Shares of Steel Excel are trading well below the value of the merger consideration they will receive when the company is taken over by its majority owner, Steel Partners LP.

On December 7, Steel Partners announced an agreement to acquire the 36% of Steel Excel that it does not own in return for preferred units of Steel Partners LP. The units would carry a 6.0% coupon and mature in nine years. Steel Excel shareholders would receive $17.80 in Steel Partners LP preferred units per share. Evidently, the deal was not acceptable to one of Steel Excel’s major shareholders, GAMCO. After discussions with GAMCO, Steel Partners unveiled an amended merger agreement on December 23. The preferred units’ distribution would now be cumulative, and Steel Partners agreed to offer to redeem at least 20% of the preferred units on a pro rata basis in cash within three years of issuance. Steel Partners also agreed to seek an NYSE listing for the preferred units.

Following the announcement, shares of Steel Excel scarcely budged, though the amended terms offered much better value for Steel Excel shareholders. Specifically, the fact that 20% of the preferred units will be redeemed within three years reduces both the effective maturity and the credit risk of the preferred units.

Modeling the implied IRR of Steel Excel shares is a simple matter. When converted into Steel Partners preferred units, holders will receive $1.07 in dividends per year and will have the option of redeeming 20% of their preferred units some time in the first three years after the merger closes. Assuming Steel Partners waits the full three years to redeem units for cash, the IRR for purchasers of Steel Excel shares at $14.75 is 9.3%. Earlier redemption would result in a higher IRR.

9.3% is a generous return for these Steel Partners LP obligations. Though the preferred units are junior to all of Steel Partners’ other obligations, the holding company is quite well-capitalized. At September 30, Steel Partners LP held cash and investments of over $97 million against debt of $57 million. Upon taking full ownership of Steel Excel, Steel Partners will assume direct ownership of another $122 million in net cash and securities. The full face value of the Steel Partners LP preferred units in issuance as the result of the merger transaction will be $72 million.

So what are Steel Excel shares/Steel Partners LP preferred units worth? I think it’s worthwhile to break down the cash flows into buckets and value each using a spread over treasury rates. I ran some numbers using current treasury rates and various credit spreads: 200 basis points over treasureies for 0-3 year cash flows, 350 basis points over for 3-6 year flows, and 500 basis points over for cash flows in years 6-9. The resulting calculation values Steel Excel shares at $17.09, 16% higher than the current trading price. At $17.09, Steel Excel shares would provide an IRR of 6.7%, which seems fair to me.

In reality, I don’t expect the gap between the current Steel Excel price and the face value of Steel Partners LP units to close because of the rich interest rate spread, I expect it to close because investors will see a listed preferred unit trading at a 17% discount to face value (at a $14.75 trading price for Steel Excel shares) and bid the price up.

The Steel Excel merger is expected to close in the first half of 2017 and is subject to a shareholder vote. Holders of more than half of the 36% of shares not owned by Steel Partners LP must approve the deal. GAMCO owns one third of those shares and has implicitly blessed the merger, so I don’t expect approval to be a problem.

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Alluvial Capital Management, LLC holds shares of Steel Excel Inc. for client accounts. Alluvial may buy or sell shares of Steel Excel Inc. at any time.

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