Everybody Wins With The Kinder Morgan / El Paso Merger

Here's a thing that you probably know: acquirers pay a premium to do acquisitions. That tends to be why the target sells, with some exceptions. So it is no surprise that Kinder Morgan is paying a premium to buy El Paso. And, when they announced the merger last month, they talked up that premium pretty good:

The consideration to be received by the EP shareholders is valued at $26.87 per EP share based on KMI’s closing price as of Oct. 14, 2011, representing a 47 percent premium to the 20-day average closing price of EP common shares and a 37 percent premium over the closing price of EP common shares on Oct. 14, 2011.

This was not enough for some people, who are suing because EP isn't getting paid enough - and also because of little things like how Goldman advised EP on the merger while also being a regular advisor to Kinder Morgan and owning 19% of Kinder and being on its board and stuff like that.*

Fortunately Kinder and El Paso have a chance to clear all that up in the merger proxy that they filed yesterday afternoon. Others have noted some of the fun in the "Background" section, including lots of back-and-forth on price and tactics and one-liners like "On September 23, 2011, Weil delivered a draft merger agreement to Wachtell Lipton, and on September 24, 2011, Wachtell Lipton delivered a revised draft merger agreement to Weil," which, I can tell you from experience, captures a whole lot of human suffering in a single sentence.

But let's skip that and talk instead about another source of immense suffering, the financial opinions disclosure, which is distinguished by being 45 pages long.

This disclosure is customarily designed to do two, related things. First of all, it should - in dry and legalistic language - convince EP shareholders that they are getting a fair price in selling their darling company. To do this, EP's financial advisors run through a bunch of valuation metrics and check off that, on each of them, the merger price is at least in the range of a fair price for EP. Ideally, the merger price would be above a fair price on many of the metrics - that is, EP would be getting a premium not only to its market price but also to a "fair" price - though you don't always have that. But you like to be able to at least gesture in that direction: look, guys, we didn't get you a fair deal - we got you a great deal.

The second purpose, which is far more important (you go read that disclosure and see if you're convinced of anything other than the need to start cocktail hour), is to protect EP's board when they inevitably get sued. If the bankers ran some models, did a customary analysis, put together a book, punched a few first-year analysts in the face, and blessed the price as fair, then the board can approve the deal without worrying that a judge will later second-guess them. Usually.

A complication comes in because, in the KMI-EP deal, like many stock-for-stock deals, you have fairness opinions on both sides, since both Kinder and EP stockholders are being asked to vote on the merger. And that creates a bit of - not a problem, exactly, but a touchy issue, since the two sides have sort of obviously opposite motivations when it comes to price. Kinder wants to pay - but also to tell its shareholders and any future lawsuit plaintiffs that it paid - a low price. EP wants to get - and tell its shareholders and the current lawsuit plaintiffs that it got - a high price.

This isn't a huge problem. Investors understand that a deal can be good for both sides even if there is a big premium. The range of "fairness" that a court will live with is wide, and valuation is nowhere close to so exact a science that both sides can't fit the deal price well within their fairness range.

But let's be annoying anyway and take a look. One thing notice is that those 45 pages are put to good use obscuring the range of fair values that the banks come to. Morgan Stanley, EP's adviser, was nice enough to put together a table:

That's a nice chart. It helpfully summarizes all of Morgan Stanley's analyses in one place and, since in almost every case the low end of the "implied price" (what you're getting in the merger) is higher than the high end of the "reference range" (what your stock is worth without the merger, on the same valuation metric), it paints a nice picture that the deal is a good one for EP shareholders. The chart is also really mathematically dubious but we can't have everything.**

Then you turn to the thirty pages of opinions from Kinder's two advisers, Evercore and Barclays. They do not have a helpful chart, and in fact lay out their analyses in as different a format as possible from MS and each other, so as to defeat comparability. But you get the distinct impression that, if you lined them all up, EP would not be getting as good a deal in Barclays' and Evercore's world as they are in Morgan Stanley's. Which makes sense: EP's board wants, even needs, to be told that they're getting a big premium even to fair value. KMI's board wants to be told that what they're paying is in line with fair value, i.e. not at a big premium.

So let's line them all up. Not putting the chart here but click over to the spreadsheet.

The this-is-not-science disclaimers to that spreadsheet could go on for 45 pages, so I'll skip them all and leave you to get angry about all of the problems with it. But the upshot is:
- Morgan Stanley thinks that EP is getting a 33-36% premium (using mean/median of its own valuation), or 37-41% if you value the KMI warrant like a human ***
- Evercore thinks its 17-31%, or (2)% to 8% taking into account synergies
- Barclays thinks it's 16-18%, or 2-8% with synergies
- In rough aggregate, EP's board heard that it was getting a 33-36% premium to fair value, while Kinder's heard that it was paying a 2-8% premium to fair value taking into account synergies (or 17-26% without).

Which is a nice way for everyone to feel like they're winners.

Kinder Morgan Form S-4 [EDGAR]

* Hey! For the record I think that the "Goldman was on both sides" complaint is crap and that what Goldman did here was obviously kosher, fully explained to both boards and to the public, and just a fact of life when there are only so many banks in the world that advise energy companies. Full disclosure, I know and like several GS people who worked on the EP banking team, as well as some EP employees. But I'd say that even if I didn't. Also, I've had no discussions with any of them about anything even slightly related to the merger or this post or anything else, ever.

** I'm being annoying, but, really. Each EP shareholder gets (1) $14.65 in cash, (2) 0.4187 shares of KMI stock, and (3) a five-year warrant on 0.64 shares of KMI stock struck at $40, which at the time the deal was announced Morgan Stanley decided was worth $0.96. The "implied price" equals (1) $14.65 plus (2) 0.4187 times the value of KMI stock on whatever valuation metric MS is using plus (3) $0.96. That's sort of questionable: if KMI stock is worth much more than $26.89, its closing price when the deal was announced, then that warrant is worth more than $0.96, and if it's worth less then the warrant is worth less. You could have a theoretical debate about whether the warrant should really be valued on the same metrics as the stock, and I might actually agree that the warrant valuation inputs should be limited to market data rather than DCFs etc., but offhand this looks to me more like laziness than a rational choice. MS, I'll redo this for you for a small fee! Ah, screw it, I'll redo it for free in this post. But you might want to check my work.

*** See ** above. Wonky note: the excel Black-Scholes model I'm using freaks out with high dividends so these numbers should be taken with tons of salt; some of them are negative. I used inputs that will get to a $0.96 warrant valuation at the time of announcement, which is what MS said they were worth, and changed only the spot - not, awkwardly, the dividend yield, for laziness reasons.