PPG/GGC arbitrage

Both alpha vulture and whopperinvestments have posted about the odd lot arbitrage available for PPG holders due to PPG’s sale of its Chlor-alkali and derivatives business.

Basically, PPG Industries is selling that business to Georgia Gulf in a Reverse Morris Trust transaction. You can read the details of the transaction in the sec filing here.

You might read that filing and be a bit confused. I was. But I think I’ve got it figured out.

The first thing to realise is that transactions that avoid or minimise taxes are necessarily different in legal form than economic substance. That’s because generally, tax systems do try to tax economic substance. But because tax law is based on legal structure, tax law will attempt to determine a transaction’s economic substance by looking at the transaction’s legal form.

So what’s the best way to hide the economic substance of a sale? Make it look like a purchase! That’s what a Reverse Morris Trust transaction does.

Economically, what happens in this transaction is that PPG sells GGC its chlor-alkali and derivatives business for $900 m, plus 50.5% of GGC.

But GGC can’t just give PPG $900m and the shares, because that would legally be a sale of the business for $900m and the shares. And it would be taxable.

So PPG does the following:

  • Splits off the business it wants to sell into a subsidiary.
  • Has the subsidiary borrow $900m (it even does this in a slightly complicated way but we don’t need to worry about that).
  • Gets the subsidiary to pay it (PPG) the $900m.
  • Gives its shareholders an 11% discount in the new shares of the subsidiary, to entice them to buy (more on this a bit later).
  • Has a subsidiary of GGC merge with the PPG subsidiary (so the GGC subsidiary disappears and the PPG subsidiary is the only thing left).
  • The shareholders of the PPG subsidiary (who got their shares at a discount) now get GGC shares because of the merger (in a special formula).
  • GGC is now the debtor of the $900m.
  • PPG subsidiary shareholders now own 50.5% of GGC (because they exchanged their subsidiary shares of GGC).

So it looks like PPG bought GGC (hey, it now owns 50.5%), but it actually sold GGC its chlor-alkali and derivatives business, got $900m, and a chunk of GGC shares.

(I figured this all out last night so I might have a few details wrong – let me know if I’ve missed something).

And the opportunity? Well, normally this would just be a complicated merger transaction and there would be the usual spread of a few percent to take into account transactions costs/hedging costs/risk that the deal falls over at the last moment.

That isn’t interesting to someone like me who can’t minimise those transactions and hedging costs and has no advantage knowing whether the risk is higher or lower than perceived by the market.

But the real arbitrage opportunity comes if you only have a small amount of capital. PPG is much larger than GGC. So not all PPG shares can be exchanged for the 11% discount.

At first you might ask, why even have a discount? I think it’s because the transaction needs to give PPG shareholders an incentive to acquire more than 50% of GGC. When this happens, it looks like (and in legal form it is) PPG shareholders buying GGC.

But PPG shareholders are actually just interested in getting a fair price for the chlor-alkali and derivatives business. So there needs to be an incentive in the deal to get enough PPG shareholders to exchange their shares so that PPG shareholders end up buying a chunk of GGC. Hence the discount.

Now, because the discount is limited to only a certain amount of shares, the market isn’t discounting the PPG/GGC spread enough to fully factor in 11%. But some PPG shareholders get to tender all their shares – odd lot holders.

If you hold 99 shares or fewer (an “odd lot”), you will not be prorated. So the arbitrage opportunity is basically hoovering up the discount from other PPG shareholders who own more than 99 shares and will be able to tender fewer and fewer the more odd lot holders there are.

Odd lot holders can fully hedge by shorting the right amount of GGC, but hedging for such little amounts is expensive. I intend to simply hold PPG.

Disclosure: Long PPG. Do your own research – I could be wrong about several details above. 

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One thought on “PPG/GGC arbitrage

  1. Pingback: Performance Update Update | fund of well-conceived investments

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