CapitalSource Turns a Deaf Ear to TierOne

Here's another item you can add to the list of things undoing mergers these days: bureaucratic red tape. Tucked away in the tie-up agreement between CapitalSource (NYSE: CSE  ) and TierOne (Nasdaq: TONE  ) was a provision that allowed either party to walk away from the merger, no questions asked and no penalties assigned, if, after nine months, the Office of Thrift Services had not yet approved the deal.

That deadline passed on Feb. 17, and CapitalSource's board hasn't made a decision either way. However, it wasted no time in approving a measure giving management the leeway to either kill the deal or negotiate new terms. But why has it taken so long for this deal to get regulatory consideration? On its recent fourth-quarter earnings conference call, CapitalSource's management said that one of the reasons the OTS had not yet approved the deal is that it's, um, "busy."

TierOne says it remains committed to the merger as it was originally written. It's no wonder why. For each share of TierOne stock that shareholders own, CapitalSource was offering them $6.80 cash plus 0.675 shares of the specialty finance company. In addition, if CapitalSource's shares were trading at less than $25 a share, TierOne shareholders would get an additional 0.405 shares of CapitalSource stock. When the deadline arrived, shares of CapitalSource were trading just at just above $16 a share. It was a sweet deal that would have earned TierOne shareholders a large premium instantly upon approval.

CapitalSource, meanwhile, is probably breathing a sigh of relief that red tape has held up the agreement. When the deal was announced last May, the agreement had valued TierOne stock at $652 million, or a little more than $34 a share, a nice 14% premium to where the shares had been trading. By the time CapitalSource announced that it was rethinking things, that premium had widened considerably, as the shares were trading at just half the price at which the deal had originally valued them. TierOne says it remains committed to the deal as originally written, but CapitalSource will undoubtedly want to rewrite the terms or walk away altogether.

Being an arbitrageur is no easy game, because so many things can go wrong. Even a savvy hedge-fund artist like George Soros has gotten it wrong a time or two. This entire episode has been an important lesson in risk, even for an observer like me. After all, I had anticipated that this deal would go through as originally written, giving TierOne investors a nice premium as well as ownership of a quality company when completed, but now it seems that if CapitalSource remains committed to acquiring TierOne, the terms of the agreement will undergo a dramatic alteration. Perhaps the best takeaway here is to always focus on the risks and to heed those cautionary words: "If something appears too good to be true, it probably is."

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