Why value investors need clarity in deals involving put options

Why value investors need clarity in deals involving put options. PHOTO | SHUTTERSTOCK

On November 30, 2022, KCB Group acquired 131,750 of the issued shares of Trust Merchant Bank (TMB) for Sh25 billion in cash, representing 85 percent shareholding and voting control.

As part of the post-completion shareholders’ agreement, KCB purchased (irrevocable) call option rights relating to the 23,250 shares held by the non-controlling interest (NCI) for Sh123 per remaining shareholder exercisable within two years post-acquisition.

But another key feature in the post-deal involves “put options” — a contract that gives its holder the right to sell a set number of equity shares at a set strike price before a certain expiration date — given to the remaining TMB shareholders, which can only be exercised in the event that KCB does not exercise the call options within 60 business days from December 15, 2024.

Our focus today is: will investors still be able to estimate a realistic target equity value in view of the written put options?

Before we proceed, some background. Entry into the Democratic Republic of Congo (DRC) market has been part of a bigger strategy to accelerate KCB’s market presence in the region.

TMB commanded an 11 percent market share so it was a perfect candidate. The deal rode on TMB’s 18-year operational history, over 100 branches and total assets amounting to Sh250 billion.

Besides, the transaction fulfils a strategic aim; it capitalises on the cross-border trade from the East Coast (Indian Ocean) to the West Coast (Atlantic Oceans).

After the smoke is clear, the management expects the deal to be earning accretive starting this year onwards before any synergy assumptions. That remains to be seen.

Now, although TMB’s put option exercise price is not mentioned, the wording in KCB’s 2022 annual report indicates it’s above the assumed fair value of the underlying shares.

This means TMB has every economic incentive to exercise the option. Stated differently, the intrinsic value (IV) of the put option, which is the difference between the strike price and TMB’s underlying share price, is positive. Of course, an option with zero IV is not worth exercising at expiry.

That said, here’s where the problems for value investors begin as the fair value of derivatives classified as equity is not required in financial statements.

As a result, plenty of questions arise in this case. To cite an example, since the exercise of the put options involves a reduction in both assets and equity, and not simply swapping different forms of assets, what happens to its equity valuation? And assuming the remaining TMB shareholders have the option to exercise using a fixed amount (and not tied to a fair value), what will be the impact on the fair value of reported NCI figures?

In short, when it comes to written options (and particularly put options), providing a fairer depiction of financial position, may not be that straightforward. As typical arrangements involving options between a parent company and non-controlling shareholders tend to be complex, it’s best for value investors to ask for additional information. The idea is to gain useful data which can be used in better estimating the fair value of the group.

Mwanyasi is MD Canaan Capital.