GTH - Genetron Holdings' Enticing Arbitrage Return

2024-01-09 11:14:54 ET

Summary

• Genetron Holdings Ltd. is a Buy with a 9.2% arbitrage return and favorable odds of timely deal closure.
• Concerns include geopolitical risks and the possibility of the deal stalling indefinitely.
• Regulatory risk exists as approval from Chinese authorities is needed to convert and offshore funds for the transaction.
• If the deal breaks, expect the stock to collapse into oblivion.

Genetron Holdings Ltd. ( GTH ) offers an enticing ~9.2% arbitrage return with a 3-month return timeframe and favorable odds that the deal closes on time. If the transaction closes, ADS holders will receive $4.03/ADS in cash (after subtracting the $.05/ADS depositary cancellation fee) for their shares. Currently, GTH's trading price is $3.68/ADS.

With that said, there are a few concerns with this deal . First, this is a foreign transaction (Chinese privatization). With that comes the inherent geo-political risks that are hard to assess. GTH is a biotech company primarily operating in China, but has a small presence in the U.S.--including a clinical laboratory in Maryland, as well as patent IP. There is always the potential for some kind of governmental crackdown on biotechnology by either country that could jeopardize this transaction. Escalating Sino-U.S. relations, however, seems unlikely especially in an election year.

Also, along these lines, is the smoke-and-mirror possibility that one finds from time to time when investing in these Chinese go-private transactions (i.e., a deal is announced but then seemingly stalls indefinitely or outright disappears). What perpetuates this risk is how these Chinese companies are presented to international investors at inception. GTH is only available through American Depositary Shares ("ADS") that represent equity in a Cayman Island variable interest entity ("VIE") structure. Meaning, the ADS holder has no recourse in China where the physical assets, operations, and management of the company are located. Furthermore, the legal structure prevents, or at least severely limits, damaged ADS holders from pursuing legal remedies if a transaction goes sideways or falls apart altogether. Therefore, this is a legitimate risk to consider, not only for the GTH transaction, but for many of these Chinese privatizations.

There is also regulatory risk with this deal. The deal is conditioned on 3 of the 6 equity sponsors receiving Overseas Direct Investment ("ODI") approval from China's SAFE, NDRC, and/or Ministry of Commerce, or any one of their counterparts, in order to convert and offshore ~$13m of the ~$52m necessary to consummate the transaction. There was much negotiation between the special committee, assigned to represent the interests of minority shareholders, and the Buyer group whether to require a termination fee in the event the sponsors failed to receive ODI approval. After deliberation, the special committee decided to forgo the requirement after finding:

(i) it is in the Company’s best interest to speed up the transaction process; (ii) the risk of the Proposed Transaction being terminated due to the failure of obtaining the ODI Approval is relatively acceptable given the equity commitments from the ODI Sponsors are less than 50% of the total commitments; (iii) obtaining the ODI Approval is reasonably practical based on the details of the anticipated ODI procedure provided by the Buyer Group; and (iv) the Buyer Group did not have much flexibility on this point given the internal policy of the ODI Sponsors.

GTH proxy statement, p. 25 . Despite the special committee's assessment, this remains a very real concern because it leaves room for the Buyer group to walk under the guise that it could exchange the necessary funds for U.S. dollars.

There is also the possibility that shareholder dissent disrupts this deal. The parties agreed to a <15% threshold for shareholders exercising their respective dissenter rights. The Buyer group can still move forward at its discretion even if the dissenting pool crosses the threshold. With that said, there is already close to 70% or more of the shares that will be cast in favor of the merger, making it hard pressed for the dissenting pool to grow beyond the 15% mark.

Another concern is that a general meeting date is not set. Based on my own empirical evidence of Chinese privatizations, deals are less likely to break after the general meeting date is set. The agreement has a long stop date of October 11, 2024 (giving the parties 1 year to close the transaction). Based on statements in their proxy, GTH expects for this transaction to close in Q1'24 (i.e., by March 31st), but until the company announces a meeting date, remain cautious about investment sizing.

In regards to sizing, this transaction is really only accessible for smaller portfolios. The total EV of the transaction is ~$108m. However, nearly 60% of GTH's shares are being rolled over into the private company. This means that only ~$52m shares will be purchased to close the transaction. As of Friday, the average volume of GTH was only ~14k. At its current trading price of $3.69/ADS, only ~$51k worth of shares trade on a given day. This makes it hard to build a significant position, especially in a larger portfolio.

Last, the downside in the event of a deal break is significant. In the year leading up to the transaction announcement, GTH was on a steadily sliding into nonexistence:

In fact, just before the transaction was announced, the company received a noncompliance letter from Nasdaq for failing to maintain a share price over $1/ADS. As part of the agreement, GTH adjusted its ADS ratio from 5-to-1 to 15-to-1 in order to regain compliance. Assuming the deal breaks, expect this company to evaporate into thin air.

While this transaction is not for the faint of heart, hence the arb spread, it appears that the transaction will close, therefore it deserves an arbitrageur's consideration.

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