FAIR & FINE ???

Let us say, your friend and you are partners in a partnership firm. Your friend chances upon a piece of land which may be of use to your partnership firm. Let us say the fair value of that land is Rs 125 but he seems to be getting a good deal at Rs 100. What should he do?

Ideally he should come to you and after due consideration your partnership firm should go acquire the land at Rs 100 or for that matter any price upto Rs 125, since the land is needed for your business.

What does he do instead? He buys the land personally at Rs 100. He then promptly offers to sell the land to your firm at Rs 125 seeking increased stake in the partnership in exchange.

How would you feel about this transaction and more importantly your partner? Would you still consider him your friend?

Now for a true story on similar lines.

Listed Entity X owns a majority stake and not whole of listed Company A.

X now buys unlisted Company B for Rs 100.

On the very same day, in an apparent act of day trading, X sells B to A. So much for not treating business as pieces of paper.

Remember that A is only partly owned by X. X does not seek money for this transaction but additional shares in A which would result in increased shareholding. Interestingly based on CMP of A and the swap ratio, the implied value of this transaction works out to Rs 132. Its of course only a matter of detail that X paid Rs 100 to buy B, that day itself.

One could correctly argue that CMP of A may not be the right benchmark to make this calculation given various unknown influencing factors. Since the net effect of this transaction is increase in shareholding of X in A, maybe we should look at the SEBI defined pricing for preferential issue allotments to promoters. On that basis, the implied value would work out to roughly Rs 122. Again remember that X paid Rs 100 that day itself.

Whether you look at CMP or SEBI discovered price, it seems that X made itself neat gains of 20-30% in one day. When somebody gains somebody loses. So who lost in this transaction? Company A lost the opportunity to buy B at Rs 100 directly and ended up paying a premium of 20-30% through its equity as currency and/or minority shareholders of A ended up ceding increased control to X. All without X seemingly having brought much to the table.

Remember that X is also listed, therefore this favourable transaction should have some bearing on its share price/NAV.

Further, what if the whole of Company B was not sold in this transaction? What if X retained some undisclosed part, probably insignificant but not quantified, and sold the balance to A? How would you think about this transaction now?

Company X in the above story is Fairfax India. Company A is Adi Finechem and B is Privi Organics. However, nobody seems to be asking any questions even after 5 months of the transaction. Maybe because Company X is Fairfax?

The Dry Details

Adi is a listed speciality chemical company controlled by Fairfax. Fairfax India had acquired management control of Adi in February 2016.

On July 12^th, Fairfax acquired a 50.8% stake in an unrelated unlisted speciality chemicals company, Privi Organics Limited (POL). To acquire this stake, Fairfax paid approximately Rs 370 cr valuing POL at roughly Rs 725 cr.

The very same day, an announcement was made to carve out the aroma chemical business of POL and merge it with the listed Adi Finechem. In lieu of this merger, Adi would issue shares as well as CCPS as per the exchange ratio recommended by Grant Thorton to the shareholders of POL, including now Fairfax.

Read the related announcements here and the presentation here

Slide 23 of the presentation discloses that the implied share price for Adi for the transaction works out to Rs 287 per share. This is interesting in the backdrop that Adi shares traded on July 12^th in the region of Rs 380 per share (32% premium) while the pricing of Adi as per the SEBI formulae would work out to roughly Rs 350 per share (22% premium).

Therefore Fairfax bought POL at a valuation of 725 cr and sold it to Adi (interestingly retaining some small unquantified part of POL) at an implied value of roughly 900 cr depending on which price you use to calculate, on the same day.

We reproduce Fairfax statement on this transaction as part of their Q3 Interim Report and YES they seem to say the same thing !!!

Investment in Privi Organics Limited

On July 12, 2016 the company, through its wholly-owned subsidiaries, announced it had entered into a share purchase agreement with existing shareholders of Privi to acquire a 51% equity interest in Privi. On August 26, 2016 the company closed the acquisition of Privi for total consideration of approximately 3.7 billion Indian rupees (approximately $55 million). Additionally, on July 12, 2016 the boards of directors of Adi Finechem Limited ("Adi") and Privi approved a merger arrangement (the "Merger") involving the two companies, which is expected to bring significant diversification and synergies to both. The Merger is expected to occur in the first quarter of 2017 and is subject to regulatory approvals in India and approvals by Adi and Privi shareholders. Upon completion of the Merger, Fairfax India will own approximately 49% of the merged entity. Under the terms of the Merger, the Privi shareholders will receive 27 subordinate voting shares and 27 compulsory convertible preference shares of the merged entity for every 40 Privi shares exchanged ("swap ratio"). At September 30, 2016 the company prepared a valuation model to determine the fair value of its holding of 9,517,042 Privi shares using the quoted bid price of Adi and the swap ratio. The company's internal valuation model indicated a fair value of $82,148* and an unrealized gain of $26,568* which was not recorded in the consolidated statement of earnings as the Merger is still pending regulatory and shareholders approvals. Transaction price was considered to approximate fair value due to the proximity of the transaction closing date to September 30, 2016. At September 30, 2016 the company had appointed two of the eight Privi board members. Privi is a supplier of aroma chemicals to the fragrance industry. Privi's world-class products are the result of its very strong research and development team that has proven expertise in developing new products, customizing odor as per customer requirements, scaling up products from basic research to commercial scale, and designing process improvements to drive quality and cost optimization. With an installed capacity of 22,000 TPA of aroma chemicals, Privi enjoys a dominant position and economies of scale in its product categories.

* in '000

For listed entities Fairfax uses market price to disclose its NAV to its investors. It is not tough to conclude the impact of this transaction on its NAV.

In Conclusion

Many a time we are easily swayed by the opinion of others as well as that of media. In this case it is widely known that Fairfax is the vehicle for Mr. Prem Watsa who is widely known and respected by investors and the media as the “Warren Buffett of Canada”. This episode to us however seems to be in sharp contrast to the perceived ‘fair’ image of Fairfax. 

To our mind this has reinforced what we already know but are not always able to practice. It is important not to fall prey to the Bias of Authority and make our own independent judgements. In this case by being able to focus on what is being done rather than what is being said.

Many of our beloved notorious promoters may be wondering. “Tum karo to Ram. Hum Karen to Asaram ??” J

Best of Manufactured Luck!!

Disclosure: We have no position either long or short in either Adi Finechem or any other Fairfax controlled entity in India. This piece does not offer any view on the suitability or otherwise of Adi Finechem as an investment but only focuses on the specified transaction structuring. As such it does not constitute Investment advise and is merely a post towards enhancing learning and knowledge.