the Contrary Investor

August 14, 2007

Chicks dig the long VOL

Filed under: Market Neutral,Sallie Mae — contraryinvestor @ 9:43 am


On April 16, 2007, Sallie Mae (SLM) announced that an investor group (“Investor Group”) led by J.C. Flowers & Co. (“J.C. Flowers”) signed a definitive agreement (“Merger Agreement”) to acquire the Company for approximately $25.3 billion or $60.00 per share of common stock. When the transaction is complete, J.C. Flowers and certain other private equity investors, including Friedman Fleischer & Lowe, will invest approximately $4.4 billion and own 50.2 percent, and Bank of America (NYSE: BAC) and JPMorgan Chase (NYSE: JPM) each will invest approximately $2.2 billion and each will own 24.9 percent. The remainder of the purchase price is anticipated to be funded by debt.

Any enterprising young man looks at the current share price of SLM and $46.90 and sees a $13.10 discount to the announced take over price of $60 a share of SLM and he say him self, “Free Money”. Yet, the Contrary Investor remembers his finance professor telling him something like “There’s no such thing as a free lunch”. Alas, the poking around of the new congress in regards to the excessive profit of the student loan industry as made Chris Flowers a bit less than enthusiastic about his trophy deal. The Senate and House voted to reduce education-loan subsidies by $18.3 to $19 billion during the next five years. Certainly this decreases the value of SLM to Chris Flowers by lets say $6.0bn ($19.0bn/5 (per year) discounted back at 20% (assumed general private equity fund hurdle rate) adjusted for cash taxes of $528mn on $1.07bn in pre-tax income for the first 6 months of 2007). However, Sallie Mae’s share holders certainly are not going to just hand this value over to J.C. Flowers. I really don’t think they have any incentive to do this deal at a lower price now that $60 has been set as the price. So the question Chris has to ask him self is if he is willing to give up his $25bn deal.

Personally, I don’t think J.C. Flowers is very likely to pack it in over legislation that hasn’t even passed yet. Certainly his old boss Hank Paulson (now secretary of the treasury) could help him lobby to lower this figure. Maybe J.C. Flowers really has the discipline to walk away from this deal. But they also have to ask them selves when they’ll be able finance another deal of this size. $25bn, though not the size of TXU, HCA or EOP, is still a HUGE deal and two years a go would have been unheard of. I have devised a formula to I call the Rain Maker Ego Ratio (patent pending) to calculate likely hood of Chris Flowers walking away from this monster deal. E (for Rain Maker Ego)=1 H (for fund manager Humility) = 0 C (Completion likely hood): E/H= C or 1/0=infinity *

So I therefore calculate an infinitely high likely hood that the deal will get done. Seriously though, it is far more likely that either the deal will get done at $60 per share original price or not done at all. If the deal doesn’t get done at all the shares should return to their April 12th pricing of $40.75, if not lower given SLM’s deteriorating fundamentals and the over all tumult in the credit markets. In oder to properly take advantage of these events I’ll be buying the $55 Jan 08 calls and the $40 Jan 08 puts. I’m long volatility in SLM shares, though I ultimately think the deal will get done…but maybe it won’t. Either way deal is due to close by October 2007 leaving time to deal with the January options. This technique is known as a strangle.


* I was advised by a friend to who is quant to calculate the implied vol for this strangle and then if the volatility I believed was appropriate was higher than the implied volatility then I should do the trade. This is sounded good enough on paper, but how exactly do you quantify the volatility associated with “Chris Flowers’ Ego” or the opportunity cost of having to wait an unknown number of years for them to do another $25bn deal. So alas I came up with my own formula (E/H=C), which I believe to be at least half as accurate as Black-Scholes. I’m hoping to receive my Nobel nomination any day now. I could be the next Bob Merton

“The combination of precise formulas with highly imprecise assumptions can be used to establish, or rather to justify, practically any value one wishes . . .Calculus . . . [gives] speculation the deceptive guise of investment.”
–Benjamin Graham, 1949


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