The Great Atlantic and Pacific Tea Company Part 2

See Part 1 first.

Capital Structure Arbitrage

In the 10-Q from July 29th, 2010,

we see the following indebtedness table. The $150mm converts maturing in June 2011 presented a major liquidity challenge and a potential bankruptcy catalyst. They couldn’t just pay it off with the bank facility (I think), their main liquidity source.

5.125% Convertible Senior Notes, due June 15, 2011                                    $   157,677       $   155,333
Related Party Promissory Note, due August 18, 2011                                         10,000            10,000
9.125% Senior Notes, due December 15, 2011                                                 12,840            12,840
6.750% Convertible Senior Notes, due December 15, 2012                                    226,741           223,838
11.375% Senior Secured Notes, due August 4, 2015                                          253,928           253,668
9.375% Notes, due August 1, 2039                                                          200,000           200,000
Borrowings under Credit Agreement                                                         132,900           132,900
Other                                                                                       2,702             1,971
                                                                                      -----------       -----------

Now I wondered if there was cap structure mispricing. First, I was intrigued by the 9.375% Notes. They were an unusual instrument called QUIBS, securitized quarterly interest bonds traded under “GAJ” on the NYSE.

Looking up the prices, I saw that the 6.75% Dec 2012 Senior Converts were trading around $56 (56% of par) and that GAJ was trading around $18. 18?! I was excited by how cheap that was until discovering that the notional was $25, or 72% of par.

Structuring The Trade

The mispricing was not immediately clear to me. There were other securities to examine, and yield and cap structure positions to compare. Eventually, I worked out the trade: long the Senior Converts while shorting an equal notional amount of GAJ. You’d short 40 shares ($1000 notional) of GAJ, getting $720 in cash, while longing 1 Senior Convert ($1000 notional) and paying $560 in cash .

GAJ current yield was around 9.375/72 = 13% while Senior Converts current yield was around 6.75/56 = 12%, so you’d be paying north of 1% of N each year to put on this trade (quarterly vs. semi-ann). But if they had the same seniority, one of two things could happen.

  • GAP would somehow turn around and pay off the Senior Converts in Dec 2012 at 100. I would expect GAJ to rally to slightly north of $25, but not exceed 100% of par by much. Thus, you make the substantial 16% (=72-56) of N spread by Dec 2012, carrying the -1% of N until then.
  • GAP would go bankrupt sooner, the securities would be forced DOWN, and you’d make the 16% (=72-56) of N spread, carrying the -1% of N until then.

Basically, other than the carry and the Senior Convert conversion option (both negligible), we had the same security trading at 56% of par and 72%. They would be forced to meet in price either in bankruptcy (perhaps around 0?) or in solvency (near 100) in two years.

Considerations and Disappointment

I couldn’t believe such clean arbitrage existed, so I had to verify that GAJ and the Senior Converts were indeed pari passu. This meant diving into the original bond prospectuses. They were hard to understand, so I wasn’t fully confident, but it was clear enough to send an e-mail to my fund PM.

I wish the story had an ending where the PM put the trade on in size, but I was ignored. I was headed home anyway the next week anyway, so I didn’t have time to keep pestering. But I realized that GAJ, because it was securitized, could be shorted by retail brokers at no borrowing cost (besides the quarterly interest).

Executing the Trade

I put on the following series of trades for my personal account:

Symbol Shares Price Action Date
GAJ -200 17.9 Sell 8/12/2010
GAJ 200 13.5 Buy 8/20/2010
CB4AK9 5000 57.75 Buy 9/27/2010
GAJ -200 18.4 Sell 9/27/2010
GAJ -400 20.25 Sell 10/6/2010
GAJ 40 19.46 Buy 10/13/2010
GAJ 100 17 Buy 11/16/2010
GAJ 60 17 Buy 11/16/2010
GAJTQ 400 3.5 Buy 12/13/2010
CB4AK9 -5000 27.125 Sell 12/13/2010

In August, I shorted 200 sh GAJ (without longing the Senior Converts) to play my bankruptcy idea. I was lucky to cover at $13.5 because it came roaring back up in September, as GAP sold off a few stores and people responded to the extra liquidity enthusiastically.

In September, I put on the arbitrage trade, longing $5000 notional of the Senior Converts (CB4AK9) while shorting 200 shares (also $5000 notional) GAJ. As GAJ continued to climb into October, I put on a pure short of  400 shares of GAJ at $20.25/sh. At this point, I had serious doubts about my research and the trade, but luckily school and job-hunting distracted me from doing anything rash. Over November, the stock came back down, and I covered 200 sh of the pure short.

As you might guess, GAP announced bankruptcy on December 12, 2010. Notice that I covered GAJ at $3.5/sh or 14% of par, while I sold the Senior Converts at 27% of par! Ironically, the spread had swung the other way – GAJ was now underpriced relative to the Senior Converts. And of course, my 200 sh pure short of GAJ was still on and probably made the most money of all.


2 thoughts on “The Great Atlantic and Pacific Tea Company Part 2

  1. About Great Atlantic & Pacific
    Very nice analisis, so what you think are you Bullish on GAPTQ and GAJTQ? Im holding both for a possible merger or adquisition.

    1. Hi Federico,

      This post is mainly to review an opportunity that existed half a year to a year ago in GAJ and the Senior Converts. I haven’t followed Great Atlantic and Pacific since then and don’t have any holdings in it, so I can’t advise. My impression is that GAJ might be okay, but holding equity during a bankruptcy (i.e., GAP) is usually bad news.


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