Capricorn’s NewMed merger plan runs up against strong shareholder opposition

Following an announcement that the UK-based Capricorn Energy, previously known as Cairn Energy, entered into a merger agreement with Israel’s NewMed Energy, formerly known as Delek Drilling, certain shareholders have voiced their concerns over the proposed plan, as it is seen as “profoundly unfavourable.”

While announcing merger plans in September 2022, NewMed highlighted that the merger with Capricorn would create a “leading East Mediterranean energy company” while Capricorn outlined that it would establish a “MENA gas and energy champion and one of the largest upstream energy independents listed in London.” The completion of the transaction, subject to approvals and conditions, is expected in 1Q 2023.

As explained at the time, the combination would result in Capricorn shareholders holding approximately 10.3 per cent of the share capital of the combined group and NewMed unitholders, together with NewMed’s current general partner, holding in aggregate approximately 89.7 per cent of the share capital of the combined group at the completion of the combination.

As the dust around the merger announcement settled, a Capricorn shareholder, Irenic Capital Management, voiced concerns over the proposed deal in a letter to the board of directors of Capricorn Energy, urging them to abandon Capricorn’s proposed merger with NewMed as it remains “profoundly unfavourable to Capricorn shareholders.” This shareholder encouraged the board to pursue “a thoughtful liquidation of the company’s assets.”

“Like the Tullow transaction, the proposed merger materially undervalues Capricorn’s collection of liquid or otherwise easily monetizable assets. Based on readily available markers of value for the majority of the company’s assets—including its large net cash position, several near-term contractual earn-outs that will mostly turn to cash within the next year, and its sole production asset in Egypt—we believe the company could realise almost 40 per cent of incremental value through a straight liquidation relative to the proposed merger,” explained Irenic.

Another shareholder, Palliser Capital published a plan at the end of October 2022, outlining a clear path to unlocking up to 400 pence per share in total value for Capricorn shareholders over the medium term. Palliser followed up on this in December 2022 to formally requisition the board of Capricorn Energy to convene a general meeting of shareholders (EGM) given “a loss of confidence in the judgement and priorities of the current board and its sustained inability to execute a value-accretive corporate strategy.”

This EGM would enable shareholders to vote on removing seven existing board directors and appointing six “highly qualified and experienced” independent candidates to replace them, outlined Palliser. By Palliser’s assessment, shareholders representing more than 40 per cent of Capricorn’s issued share capital disapprove of the NewMed transaction and at least a similar level of support is expected for comprehensive board change, as some shareholders have “lost trust in the existing directors and agree that drastic board change is now required.”

Adam Katz, Co-Founder and Chief Investment Officer of Irenic, commented: “We agree with Palliser that Capricorn’s leadership has been dismissive of investor feedback and, in turn, has lost the confidence of shareholders. Like many of our fellow shareholders, we strongly oppose the company’s currently proposed merger with NewMed Energy Limited Partnership. It is time for Capricorn to benefit from new leadership that is committed to embracing shareholder input and pursuing value-maximizing strategies that are superior to the proposed merger.”

The following day, Britain’s largest asset manager, Legal & General Investment Management, agreed that “a change of directors is now warranted,” according to Palliser. The firm underscored that “shareholders representing 39 per cent of Capricorn’s issued share capital have lost trust in the current directors and agree that drastic board change is now required. Based on the turnout at Capricorn’s most recent general meeting, held on 15 December 2022, this represents indicated voting support of 70 per cent and more than 57 per cent when compared to the average turnout recorded at all Capricorn general meetings held since 2010.”

In response to these requests, Capricorn provided an update to its shareholders on 5 January 2022 regarding the proposed combination with NewMed Energy and Palliser Capital’s director nominations while reiterating its support for the merger with NewMed. The board further underscored that the update addressed “incorrect facts and assumptions” made by Palliser about Capricorn and the NewMed combination, demonstrating the “superior value” of the NewMed combination over Palliser’s plan.

Capricorn’s board further elaborated that Palliser’s analysis of the fair market value of Capricorn was overstated by $265 million based on “corrections of simple factual errors.” Henceforth, Palliser’s plan was not deliverable as described – “it would deliver less cash and less value, over a longer timeframe with more risk than the combination,” concluded the board.

Furthermore, the Capricorn board believes that the combination with NewMed will enable a cash return of approximately $620 million, which is around $120 million more than could be returned to ordinary shareholders on a standalone basis in the near term. This capital return facilitated by the combination is in addition to the more than $780 million in cash returned to shareholders over the past two years and $5.5 billion over the past 15 years.

In addition, Capricorn says it will realise approximately a 46 per cent premium for Capricorn’s remaining assets and provide exposure to “the largest gas-focused, UK-listed energy company on LSE’s premium segment (by 2P reserves);” create “a world-class gas and energy champion that will provide enhanced scale, liquidity and a superior investment case;” benefit strategically from both energy security and energy transition trends; generate approximately $3 billion in unlevered free cash flow between 2023-2027 from existing assets, with a shareholder distribution policy of at least 30 per cent.

The Capricorn Board believes that the combined group will have “a very high-quality asset portfolio and a resilient revenue base generating regular returns to Capricorn shareholders. This includes the largest interest in the world-class Leviathan field, enabling the combined group to provide gas to growing regional energy markets and potentially LNG to European and international markets.” It is also expected to “facilitate and further accelerate gas trade and decarbonisation in the MENA region and will invest in the transition to a low-carbon energy system in line with its commitment to achieve net zero Scope 1 and Scope 2 emissions by 2040.”

Meanwhile, a notice of a general meeting was posted to shareholders in response to Palliser’s request to consider resolutions to remove seven of the current directors from the company’s board of directors and appoint six new directors to the board. Taking account of the date on which Palliser’s requisition notice was deposited, Capricorn’s board revealed that the general meeting would be held at the Sheraton Grand Hotel in Edinburgh on 1 February 2023.

Commenting on the timing of GMs, Palliser said that it believes “any reasonable board acting with integrity towards its shareholders and wishing first and foremost to promote the success of the company with shareholders’ best interests in mind would, in the circumstances, ensure that the board change GM is held in adequate time ahead of the NewMed GM. We, therefore, call on the Board urgently to reconsider the timing of the NewMed GM such that it ultimately takes place on a date which is at least 4 weeks after the date of the board change GM, which should be held no later than 30 January 2023.”

In its statement this week, Irenic addressed Capricorn’s recent communications pertaining to the proposed merger with NewMed and reiterated its support for Palliser and its effort to reconstitute the company’s board of directors while Katz pointed out: “Irenic believes Capricorn’s 5 January letter and presentation are error-ridden, misleading and simply unpersuasive. The proposed NewMed combination lacks compelling industrial and financial logic and appears to require contortions to justify. We remain opposed. In contrast, we view Palliser’s plan as a superior alternative that delivers substantially higher value to Capricorn shareholders.”

Irenic claims that Capricorn appears to “intentionally omit” several factors since the initial transaction announcements, including that NewMed’s share price has decreased approximately 12 per cent; the shekel has weakened approximately 10 per cent versus the pound; the portion of the share consideration of the deal has decreased by approximately 20 per cent in total; the 46 per cent premium is in fact a 9 per cent discount today; and the trading of Capricorn’s shares “reflects the degradation in the value of the proposed combination,” given they are trading approximately 3 per cent through the terms of the NewMed transaction and have done so for several months now. 

“In our view, Capricorn’s flawed analysis of the NewMed merger’s potential value only reinforces the need for shareholders to support Palliser’s efforts to facilitate the reconstitution of Capricorn’s board. By catalyzing prompt and meaningful boardroom change, we believe shareholders can ensure that a comprehensive and impartial review of all strategic options is conducted. Palliser has Irenic’s full support for its requisition proposal at the upcoming general meeting of shareholders,” elaborated Katz.

Moreover, Irenic says that it is “illogical to assume” that the core net asset value (NAV) and Total NAV estimate by Palliser – including the entire existing net cash balance that represents approximately 55 per cent of Palliser’s Core NAV – should be penalized through the application of the market discount that UK-listed E&P comparable companies currently trade at, but then not to assume that a similar discount should apply to the combined Capricorn-NewMed entity moving forward.

After Capricorn stated its current estimated value for the Egypt asset at just $71 million – plus an incremental $264 million of 2P value upon spending of associated CapEx – Irenic recognised that the asset produced meaningful operating cash flow in FY22 – including ~$50 million as reported in 1H22 alone – but pointed out that Capricorn paid $323 million for the asset just 18 months ago for a price agreed at much lower commodity prices.

In light of this, the shareholder underlines that Capricorn’s new value assessment, if true, suggests “substantial value destruction by current management in a relatively short period of time.” Additionally, unlike every sell-side analyst and the independent valuation by ERCE, Irenic claims that Capricorn “misleadingly excludes” any value for the asset’s 2C phase from its calculation of value but gives credit for the 2C phase in its pro-forma production profiles.

The reference to debt service leakage within G&A assumes that Capricorn’s 2P CapEx spend will result in no incremental reserves, requiring repayment of a significant quantum of its reserve-based lending facility. “This strikes us as an illogical assumption that has also been highlighted by Stifel in its 5 January research note,” explains Irenic, while adding that the estimate on page 22 of the Capricorn’s Investor Presentation appears to “overstate G&A leakage to the tune of close to $100 million, at a minimum.”

Irenic further says that CapEx is similarly assumed at approximately $250 million for the 18-month period versus Capricorn’s FY22 mid-point guidance of $185 million that included approximately $78 million of pre-committed exploration CapEx, “much of which is rolling off.” Hence, the estimate on page 22 implies “a scaled-up budget for the next 18 months at the same level of FY22 mid-point guidance. This is unrealistic leakage based on the rolling-off of commitments on exploration assets and could be significantly lower,”  emphasised Irenic.

The company also reports that the continued assumption of zero incremental cash flow benefit from the large receivable balance with EGPC “appears illogical” considering the significantly lower historical balance. Irenic believes there is a “reasonable likelihood” that the majority of the more than $100 million balance will ultimately accrue to Capricorn’s benefit, as “it was as low as $50 million as recently as 2021.” 

“It is misleading to refer to the $620 million upfront cash dividend to be accruing to public shareholders when $15 million is, in fact, going to satisfy dividend equivalent rights of Capricorn’s own employees,” claims Irenic. Additionally, Capricorn’s notion of $780 million in historical shareholder distributions over the past two years is also seen as “an equally misleading representation of the level of organic distributions the business would be able to achieve on a standalone basis,” according to this shareholder.

“Only approximately $266 million was returned in FY20 and FY21, disregarding the initial $500 million tender offer following the India tax refund receipt; and of that approximately $266 million, the vast majority related to capital return of the upfront portion of the sale proceeds from its Senegal asset in FY21. Further, the reference to $5.5 billion in historical shareholder returns over the past 15 years is comprised in large part of the company’s India refund dividend – a product not of current management’s astute operation of Capricorn’s assets, but rather of the sale of past management’s assets,” continued Irenic.

Bearing all this in mind, Irenic concludes that shareholders’ true distributions for the business would be “significantly lower than management is trying to make shareholders believe.”