Proration: Getting Your Fair Share of a Deal

Great news! A company you own has agreed to buy back 10% of its stock at a nice premium to the current price. That tender price just happens to be the price you'd be willing to sell all your shares, so you decided to tender 100% of your stock position.

However, you're not the only investor who loved the deal -- in fact, when all is said and done 20% of the company's outstanding stock were tendered by investors. Because that's more than the company wanted to buy back, it will prorate the deal and only accept 50% of what was tendered.

Welcome to the world of proration, which enables an investor to get their fair share of a deal when an offering company sticks to its original target.

What is proration?
Proration refers to a situation when there isn't enough cash or shares to meet demand during a corporate action. The corporate action could be a result of a stock buyback or a merger wherein investors are offered a choice. When investors heavily favor one choice over the other, the company can prorate the deal so that everyone gets a fair share.

Proration in action
Halliburton's (HAL -1.69%) big stock buyback in 2013 offers a recent example. The oilfield service giant offered to buy back $3.3 billion in stock using a modified Dutch auction. Investors liked the deal and tendered 100.2 million shares by the time the auction expired. However, given the company's stock price it only had the capacity to buy back roughly 68 million shares. Because of that, the company's proration factor for the tender offer came to 67.9%, which meant that for every 100 shares an investor tendered about 68 would be accepted. 

Another recent example was when Kinder Morgan (KMI -1.56%) acquired both of its MLP subsidiaries late last year. Under the terms of that deal, investors in both Kinder Morgan Energy Partners and El Paso Pipeline Partners had the option to select either cash, Kinder Morgan common stock, or a combination of the two. Here's a chart that shows the three options:

Source: Kinder Morgan Press Release.

While investors had the option to choose, Kinder Morgan was clear that the all-cash and all-stock selections were subject to proration, as its goal was to close the deal at the combo offer. 

With that in mind, here is a look at the primary selection of investors:

Source: Kinder Morgan Press Release.

As that chart shows, a majority of investors chose the all-stock option -- however, the company's goal was to issue 88% stock and 12% cash to close the deal, which is where proration came into play. In reviewing the deal in its Annual Report Kinder Morgan wrote that through both election and proration, on average, each common unitholder of Kinder Morgan Energy Partners received 2.1931 shares of stock and $10.77 for each unit they owned. Likewise, each El Paso Pipeline Partner unitholder received, on average, 0.9451 Kinder Morgan shares and $4.65 in cash per unit owned. This was in line with its original combo offer, and meant that some investors didn't get their first choice. However, by using proration Kinder Morgan kept its share issuance in check and its cash outlay on target so that it could meet its post-merger targets while still offering investors a fair deal.

Investor takeaway
Proration serves an important purpose. It ensures that a company can stick to its initial target in a merger deal or tender offer without favoring one investor over another. While that means not every investor will get exactly what they want, they will at least get a fair deal as others are making a similar sacrifice.