Monday, March 10, 2014

Avalon Correctional, an unlisted information arbitrage

Gaining an edge in small unlisted companies isn't uncommon, and done timely can be lucrative.  I want to talk about an investment I made that symbolizes everything that's great about unlisted stocks.  Opportunities like this don't come often, but when they do investors need to have the foresight and ability to act quickly.  For those of you who scan for a ticker and purchase without reading further I'd urge you to not act.  This investment has already run its course, this is a post-mortem writeup.

At the end of 2012 I was working my way through a list of stocks that no longer file financials with the SEC or OTCMarkets.  At the time I had a habit of checking companies who's OTCMarket filing status had changed to "No Information".  I would then Google the company and see if I could find any morsel of information that might prove valuable.

I came across Avalon Correctional (CITY) and a press release filed the same day announcing a tender offer in response to a lawsuit ruling.

Company tender offers can be a great source of value for investors.  An investor might buy shares at $10 and then tender them to the company for $10.50 picking up a 5% gain in the process.  When a company announces a tender arbiters bid up the shares and the spread between the market price and tender price tightens.  If you listen to financial academics the spread between the tender price and the market price reflects the risk of the tender not happening.  Of course the market isn't always right.

To understand this transaction you need to understand Avalon Correctional and how they ended up at this forced tender.  The company operates halfway houses across Oklahoma, Texas and Wyoming.  States contract with them to provide services that the state would normally otherwise provide.  Private prisons are supposed to be cheaper for taxpayers.

Up to 2005 the company was SEC reporting and exchange listed.  They decided to go dark suspend regular reporting.  Around the same time the company changed their corporate registration from Oklahoma to Nevada.  When a company goes dark sometimes investors will allege that management simply wants to loot the company while remaining out of sight from investors.  That accusation was leveled against Avalon Correctional by Ravenswood Management, a fund with a large holding.

Ravenswood Management is run by Robert Robotti, a one time protege of Mario Gabelli.  Robotti has had a history of investing in smaller companies with value traits such as Avalon Correctional.  Robotti's firm issued a large records release request via lawsuit soon after the company went dark.  The two parties fought back and forth in court for years.  The company claiming that due to their new Nevada domicile they weren't required to release any information to investors.  Robotti claimed the company was paying above market rates to lease equipment from a management owned entity, insider dealing and other disturbing practices.  The company fought back against Ravenswood every step of the way, which for me only served to validate his claims.  Ravenswood was seeking a $10m payment to shareholders.

The years of lawsuits ended with a ruling that Avalon Correctional was to tender to purchase any and all remaining shares.  Additionally Ravenswood was to sell their stake back and agree to not sue any further.

The company was offering to repurchase shares at $4.05 a share, which was a full dollar higher than the last trade price.  In some versions of the press release it also mentioned that shareholders who tender would receive preferred shares with a par value of $1.60 that pay a 7% dividend.

Stocks on the OTCMarket are famously inefficient and I ventured that most investors in Avalon Correctional hadn't seen the news.  I placed an order for shares at $3.01, and unsurprisingly a portion of my order filled.  It was at this point that I made a big mistake.  I noticed that more shares were available at $3.25 and $3.50, but I decided I'd rather be patient and wait for more to fill at $3.01 rather than follow the price up.  I was greedy and stupid, as a result my position wasn't as large as I wanted it to be.  I should have purchased as much as I could at any price under $3.50.

The press release I had relied on for my purchase decision didn't have any of the finer details of the transaction.  I thought that maybe the gap between the share price and the offer price was due to some investor ignorance, but also the risk of the deal not closing.  Soon after I had my shares I started to receive massive legal briefs in the mail regarding the position.  The transaction between Ravenswood, Avalon Correction and shareholders was a result of a ruling, and was being enforced by the courts.  I reasoned that since the transaction resulted from a legal ruling there was almost no chance of it failing.

I continued to receive briefs updating me over the months on what was taking place.  I sat tight with my extremely illiquid shares and attempted to buy more when possible.  Eight months after the deal was announced I received my cash of $4.05 per share and the preferred shares, which have already paid dividends.

There are a number of take aways from the investment.  The first is that small and unlisted stocks are often not efficient, or even close to efficient.  I was able to buy shares for $1.04 less than the tender price, and receive preferred shares for 'free'.

The second take away is when investing in these companies and situations you need to be confident in your conclusions.  When I called Fidelity to tender my shares I found out they had bad information on the deal.  The investment rep said there'd be no preferred shares to accompany the tender.  As he explained what he thought the deal was I had my massive notice from the District Courts in Oklahoma detailing that if I tendered I would in fact receive shares.  I went with the information I knew and trusted my conclusions.

The last lesson is that while these deals aren't often they do exist, and when they happen investors need to act in size and act quickly.  I tried to act in size, but due to a foolish mis-calculation on my this was a small portfolio position instead of a larger one.

Disclosure: Long Avalon Correctional preferred shares

10 comments:

  1. Good story and I can understand why you didn't want to post about it before. You can find value by reading things that no one else is reading, but sometimes it is hard to keep the faith that you will find something. You have to go down a lot of dead ends to find stuff like this.

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    1. Matt,

      Your last sentence rings true, lots of dead ends indeed...

      Nate

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  2. Great post, very interesting case. How soon after you found the news of tender did you move to buy shares? Did you have any indication of the value or the company (in case the tender somehow fell apart) or was this purely a play based on the legal facts?

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    1. I placed my order to by the following Monday, it took about a week for my shares to fill.

      As for value, I remember seeing an older balance sheet and income statement for the company. I can't find it online anymore, but at the time I remember thinking that I wasn't going to lose my shirt. If I remember correctly the tender and preferreds undervalued the company, I wasn't complaining.

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  3. nate - can you share how many shares you were able to purchase at the $3 level? curious how actionable this was. very interesting.

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    1. My initial order was for 2,000 shares I think, I didn't get a full fill. A friend got a full fill on a similar sized order.

      Looking at the reported volume online I can see maybe 5k shares or so traded. There could be volume that was unreported as is common with these stocks. I'd say the total opportunity size was maybe $20-30k.

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  4. I remember CITY well; had a standing bid at $1.80, I think, throughout 2008, and at other sub-market prices at various times thereafter, and never got a share! I liked the assets and found management okay, but had no vision of a catalyst. I guess confidence in one's conclusions should be tied in with one's willingness to pay a market price. Which reminds me that I ought to take another look at VVDL...

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  5. Great story. Focusing on the small ponds can definitely reward investors who don't have to worry about scalability.

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  6. Hi Nate!

    As most of the time an terrific article! Great arbitrage opportunity, taken into account all the commissions. I have to know, did you make any more, retain it or lost any money?

    - Rens

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  7. Nate, Good luck and bad over time tend to even out. Not being a naysayer but if you had gotten to this company one week earlier, you might (probably?) have missed this opportunity.

    Obviously, by going through unlisted companies and looking for an informational edge, good luck is more likely to be on your side. I feel like for every opportunity that I find (didn't find this one) there are 5 others that I would say, oh if I got to this company a week earlier, I would have bought and been up 20%.

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