The right way to split up

COMMENT

The separation transaction at Element Financial Corp. is scheduled to be completed next Monday. As a result there will be two companies — Element Fleet Management and ECN Capital — associated with the former Element.

Certainly shareholders expressed their enthusiasm for the breakup, with 99.5 per cent of the votes being in favour. That level of support was slightly higher than for the second item on the agenda, the decision to allow ECN Capital to purchase INFOR Financial, a special- purpose acquisition company.

While time will tell whether the market will ascribe a higher value to the two elements of Element, some investors, particularly those who own convertible debentures, have expressed concern at the process.

Under t he separation agreement, $ 920 million of convertible debentures issued by Element stay with Element Fleet — but because of the separation, the previous conversion price has to be adjusted.

In t he supplementary disclosure to Element’s Q1 financials, released May 11, we were told, “the respective Conversion Prices of the Debentures will be adjusted downward based on the relative fair market value of the Commercial Finance business being spun out at separation, as determined by the Element Board ( in consultant with independent business valuator and advisors).”

Holders were then given a mathematical example of how the adjustment would work. Three factors went into that calculation: the conversion price for the debentures ( known to investors when the issue was sold); “the historical trading price” of Element’s common shares “for a trading period prior to the effective date of the separation;” and the assumed fair market value of the commercial fleet business “being spun out at separation.” The two final factors were to be “determined by the Element board.”

Three months later we are told something different. In the Aug. 11 separation update, this was said: “The respective conversion prices of the debentures will be adjusted per indentures with reference to the relative trading prices of Element Fleet common shares and ECN Capital common shares over a 10 VWAP (volume weighted average price) period immediately following the separation close (subject to TSX approval.)”

Accordingly, the new formula will incorporate trading prices 10 days after the separation compared with the previous 20 days prior; and it will use market prices compared with the previous board- determined fair market value.

As for the effect of the change, in general if ECN trades better than expected, t he adjusted conversion price will be l ower; if it trades worse than expected, t he adjusted conversion price will be higher. In general, a higher conversion price leads to less dilution.

Scotiabank analyst Phil Hardie released a report this week on ECN, which has already been trading in the grey market. ( He argues book value is $ 3.95 a share.) After noting the wide range — between $ 2.75 and $ 3.25, with $3.03 being the volume weighted average — he said investors should prepare for potential volatility in ECN Capital shares over its first few days as a publicly traded company.

Complicating matters is the vote by INFOR shareholders on being acquired by ECN. The further ECN trades below book value, the less likely are INFOR shareholders to support the acquisition.

John Sadler, Element’s head of investor relations said, “This is common practice in the U. S., where there are a number of precedent transactions. By using VWAP, there is no need to use an estimate of fair market value, because there is a market indication of the relative value of the companies.”