Mandalay event sparks furor on concern about no cash takeover protection; 20-30 names suffer

By Ronda Fears

Nashville, June 7 - Shockwaves reverberated throughout the convertible market in the wake of the surprise takeover bid for Mandalay Resort Group by MGM Mirage. Even the rally in stocks and flattish bond market couldn't rouse convertible players from the stupor hinged to the lack of takeover protection in the event of all-cash transactions like this one.

"Our market is filled with companies that have a $2 to $3 billion market cap. As for Mandalay, I don't think anyone saw it coming," said a buyside convertible trader at a huge hedge fund in New York.

Another, in New Jersey, said, "I'm a little shell-shocked myself and I don't even own any."

Ironic, perhaps, there was an upset over the weekend as well for Smarty Jones, the favorite to become the first horse since Affirmed in 1978 to win the Triple Crown. The colt was bested by Birdstone, which passed him at the 16th pole and won the race by a length, paying 36-to-1.

On whole, market sources estimated that convertibles came in something like a half-point to full point.

The Mandalay convertible plummeted almost 20 points on swap as hedgers got crushed by the par put that would be triggered by an all-cash takeover. For outright holders, which hold just 25% of the floating-rate issue, it was a flip-flopped situation as the 16.5% runup in the Mandalay stock boosted valuations.

Outright levels could even track higher as Mandalay stock surpassed the MGM offer of $68 a share on speculation that a higher bid is lurking.

Meanwhile, for some 20 to 30 other convertible issues seen vulnerable to such an event, and some that probably aren't realistic takeover targets, traders estimated price levels came in 1 to 2 points outright and 2 to 3 points on swap.

Collateral damage widespread

Despite the bullish stock market and tame bond market, the bulk of the convertible market lost ground Monday and traffic came to a virtual standstill.

"There was lots of collateral damage," said a fund manager involved in capital structure arbitrage. "Just like with the MBG cash dividend launch one year ago, all the convert hedge guys it seems to us are frantically running around trying to figure out where in their portfolios they might have ... a bond at greater-than-normal risk to premium collapse after a cash takeover.

"We are seeing some names in this category in 2 to 3 points on swap from a week ago. So, it may be 17 points loss on MBG today, but I think it's also 1, 2, or more points loss on 20 to 30 other names, too."

Many holders of the Mandalay convertible had exited the situation last year when the casino operator initiated a common stock dividend; but even those that held onto the paper didn't see a takeover event coming. So, the news sparked a massive hunt for any others looming in the market. Even some names where there is no risk at all of a takeover were getting hit.

"A lot of people took time today, looking for situations where you get killed like this," said a buyside trader. "It was pretty nasty."

Biotechs thought vulnerable

Sellside dealers mentioned a few specific names that came in Monday specifically because they are considered vulnerable to similar all-cash takeover transactions. Sepracor Inc. was one among several in the biotech area as Big Pharma might find some of those smaller firms ripe for the taking.

"A lot of things came in today. Everything is weaker," one dealer said. "Lots of the biotechs were particularly coming in because a lot of the smaller companies could so easily be picked up by one of the Big Pharma companies."

One dealer also noted that the Wells Fargo & Co. and Carnival Corp. convertibles similar in structure to the Mandalay issue were stand-out losers on the day. And, he added, the remaining pack of casino convertibles obviously dropped in sympathy with Mandalay as there could be further takeover plays made in that group.

On takeover buzz in action, General Mills Inc. initially fell back with the pack, still reeling from last week's rumors that Nestle SA had targeted the food maker, traders said, but then some players reached for the General Mills convertibles on the weakness as the Nestle takeover talk was more or less dismissed as unfounded speculation.

The bottom line, particularly for hedge fund players, was summed up by one buyside trader: "Life doesn't seem to be getting any easier."

Another buyside trader was gloomier, saying the markdowns taking place plus anticipated redemptions at convertible funds and the looming interest rate hike are "taken together, a recipe for disaster."

Cash takeover defenses sought

The sting of convertibles having no recourse for bondholders in the event of an all-cash takeover was still fresh for many players involved in the Kroll Inc. situation, which is less than a month past. And the Kroll event was the third in as many months.

Market sources have been talking about the lack of, and need for, specific protection in the event of all-cash takeovers for months but the chatter elevated after the Kroll event in mid-May - which also caught holders off guard - and got even louder Monday on the Mandalay news.

The pain was severe for holders of the Kroll convertible set up on a traditional hedge. When the all-cash $1.9 billion takeover by Marsh & McLennan Cos. pushed the stock up 30%, the convertibles added just a couple of points. With the bonds barely up and the stock way up, arbs in a traditional hedge got crushed in the short squeeze, which one source referred to as a "disaster."

At least one deal of late came to market without any change-of-control protection. CSG Systems International Inc.'s $200 million of 20-year convertible notes sold a couple of weeks ago at 2.5%, up 43%, according to a buyside market source, who had also pointed out that CSG Systems had been rumored to be a takeover target of Amdocs Ltd.

Providian, Digital River eyed

However, there also have been a couple of deals recently - the Providian Financial Corp. and Digital River Inc. convertibles - with potential blueprints for holders to warm up to, said a buyside market source who has spent time on a sellside origination desk.

A sellside analyst said he had not seen the Providian language specifically, but cautioned that the wording had to be scrutinized carefully.

"Other recent deals with cash take out language include [Oscient Pharmaceuticals Corp. and Palm Harbor Homes Inc.], although my understanding is that those two issues specify 100% cash take out," he said. "A potential buyer could, in theory, offer to buy 99.9% of [the] company for cash and sidestep the matter."

Origination officials say they are aware of the market screaming for something, but one at a top underwriting desk admitted that it sometimes can be tough to sell an issuer on a concept that could be construed as one that would protect bondholders to the detriment of stockholders.

Nonetheless, buyside sources said they will have to be acknowledged, because the impact being felt in the secondary market could be a deterrent for building investments in convertibles as well as wooing issuers.

The Mandalay situation is "unfortunate for those that hold it and no joy for those of us who did not," said a fixed-income fund manager involved in several convertible issues. "This corporate action will increase the risk premium with respect to convertibles of issuers in consolidating industries and probably exacerbate the present aversion to buying this market in a meaningful way."

Credit analysts put off thus far

Credit analysts took negative views of the Mandalay union with MGM, at least at first blush.

Standard & Poor's and Moody's Investors Service each said the credit ratings of both companies may be downgraded if the merger is consummated. S&P rates the Mandalay convertible at BB+, and Moody's rates it Ba2.

S&P said that based on the merger right now, if a downgrade were the outcome of its analysis, the cut would be limited to one notch.

If the merger was financed with all debt, Moody's said pro forma leverage for the combined company could be as high as 6.5 to 7 times. The ratings of the combined company could be confirmed at Ba1, Moody's said, if the merger is not entirely debt financed, there is a well defined plan to reduce debt and there was a high level of comfort with the future financial policy of the combined entity.

Moody's noted that both companies have a fairly high allocation of free cash flow to share repurchase as opposed to debt reduction.

Although the combination of Mandalay and MGM would create dominance on the Las Vegas Strip where the companies collectively own 11 major properties, Kimberly Noland, bond analyst with Gimme Credit, said, "A successful all-cash deal would result in a worsening of credit measures for the combined entity."

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