In January, start-up fund Ichigo Asset Management announced that it had acquired a 10.96% stake in Japanese steel maker Tokyo Kohtetsu along with its intention to "seek a dialogue with management" over the terms of a merger agreed last October with Osaka Steel Co. Ltd. That might seem like another western hedge fund hijacking the activist agenda for its own greenmail purposes. The reality, though, is quite different.
"The whole things been a nightmare," says Scott Callon, partner and CEO of Ichigo. "We spent more than six months researching Tokyo Kohtetsu as a key investment for our new fund. Then literally five days before our fund launch, it decided to go sell itself."
Not that Ichigo was averse to the merger more, it was the terms of the deal that concerned it. When these were announced, it became apparent that the interests of Tokyo Kohtetsu shareholders had been largely disregarded.
"The deal makes a lot of sense strategically," says Callon. "They are two very successful companies and the deal will bring synergies of more than 50% of Kohtetsus earnings. But then you look at the terms of the deal and its clear that shareholders are being left behind."
He has a point. Under the terms of the merger, which is in fact a takeover by Osaka Steel, shareholders in Tokyo Kohtetsu would receive 0.228 Osaka Steel shares for each of their shares. That translated into a niggardly 0.3% premium over the average Tokyo Kohtetsu share price for the one month before the announcement of the deal. Part of the reason for the skewed ratio is explained by the vastly different market values of each company Osaka Steel is many times larger than Tokyo Kohtetsu but then that underscores the fact that Osaka Steel, as the acquirer, should be paying a control premium. Callon reckons that premium should be at least 30% and in fact Osaka Steel could pay as much as 150% before the deal might become earnings dilutive.
When Ichigo approached the Tokyo Kohtetsu board about the deal, it refused to seek better terms from Osaka Steel and justified its acceptance of the terms with an independent valuation conducted by Mitsubishi UFJ Securities. Callon questions the independence of that valuation.
"[Tokyo Kohtetsu management] told us they were going to do the deal and they had a fairness opinion to back it up," he says. "But Mitsubishi UFJ Securities is a subsidiary of the Bank of Tokyo-Mitsubishi UFJ Group, and theyre the main lender to Osaka Steel. That is a long way from best practice."
Protection not a priorityAlso a breach of best practice, says Callon, is the manner in which Tokyo Kohtetsu chose to announce its recent upgraded earnings guidance. Covering the results of the first half of 2006, a period that had already ended, the announcement presaged a 32% increase in earnings for the period but crucially was delayed until after the announcement of the transaction with Osaka Steel.
"If theyd been interested in protecting the interests of their shareholders, theyd have announced their earnings upgrade before the deal," says Callon.Despite these unfortunate experiences with Tokyo Kohtetsu, Ichigo decided to invest in the company and quickly built up a significant stake. Callon and his colleagues used this stake to contest the proposed merger with Osaka Steel in what is believed to be Japans first shareholder-initiated proxy fight. The deal required the approval of two-thirds of Tokyo Kohtetsus shareholders, with a 50% quorum. Ichigos target was to gain sufficient support from other disgruntled shareholders combined with its stake, to reach the 33% of votes needed to reject the deal.
A close-run thing
The vote for the deal was an extremely close call. While existing larger shareholders sided with management, Ichigo received strong support from small investors.
"Many individual holders are saying enough is enough", Callon said just ahead of the vote. "Its hard to know if well get there, but its entirely possible."
There proved to be just enough disgruntled holders in the end. More than 500 individual investors with approximately 16% of Tokyo Kohtetsu shares rejected the merger. Combined with Ichigos stake and another 7% from several institutions, Ichigo secured almost precisely 33% of votes needed to scupper the deal. Now Callon says he will continue to support the company, despite a likely frosty reception from management.
Whatever the outcome, Callon believes he has adopted the right strategy.
"We believe you should take action when somethings wrong," he says. "Im fine with the term activist, but were respectful and, in this case, reluctant activists. We tried to do our best privately but ended up like this."