Case 066Event-driven and merger arbitrageHard

Nalvar Infotech will buy back 5% of its shares at Rs 1,500 through a tender offer while the stock trades at Rs 1,380. If 60% of shares are tendered and unaccepted shares fall back to Rs 1,350, what do you make tendering 1,000 shares?

The situation

Nalvar Infotech, a listed IT services company, announces a buyback of 5% of its shares at Rs 1,500 each through a tender offer. The shares trade at Rs 1,380, and before the announcement they traded at about Rs 1,350. You expect holders of 60% of the shares to tender.

Assume, as a framework to be checked, that the rules reserve 15% of the buyback for small shareholders, those holding shares worth no more than Rs 2 lakh on the record date, and that small shareholders own 10% of Nalvar's stock and tender at the same 60% rate. Shares not accepted are returned and, you expect, drift back to Rs 1,350 after the offer closes. You are considering buying 1,000 shares at Rs 1,380 to tender.

Your task

Work out the acceptance ratio, the value and return of your 1,000 shares, the acceptance ratio you would need to break even, and how the small-shareholder quota changes the picture. State the framework and tell the reader to confirm current rules.

Quick check

The buyback pays Rs 1,500 against Rs 1,380 in the market, an 8.7% premium. What does tendering 1,000 shares make?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Tendering 1,000 shares loses about 1.3%, because only about 7.9% are accepted. 5% of the stock bought against 60% tendered is 8.3%, and the small-shareholder quota trims the general category to 7.9%. About 79 shares earn Rs 120 each; about 921 come back and lose Rs 30 each. The trade needs 20% acceptance to break even. The acceptance ratio, not the headline premium, decides the return.

Step 1How many of your shares will actually be bought?

Divide what the company buys by what is offered to it. A shop giving a Rs 120 discount on the first 50 of 600 people in the queue does not give each person Rs 120; it gives one person in twelve the discount. Nalvar buys 5% of its shares and holders of 60% tender, so without any quota each tendered share has a 5 / 60 = 8.3% chance of being bought, the acceptance ratioThe share of the shares you tender that the company actually buys, set by the size of the buyback against the total tendered in your category.. Everything else comes back to you at whatever the market then pays.

Step 2What does the small-shareholder quota do?

It splits the buyback in two. Under the framework assumed here, 15% of the buyback is kept for small shareholders, who own 10% of the stock. Small holders then get 0.15 x 5% over 0.60 x 10%, a 12.5% acceptance ratio; everyone else gets 0.85 x 5% over 0.60 x 90%, 7.87%. A fund buying 1,000 shares at Rs 1,380 holds Rs 13.8 lakh, well above the small-shareholder limit, so it sits in the general category. SEBI's buyback regulations set the reservation, the definition of a small shareholder and the entitlement rules, and they have been amended; confirm the current provisions before relying on these figures.

What happens to the shares you tender: accepted at Rs 1,500, the rest handed backGeneral category: 1,000 sharesAcceptance ratio 7.9%921.3 returned, fall to Rs 1,35078.7 accepted at Rs 1,500AcceptedRs 118,056ReturnedRs 1,243,750Total valueRs 1,361,806Paid at Rs 1,380Rs 1,380,000Result: Rs -18,194, -1.32%Small shareholder: 140 sharesAcceptance ratio 12.5%122.5 returned, fall to Rs 1,35017.5 accepted at Rs 1,500AcceptedRs 26,250ReturnedRs 165,375Total valueRs 191,625Paid at Rs 1,380Rs 193,200Result: Rs -1,575, -0.82%
Tendering 1,000 shares in the general category gets about 79 accepted at Rs 1,500 and 921 returned to fall to Rs 1,350, a loss of 1.32%, while a small shareholder with 140 shares gets 12.5% accepted and still loses 0.82%.
Step 3What does the trade make, and where does it break even?

Value the two parts separately. About 78.7 accepted shares at Rs 1,500 plus 921.3 returned shares at Rs 1,350 is Rs 1,361,806, against Rs 1,380,000 paid: a loss of Rs 18,194, 1.32%. Each accepted share earns Rs 120 over your cost; each returned share loses Rs 30. The trade breaks even when accepted shares are one in five of those tendered, a 20% acceptance ratio. Or, holding acceptance at 7.9%, when the returned shares hold Rs 1,370. If they held Rs 1,380 exactly, the trade would make 0.68%, a thin return for a month of capital.

The relationship
Return=a×1,500+(1−a)×1,3501,380−1=0  ⇒  a=1,380−1,3501,500−1,350=20%\text{Return} = \frac{a \times 1{,}500 + (1 - a) \times 1{,}350}{1{,}380} - 1 = 0 \;\Rightarrow\; a = \frac{1{,}380 - 1{,}350}{1{,}500 - 1{,}350} = 20\%
aacceptance ratio
1,500buyback price for accepted shares
1,350expected price of returned shares after the offer
What it says in wordsThe trade breaks even only when a fifth of what you tender is bought, because the Rs 30 loss on each returned share is a quarter of the Rs 120 gain on each accepted one.
Return against acceptance ratio: the trade needs about 20% to break even-3%-2%-1%0%+1%+2%0%5%10%15%20%25%30%Share of your tendered shares accepted at Rs 1,500Breakeven at 20%General 7.9%: -1.32%Small holders 12.5%: -0.82%
If returned shares fall to Rs 1,350, the tender trade breaks even only at a 20% acceptance ratio; the general category's 7.9% loses 1.32% and even the small-shareholder quota's 12.5% loses 0.82%.

Close with what would change the answer. Lower tender participation raises acceptance: if only 30% tendered, the general ratio would roughly double. A smaller fall after the offer helps too, as does buying below Rs 1,380. And tax matters: the treatment of buyback proceeds in shareholders' hands has changed in recent years and can turn a thin gain into a loss, so confirm the current rules before modelling after-tax returns. The disciplined version of this trade is sized on the acceptance ratio you can defend, not the premium on the announcement.

Where candidates lose it

The frequent error is quoting the 8.7% premium as the return. The premium is earned only on the accepted shares, and here that is fewer than one in twelve.

The second is ignoring what happens to the returned shares. A buyback often props the price up until the offer closes; once it closes, the support goes, and the loss on the returned shares decides the trade.

What the interviewer asks next

  • At what tender participation does the general category break even, holding the Rs 1,350 fall?
  • Could a fund split its holding into small-shareholder accounts? What would stop it?
  • How would you hedge the returned shares while the offer is open?

Company names and figures are illustrative.