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December 9, 2010

Energold “Bought Deal” Financing

After the close on December 2nd, Energold (EGD: Canada) announced that it had entered into a “bought deal” financing with a syndicate of underwriters to raise CAD $15 million. The terms are a unit at $3.70 with a 2 year half warrant at $4.50 that is callable at $5.25. I had no idea that such a financing was imminent and was shocked to hear about it. After having spent a few days thinking it over, I want to talk about what this means for the company. In particular, I want to talk about “bought deal” financings.

What is a “bought deal” financing? It is a method of raising capital where the underwriters promise to raise a certain amount of capital for a company on agreed upon terms. If the underwriters are unsuccessful in raising the capital, they are forced to purchase the shares themselves on the agreed upon terms. Naturally, brokers do not enter into these agreements unless they are confident they can find investors for the shares—hence the terms are unnaturally attractive to the purchasers.

You may wonder why companies choose to participate in such transactions. To start with, it guarantees a company that the deal will be completed on set terms. Rumors of imminent financings have a dirty habit of leaking out. Although investors are not supposed to trade on inside information, aggressive funds often maliciously push shares lower. Companies are then forced to re-price the deal. “Bought deals” eliminate this risk. However, choosing a competent broker also can significantly reduce this risk. It’s not exactly a secret who the bad apples are in the fund community. Bought deals also save companies the headache of doing a marketed road-show. Meeting with a few dozen prospective investors is time consuming and expensive. Management teams often prefer to focus on their business and leave the marketing to brokers. If this means that they give up an extra percentage or two on pricing terms, they see it as worth saving them the hassle.

To understand why I HATE “bought deals,” let me walk you through the mechanics of how they ACTUALLY work. I realize that this is a bit too much ‘inside the game’ for some of you, but please stay with me—it’s important to understand this.

The deal usually starts with something as innocent as a large fund calling a broker asking if he knows of any sizable blocks for sale. The broker then checks around and says that there’s nothing for sale, but he thinks the company may be willing to do a financing—it never hurts to ask right?  The buyer then commits to buying shares if the company wants to raise capital. This is the critical moment. The broker cannot call up a $140 million market cap company like Energold and ask to raise $4 million. Instead, he offers to raise something meaty, like $15 million. The hook is that there’s no effort for the company. No planning, no travel, nothing. They just get a check in the mail. Ask your board if they are interested? Dangerous words indeed. It’s the crack cocaine of the Canadian market. No one ever says no.

Most boards take the money when it’s offered. There’s a bit of squabbling over terms, but the broker is the one who can walk away from the transaction. They price the deal where they think it will be easy to raise the money. Think like a buyer for a second. You wanted a million shares of Energold. The stock was at 4.05. From past experience, you figure that you will run the stock up to 4.50 to complete your position. Furthermore, it will take you two months to do it and your average price will be 4.30. Suddenly, your favorite broker calls you to say that you can have your million shares at 3.70 and you also get a half warrant at 4.50. Interested? Of course you are. Heck, the terms are so good; you’ll take $5 million worth. The broker signs the deal with the company, but can they sell the other $10 million worth?

Brokers aren’t stupid. They know which clients have been buying shares lately. They know the fundamentals of the company. They know they can syndicate a bit of it to friends. They don’t do a “bought deals” unless they’re pretty damn sure they can sell it, but they are never completely sure. After the market closes, the scramble begins. You have until the open the next morning to sell $10 million worth of stock. As soon as the stock opens, you know it will get slammed—you have a $10 million time-bomb on your hands. For a small broker, that’s a big risk to take. What do you do?

To start with, you call the largest shareholders. It’s a very attractive proposition for a guy like me. I can buy 200,000 shares at 3.70, sell 200,000 shares that I already own at say 3.80 and pocket a $20,000 gain immediately. Even better, if the shares go up and the warrants get called, I will make at least 75 cents a share or another $75,000. This is only a small piece of my position, if I thought I could sell more shares at around 3.80, I could take a much larger allocation. This is called flipping. It’s the closest thing in the galaxy to free money. Actually, it is free money. Naturally, I got the call just after 4pm. This is the first that I knew of the deal.

I get to see a lot of really amazing deals that very few other funds get to see. This is because I have a reputation for not doing what I just talked about. I am not a flipper. Sure, it’s attractive to cleave off a free warrant, but if you start doing that, you never get to see the very best deals. Those are reserved only for people who are long term shareholders. I am a long term shareholder. I want to get into the deals that everyone fights for. Even more importantly, I want to get my full allocation of shares. You cannot cross the line. Once you are a flipper, you are always a flipper.

I chose not to participate in the deal. Still, the brokers offered me the courtesy of participating. I could add to my position, or flip stock. They know that as a large shareholder, they have to let me participate. Otherwise, I could get angry and aggressively dump stock. As soon as it goes under the deal price, the deal is pretty much dead. No one wants that.

After the brokers have been through the large shareholders, they start calling people who they think may be interested. They call people who have traded the stock in the past. They call whoever they can think of. Eventually, they get desperate. There are flipper funds. These guys just flip stock to get the warrants. They do the financing and immediately short out the restricted shares from the deal. The broker even sometimes facilitates the stock loan from other clients to get the deal done. These flipper funds see the free warrant and calculate a value for it. My Bloomberg says that the warrant is worth 44 cents, so I will use that value. Let’s say that from experience, the flipper fund figures it can short the stock at 3.60 or better. This means that they will lose at most 10 cents on the common stock, but they lock in the 44 cents of option value. Net-net, their model says they make 12 cents on the trade (10c loss + 22c gain on the half warrant per unit). If their execution skills are good, they may make a good deal more money. In four months when the legend comes off, they use their new free trading shares to repay the short. In the process, they’ve earned a 2 year warrant. If they play their cards right, they make or lose a few cents per share over hundreds of deals. They have no idea what most of these companies do. It doesn’t matter to them. All they know is that they’ve acquired a diversified basket of warrants. Enough of these warrants will hit for the flipper fund to earn a nice return for investors.

Sometimes, even the flipper funds won’t touch the deal—it’s just too dodgy. Sometimes the broker dangerously overestimates the demand for the deal. In a blind panic, he calls everyone he knows. “Can you do me a favor and take $100k of this crap off my hands? I’ll make sure you get a good allocation on the next deal.” Some brokers will try anything. On the opening bell, the flippers start selling stock. The flipper funds start getting short. If there’s no real demand, it will show right away. Then the broker is stuck with it because no one will step into a deal going bust. After fees, the broker probably won’t lose too much money, but his balance sheet is jammed with paper that no one seems to want. The stock will limp for a long time until it has found the level where buyers reappear.

This is why I passionately HATE “bought deals.” The company gets bad terms and if the deal isn’t popular, the shares are capped for months. If it breaks pricing, the shares can take a dive as flipper funds panic to hedge off their longs. Damn near anything can happen in the short term. What will happen on this Energold deal? I have no idea. Initial indications are that the shares have been well placed with a few large funds. The fact that the shares dropped on Friday means that at least someone is flipping stock to take the free money. Can you blame them? Eventually, these shares will find a happy home and the company will again trade on fundamentals.

When a company does a “marketed deal,” real buyers show up because they want the deal. The flippers don’t usually get a piece and the broker doesn’t end up eating the deal if it doesn’t work. The deal is priced based on an order book of firm bids. It’s just a smarter way to do things. Sure, it takes work and it takes time, but it’s a collaborative effort where the right people get to participate. “Bought deals” make investors feel like they’ve just been gamed.

So why did Energold do this deal? They needed the money. They have a very aggressive growth plan for 2011. They have the demand and they want to take market share. Per meter pricing is screaming higher and they want more rigs turning. Look at the third quarter balance sheet. There’s only $9.3 million in cash. Each rig costs over $600,000 when you include spare parts and working capital. The company could add rigs piecemeal as they earn the money, or they could opt for a capital raise. The advantage of raising capital is that you can order a few dozen rigs simultaneously and have them built during the winter. They are then delivered in the spring and they start cash flowing right away.

2 Year Chart Of Energold From Bigcharts.com

Another way to think about it is that the company intends to grow the rig count roughly 30% next year by growing the share count by only 12%. If you think of it that way, it’s not the world’s worst bargain. Of course the company could use debt, but this is a cyclical industry. You cannot risk the company just to save a few shares.

I’m frustrated to see the company raise money at $3.70. I feel that by waiting another quarter or two, they would have gotten a much better price. At the same time, such a raise would have pushed some of the growth back into 2012 as the rigs wouldn’t be delivered until the fall of 2011. In the end, saving a dollar on this deal just isn’t that much dilution in the scheme of things. At least they didn’t raise money when the shares were $2.50 a few months back. What I am really annoyed by is the “bought deal” nature of this financing. I HATE “bought deals.” For months, I’ve been saying that I wanted a chance to buy a pullback in the shares. If this deal is like other “bought deals” I’ve witnessed, I may get just such a chance. The company is doing great. You can argue the merits of raising money at these terms, but I still like the business. I just passionately HATE “bought deals.”

Categories: Current Investments
Positions Mentioned: none

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