Understanding Reverse Takeovers ("RTOs")
Reverse
takeovers are corporate actions usually undertaken by listed companies which have little or no significant businesses or whose businesses are on the
decline. These companies are commonly referred to as listed "shell
companies". Although RTOs are not uncommon, the level of understanding
amongst non-institutional investors is somewhat lacking. Here we shall examine some
of the issues pertinent to an RTO and what investors should look out for.
What is an RTO?
An RTO is an acquisition of a larger private company/assets ("Target") by a shell company via the issuance of new shares to either fully or partially satisfy the acquisition consideration. Upon completion, shareholders of the Target become the new controlling shareholders of the listed shell company and the Target business achieves its listing status in the process by becoming part of the listed shell company. The shareholders of the Target will also get to elect the board of directors and appoint the management of the combined entity upon completion. For this reason, RTOs are also known as backdoor listings.
Why do companies undertake RTOs?
An RTO is often seen as an easier or more expedient alternative for a private company to achieve its listing status without having to go through the Initial Public Offering ("IPO") route. This may or may not be true, however, especially in the instance of Singapore. Ever since the heydays of RTOs back in 2006 when Wilmar International and Indofood Agri Resources, arguably the two most successful RTOs ever completed on SGX, were listed, there has been a raft of RTOs being attempted. The success rate, however, has been rather uninspiring with less than half of them successfully completed from a period of 2008 to 2013[i]. While there are many possible reasons for the dismal statistic which we would not discuss at length here, it is clear that listing via an RTO is neither as easy nor expedient as it is thought out to be.
For listed shell company, the benefits of an RTO are usually much more obvious as it is basically a choice between holding shares of a company with no substantial or a struggling business and one with the new incoming business that will hopefully inject some new life into its shares. One possible exception, however, would be an instance where a substantial amount of cash belonging to the shell company is being used to partially finance an RTO instead of being distributed back to its shareholders in the process. The risk-benefits tradeoff would be much more complex under such a scenario.
What is shell value and how is it calculated?
Shell value is the difference between the valuation accorded to the listed shell company in the RTO and the fair value of the assets it owns. For illustration purposes, we take a look at the proposed RTO of Longmen Group Ltd, a company with natural gas concessions in China, by Memstar Technology Ltd, a shell company listed on SGX, announced on 20 December 2014.
Pursuant to terms of the RTO, Memstar is to acquire Longmen for S$546 million by issuing 33.81 billion consideration shares at S$0.01615 per share. This values Memstar at S$43.1 million based on the same issue price and its prevailing total outstanding shares of 2.67 billion shares. However, Memstar only had net assets of S$2.6 million as at 30 September 2014 (the latest quarterly report prior to the RTO announcement). This means that the shell value will be computed as follows:
Valuation of Memstar = S$43.1
Less: Fair value of its assets (NTA, mostly cash) = S$2.6 million
Shell value = S$40.5 million
A large shell value can be a double edge sword
In an RTO, while the legal acquirer is the shell company, the roles are reversed for accounting purposes under rules of International Financial Reporting Standards ("IFRS"). Here, where the shell company has no significant business and does not meet the definition of a business under IFRS 3 Business Combinations, the accounting acquirer is the private company and the accounting acquiree is the shell company instead. This means that the valuation of shell company and consequently, its shell value, will have a large impact on the Profit and Loss of the combined entity post RTO.
While a larger shell value can reduce the dilution effect of the RTO on existing shell company shareholders, the shell value often has to be written off upon completion of the RTO owing to IFRS rules. In our example above, the shell value of S$40.5 million will have to be written off as an expense in accordance with IFRS 2 Share-based Payment in arriving at the earnings of the post RTO enlarged entity. Although the impact is largely non-cash, investors and shareholder should note this big one-time drag on its Profit & Loss if and when the acquisition is completed.
An RTO can be a long drawn affair
In our experience, an RTO can take between 6 months to 2 years from the date of announcement to completion. This can be longer than a standard listing via the usual IPO process. Although the shell company being a listed entity is required to make periodic updates on any significant developments, shareholders are often kept in suspense during the interim period and as a result the trading of the shell company's shares can be subject to much volatility and speculation.
Significant costs may be incurred
In addition to the standard professional fees paid to bankers, lawyers, etc, RTOs sometimes incur one other significant cost not commonly found in IPOs: Finder's fee (also known as introductory fees). This is the fee paid to certain individuals or corporates for bringing the shell company and Target together i.e. brokering the transaction, is usually paid in new shares issued by the shell company upon completion of RTO and can be hefty at times. In Memstar's case, the Finder's fee was 4% of the total acquisition consideration or about S$21.8 million to be satisfied through issuance of new shares!
Conclusion
Investors would do well to tread with caution when trading shares of shell companies with ongoing RTOs. Owing to the lengthy and uncertain nature of RTOs, one should consider the different variables that could ultimately affect the valuation of the combined entity post completion. These should not only take into account the valuation and prospects of the incoming business, but also the shell value and valuation of the listed shell company, potential synergies if any, total expenses including any brokerage fees, etc. before a decision is taken to trade in these shares.
[i] Business Times, 19 Oct 2013: Only 19 of 47 RTOs announced from 2008 were completed, with 20 cancelled and 8 still pending.
What is an RTO?
An RTO is an acquisition of a larger private company/assets ("Target") by a shell company via the issuance of new shares to either fully or partially satisfy the acquisition consideration. Upon completion, shareholders of the Target become the new controlling shareholders of the listed shell company and the Target business achieves its listing status in the process by becoming part of the listed shell company. The shareholders of the Target will also get to elect the board of directors and appoint the management of the combined entity upon completion. For this reason, RTOs are also known as backdoor listings.
Why do companies undertake RTOs?
An RTO is often seen as an easier or more expedient alternative for a private company to achieve its listing status without having to go through the Initial Public Offering ("IPO") route. This may or may not be true, however, especially in the instance of Singapore. Ever since the heydays of RTOs back in 2006 when Wilmar International and Indofood Agri Resources, arguably the two most successful RTOs ever completed on SGX, were listed, there has been a raft of RTOs being attempted. The success rate, however, has been rather uninspiring with less than half of them successfully completed from a period of 2008 to 2013[i]. While there are many possible reasons for the dismal statistic which we would not discuss at length here, it is clear that listing via an RTO is neither as easy nor expedient as it is thought out to be.
For listed shell company, the benefits of an RTO are usually much more obvious as it is basically a choice between holding shares of a company with no substantial or a struggling business and one with the new incoming business that will hopefully inject some new life into its shares. One possible exception, however, would be an instance where a substantial amount of cash belonging to the shell company is being used to partially finance an RTO instead of being distributed back to its shareholders in the process. The risk-benefits tradeoff would be much more complex under such a scenario.
What is shell value and how is it calculated?
Shell value is the difference between the valuation accorded to the listed shell company in the RTO and the fair value of the assets it owns. For illustration purposes, we take a look at the proposed RTO of Longmen Group Ltd, a company with natural gas concessions in China, by Memstar Technology Ltd, a shell company listed on SGX, announced on 20 December 2014.
Pursuant to terms of the RTO, Memstar is to acquire Longmen for S$546 million by issuing 33.81 billion consideration shares at S$0.01615 per share. This values Memstar at S$43.1 million based on the same issue price and its prevailing total outstanding shares of 2.67 billion shares. However, Memstar only had net assets of S$2.6 million as at 30 September 2014 (the latest quarterly report prior to the RTO announcement). This means that the shell value will be computed as follows:
Valuation of Memstar = S$43.1
Less: Fair value of its assets (NTA, mostly cash) = S$2.6 million
Shell value = S$40.5 million
A large shell value can be a double edge sword
In an RTO, while the legal acquirer is the shell company, the roles are reversed for accounting purposes under rules of International Financial Reporting Standards ("IFRS"). Here, where the shell company has no significant business and does not meet the definition of a business under IFRS 3 Business Combinations, the accounting acquirer is the private company and the accounting acquiree is the shell company instead. This means that the valuation of shell company and consequently, its shell value, will have a large impact on the Profit and Loss of the combined entity post RTO.
While a larger shell value can reduce the dilution effect of the RTO on existing shell company shareholders, the shell value often has to be written off upon completion of the RTO owing to IFRS rules. In our example above, the shell value of S$40.5 million will have to be written off as an expense in accordance with IFRS 2 Share-based Payment in arriving at the earnings of the post RTO enlarged entity. Although the impact is largely non-cash, investors and shareholder should note this big one-time drag on its Profit & Loss if and when the acquisition is completed.
An RTO can be a long drawn affair
In our experience, an RTO can take between 6 months to 2 years from the date of announcement to completion. This can be longer than a standard listing via the usual IPO process. Although the shell company being a listed entity is required to make periodic updates on any significant developments, shareholders are often kept in suspense during the interim period and as a result the trading of the shell company's shares can be subject to much volatility and speculation.
Significant costs may be incurred
In addition to the standard professional fees paid to bankers, lawyers, etc, RTOs sometimes incur one other significant cost not commonly found in IPOs: Finder's fee (also known as introductory fees). This is the fee paid to certain individuals or corporates for bringing the shell company and Target together i.e. brokering the transaction, is usually paid in new shares issued by the shell company upon completion of RTO and can be hefty at times. In Memstar's case, the Finder's fee was 4% of the total acquisition consideration or about S$21.8 million to be satisfied through issuance of new shares!
Conclusion
Investors would do well to tread with caution when trading shares of shell companies with ongoing RTOs. Owing to the lengthy and uncertain nature of RTOs, one should consider the different variables that could ultimately affect the valuation of the combined entity post completion. These should not only take into account the valuation and prospects of the incoming business, but also the shell value and valuation of the listed shell company, potential synergies if any, total expenses including any brokerage fees, etc. before a decision is taken to trade in these shares.
[i] Business Times, 19 Oct 2013: Only 19 of 47 RTOs announced from 2008 were completed, with 20 cancelled and 8 still pending.
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