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INVESTING Tumult in credit markets can create opportunities:

August 27, 2007

The upheaval in the credit markets has cast doubt on whether the long list of the acquisitions announced months ago will be completed. Some of these deals will blow up, but there also is opportunity for investors who are able to weigh the probabilities a deal will be completed. The spread between the current market price and takeover price on many of the deals in the works offers potential arbitrage profits.

An example of a deal that has a low probability of completion is the purchase of Accredited Home Lenders by private equity firm Lone Star. In June, Lone Star offered $15.10 per share in cash to take Accredited private. However, with the turmoil in the mortgage market, Lone Star is backing out, relying on a material-change-in-business clause. Accredited countered by suing Lone Star to complete the deal. Regardless, this deal will almost certainly either be renegotiated at a much lower price, or fail altogether. Accredited, whose stock is trading around $6.50, has warned that it might be forced into bankruptcy if the deal falls apart.

The $25 billion acquisition of Sallie Mae is another deal where the buyer is trying to back out of its original commitment. A private equity group led by J.C. Flowers claims legislation considered by Congress to cut subsidies to student loan providers constitutes a material change in the company's business and thus is grounds to scuttle the deal.

Sallie Mae disputes that and still expects the $60-in-cash deal to close in October. Yet the market is forecasting a low probability the deal will close, as evidenced by the gulf between the $60 takeover price and Sallie's current stock price of $49 (a 22-percent cash return, and more than a 200-percent annualized return).

Another factor often present in many of these deals is the breakup fee. In the Sallie Mae deal, there is a $900 million breakup fee, which Flowers will have to pay Sallie if it walks-unless Flowers can prove a "material change in business."

Another big deal where investors will be closely watching to see if the buyers can access the debt markets is KKR's $26 billion purchase of First Data (4-percent return on a cash basis, and more than 20 percent annualized).

Locally, Finish Line's acquisition of Genesco for $54.50 per share offers both risk and/or reward (8-percent return, around 30 percent annualized), with both firms insisting the deal will close. The market appears more hopeful about Marshall and Ilsley's acquisition of First Indiana (4.3-percent return, around 10 percent annualized).

It will be good theater to see how all these acquisitions play out in the coming months. The private equity firms don't want to tarnish their image with failed deals. Yet, the investment banks are nervous about being on the hook for committed short-term bridge loans, and junk debt buyers are balking on terms of the original deals.

Through it all, arbitrageurs stand to make nice short-term profits if they can successfully navigate this minefield.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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