors was that they would be putting their money in a company that was “pre-profit” (AKA Losing Money). A mere quarter century and +$1.5T in AMZN’s market cap later, it seems like “pre-profit”, “pre-revenue”, “pre-customer”, and even “pre-idea” (okay maybe I’m exaggerating) are "pre-requisites" (haha) a company must meet, in order for an Legendary Partner (LP) at a Venture Capital Fund to invest in them. Currently, in corporate finance, the three main valuation methods used (DCF, precedent transactions, and comparable companies) commonly rely on a seemingly middle-ground Enterprise Value/EBITDA multiple to value companies. Yet, in the absence of EBITDA, some tech companies and startups have gone from a relatively tame “EV/Revenue” to now trading off "multiples of forward ARR" (next year’s expected annual recurring revenue), or "multiples of bookings" (SaaS contract commitments), or even "discount-to-ultimate-value" (X% of market leader's market cap as a base case)… wait what??

Naturally, as access to actionable investment information becomes more uniformly accessible to all, it makes sense that investors scour the lands to find potentially world-breaking and uniquely innovative companies (the Google of Web3 (what does that even mean)) as early as possible, to get in at a cheaper price (see Overton Window). The search to find these 100-baggers¹ is a grueling battle only Peter Thiel’s strongest warriors can endure, making their very own Holy Crusade from Sand Hill Road to downtown SF to dole out term sheets to “founders” (ex-Stanford, ex-FAANG, sometimes ex-McKinsey in their LinkedIn bios).  

Certainly, all this is not to say that being “pre-idea” necessarily makes a company bad, nor does being “profitable" make one good (see Enron²). As technology advances, and investors become smarter and more capable of identifying moonshots earlier and earlier, it is inevitable that more derived “levels” of valuation arise and slowly become the norm. All the more power to investors who are able to make successful investment decisions with less information to work on. I only write to hopefully discourage this from happening: 

The classic "what? you're breaking up. I can't hear you, I'm going through a tunnel"... on live TV. By the way, this was the exact top for $UPST. 

Disclaimer: I am an $UPST hater. See my writeup here.

As we stray farther and farther from GAAP every day, Benjamin Graham is no doubt rolling in his grave. But as the investor’s metaphorical Overton Window moves, perhaps different multiples or levels are needed as new measurements for a new world... until they aren't. That's all to say: there’s levels to this.

 

         Notes

1.      “100-bagger” is a term used to refer to an investment that appreciates 100 times in value, often used by venture capitalists and investors to pat themselves on the back for an impressive investment

2.      Enron infamously claimed it was profitable (net-profit), while in reality they were committing massive accounting fraud, using offshore accounts to hide significant losses and liabilities from their financial statements. Even with fraudulent Net Profit numbers, it's hard to fake cash flow. See below:

    References

1.        https://tomtunguz.com/time-to-disrupt-incumbents/

2.        https://www.youtube.com/watch?v=bKoa5xGwtJk

Chasing an Alpha High (Overton Window)

These are worth ~$10,000-20,000 btw. Each. 

If we define 'investing' as buying and selling an asset for a gain in value, a (shortened) table of contents of a book about the history of things "invested" in might look something like this:

Part I: Tangible Assets
Chapter 1 (Ancient Babylon, c. 1700 BC): Land (real estate)
Chapter 2 (Lydian Empire, c. 600 BC): Gold and shiny rocks found underground
Chapter 3 (Thales of Miletus, c. 600 BC): Olive trees/presses

Interlude: invention of Paper Money (real money?) 

Part II: “Fake Money”
Chapter 4 (Dutch East India Company, c. 1600 AD): Stocks and bonds in companies
Chapter 5 (Drexel Burnham Lambert, c. 1980 AD): Junk bonds 
Chapter 6 (internet investors, c. 2008 AD): Cryptocurrency
Chapter 7 (internet investors, c. 2021 AD): .JPG images of (arguably) fashionable monkeys

Looking at these “chapters”, we can see that ancient civilizations started out relatively tame, exchanging “real assets” that they could tangibly feel, such as olive trees in Thales’ case, for other real assets such as cattle and livestock. This evolved into paper money, which symbolized an exchangeable value for an amount of a real asset. Further on, we invented equivalents to paper money, that represented stakes in businesses, and started trading those as well.  

It is not surprising, psychologically, that humans gradually over time seek superior returns. As technology and society advance, it is not surprising either that the realms of speculation also evolve. Yet, with every “this time is different” and “my neighbor’s uncle’s goldfish made $5k staking AAVE”, you may be inclined to wonder if, truly, this time is different.  

In politics, the Overton window, as proposed by Joseph Overton, states that political ideas popular at a time lie within this “window”, and so proposed ideas do better the closer they conform to the window. Naturally, over time, politicians push ideas slightly outside of the range of the window, but just outside enough to be accepted – and policy slowly changes. Thus, the underlying idea also supported by the Overton window is that over time, society slowly becomes more progressive, as people become gradually more open to (accept) ideas laying outside the norm.

Within the box = generally accepted at this point in time. h/t David Perell

I see a similar trend in investing; after all, investing is simply buying things that society has attributed "value" to (society has accepted as being worth something), and reselling for a higher amount of this "value". Between the collapse of ancient Roman civilization, and the COVID booster shot release, we have gone from exchanging these real assets for money to levels of “trading” and speculation of assets that are increasingly questionable. But, if someone is willing to pay more than what you paid for something, does it even matter what exactly it is you are buying and selling? In the past few months, with crypto “staking” and other eye-opening, novel methods of generating returns hitting the mainstream, I see the Overton window in play: investors’ collective movement of becoming more inclusive of what they can peddle. Every time I open up Pancake Swap and think whether I should stake PoopooCoin or PeepeeCoin at 6900% APY, I remember the stories my dad tells me of Pets.com and other spectacular dot-com failures (the PoopooCoins of his generation), and I realize, humans haven’t changed. There’s just a new shiny object on the horizon.

 

Notes

1.        There is no free lunch. At least I think.

2.        The olive tree “option” trading story is my favorite trade of all time. See reference 3

3.        TLDR of this post: "...But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?" - Alan Greenspan

References

1.        https://www.mackinac.org/OvertonWindow

2.        https://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm

3.        https://medium.com/@robswc/the-first-yolo-trade-in-history-85251b910fee   

4.      https://twitter.com/david_perell/status/1259597740377399296