My first job on the “buy side” was in risk arbitrage. That’s a fancy name for investing based primarily on capturing the difference between the current price of a stock, and the value shareholders are due to receive in a merger or acquisition. At that time, there were a lot of announced deals, a relatively small number of risk arb experts investing this way, and higher interest rates. All of that meant that if you could avoid the few deals a year that broke (weren’t completed), it was possible to earn good returns.
I’ve seen hundreds of deals and read hundreds of merger agreements, and I’ve never seen anything as fascinating as the current situation between Twitter (ticker: TWTR) and Elon Musk. As a general rule, Deep Knowledge Investing stays out of political commentary. We might discuss the investment implications of a particular policy, but the only stand the firm takes is one in favor of free markets and free people. With that said, there’s no way to analyze the current situation at Twitter without understanding the political lens both sides are using.
Some Twitter employees have acknowledged that they run the company to favor a political point of view, even at the expense of profitability. Despite Elon Musk offering a huge premium to the then current stock price, management did all they could to avoid dealing with him. There is credible speculation that the reason is because while Twitter management favors a particular political narrative/eliminating “hate speech” (depending on your point of view), Musk is openly in favor of more free speech even if that means offending certain people.
Reasonable people can disagree about the range of acceptable public discourse, but what’s not up for debate is both sides have a divergent view for Twitter’s future. This is the most principled and least economic acquisition I’ve ever seen. It can be summed up as Twitter management being willing to sacrifice shareholder value for their preferred politics (which they sincerely believe to be the right and just course of action) versus the richest man in the world who is willing to overpay (in our opinion) for an asset in order to promote the value of free speech. This fight is 80% values and 20% economics.
Two weeks ago, after signing a purchase agreement, Musk threatened to not complete the deal based on Twitter’s unwillingness to provide documentation that “bots” were fewer than 5% of users. Bots are fake accounts used for a variety of purposes, and accounting for them is crucial because these fake accounts don’t buy products. That means that advertisers won’t want to pay to reach those accounts. The stock currently trades below its price prior to Musk’s offer for the company and is at a huge 26% discount to the official $54.20 offer price. We’re not touching the stock, and think some of the recent commentary on the situation is missing the mark.
The Due Diligence Question:
Twitter has claimed the 5% number in its most recent 10K, and that makes it fair game for Musk to question it. The language used is clear: “For example, there are a number of false or spam accounts in existence on our platform. We estimate that the average of false or spam accounts during the fourth quarter of 2021 continued to represent fewer than 5% of our mDAU during the quarter.”
Any claims by Twitter that this is a private number which the company can’t disclose is almost certainly inaccurate. As part of almost any acquisition of a public company, the purchaser receives inside information in exchange for signing a non-disclosure agreement. Musk has waived due diligence as part of the deal, but the optics of Twitter’s unwillingness to provide this information are terrible. By not disclosing the number of fake accounts and claiming this is privileged information, Twitter is strongly implying that the number is well above 5%. If the fake accounts were under 5%, Twitter would have every incentive to both disclose privately to Musk and to inform the public as well.
The Breakup Fee:
There is a lot of talk in the press and other financial sources that Musk could be liable for the breakup fee and other non-specified damages. Almost all merger agreements provide for the buyer to pay the seller a breakup fee if the transaction isn’t completed. In this case, the fee is $1 billion dollars. While that is a huge number for any individual to pay, Elon Musk is worth hundreds of billions of dollars. He can absorb the fee. As for the idea that he’ll be responsible for additional damages, we’re highly skeptical of that. The breakup fee exists to specify damages for non-completion of a deal. Twitter can sue for other damages, but we’d be interested to see the specific claim they’d press. We also think the probability that Twitter takes this issue to Court is remote for reasons we’ll discuss later in this piece.
In addition, there is substantial circumstantial evidence that the bot count (and other accusations of Twitter management malfeasance) is a real problem. Shortly after the deal was signed, favored accounts lost millions of followers, while famous accounts on the other side of the political aisle gained millions of followers. Credible rumors flew that management was cleaning up follower counts, shadow bans, and other acts of political favoritism in an effort to ensure that these dishonest acts wouldn’t be found by Musk after the deal closed. We can’t prove any of this is true or false, but if we were paying more than $40 billion for a company, we’d be asking the same questions Musk is.
The Risk to Twitter:
So far, most of the writing we’ve seen on this topic has focused on Elon Musk’s hesitation to complete the deal, and how this will reflect badly on him. We’ve even seen people (on Twitter) speculate on his mental state saying he was in a manic phase when he wanted to do the deal, and since then, his attention has faded. We’re always skeptical of any psychological diagnosis from someone who may not be professionally qualified, and who hasn’t spoken to or examined the person they’re diagnosing. Further, Musk is known for long periods of intense focus at multiple companies including and especially Tesla (ticker: TSLA). We believe he has a legitimate concern about the real user count at Twitter, and that (not a psychological disorder) is his reason for hesitation.
Many financial observers seem to be forgetting the massive liability that Twitter executives and directors may be facing. Despite management doing all they could to resist Musk’s takeover offer, they eventually capitulated to his offer price. There was no negotiation and no second higher offer. That indicates to us that Twitter executives neither had another buyer at anything close to Musk’s price nor a credible plan to explain to shareholders how they would get the company stock price to reflect that valuation on their own. Had they declined Musk’s offer with no other plan, management would have been facing a shareholder revolt and probable lawsuits.
Now, imagine this deal collapses because Twitter management refuses to provide due diligence materials on a matter concerning which they’ve made public claims. Because the company has said that the bot count is below 5%, it cannot credibly claim that it doesn’t know the actual number (or a reasonable approximation). At this point, the only reason the company wouldn’t disclose the number (or how they calculated the 5% number) is if it’s well above 5%. That would mean a huge drop in the stock price, loss of the Musk acquisition premium, and that SEC filings contained false information. We’d be back to the shareholder revolt and certain lawsuits in this scenario.
We See Four Possible Outcomes:
Twitter Management Provides Documentation of the 5% Number, and the Deal Gets Done:
In this scenario, the deal gets done at the announced $54.20 acquisition price. This is the least likely outcome here simply because if it were going to happen, it would have happened already. It’s also the only outcome where Twitter management doesn’t get sued.
During the writing and editing of this piece, Elon Musk arranged for a greater amount of equity financing for the purchase of Twitter. A sub-category of this outcome is Twitter management might decide to not provide any documentation of the 5% number, and Musk could decide to complete the deal at the full $54.20. While we don’t see this outcome as the most likely one, given that we believe Musk’s motivations for acquiring Twitter aren’t primarily financial, he could simply decide to overpay by a greater amount and complete the acquisition.
Twitter Management Provides Documentation of a Higher Number of Fake Accounts and the Deal Gets Done:
In this scenario, Twitter comes clean with Musk and discloses a materially higher number of bots. The deal gets done, but at a lower price because the higher number of fake accounts affects the value of the company. Management gets sued by shareholders for misrepresentation of the financial health of the company resulting in a lower price. They also have legal liability for filing false claims with the SEC. We think this scenario is possible, but unlikely because if management lied, it’s going to be a big lie. We’ve seen estimates that the fake accounts may be 20% – 30% of the total. It could potentially be even higher. If management decided to lie, they may stick with the lie all the way to the end.
Twitter Management is Telling the Truth About the 5% Number and the Deal Breaks:
In this scenario, Twitter management isn’t lying about the 5% number, but by refusing to provide proper disclosure to Musk, they cause the deal to break. With the stock currently one-quarter below the agreed deal price, shareholders will sue management for causing the deal to break and destroying a huge amount of shareholder value. This course of action would likely be interpreted to be management intentionally scuttling the deal in pursuit of their preferred political goals.
Twitter Management is Lying About the 5% Number and the Deal Breaks:
To us, this is the most interesting scenario. If this happens, Twitter could sue Musk for the breakup fee, but we don’t think that’s likely. Should this matter go to court, Musk’s attorneys would be able to question Twitter management about the 5% number. Given that Twitter claims in its SEC filings to have done the analysis, there could be no credible claim that they don’t know the number. If management is lying, and they take Musk to court, Twitter management is likely to end up providing evidence they lied to shareholders, advertisers, and the SEC. In this scenario, management definitely gets sued.
We think the only way the deal gets done at the current offer price is if Twitter provides Musk with some sort of credible analysis showing that bots and other fake accounts are under 5% as the company has informed the SEC. If Twitter declines to provide that information (and we suspect they won’t be able to show that fake accounts are under 5%), there are two options available. One would be to negotiate a lower acquisition price with Musk. The other would be to tacitly admit that fake accounts are substantially above 5%. Either way, absent a completed deal at $54.20, management is almost certainly facing shareholder lawsuits. In most scenarios, Musk is unlikely to pay the $1 billion breakup fee let alone additional unspecified damages.
We find the arguments that fake users account for more than 5% to be compelling and the fact that management is ducking the question to be concerning. Regarding the above scenarios, we have no idea whether management comes clean with Musk and shows him some sort of evidence, or whether they continue to deny the non-mandatory due diligence request. Given the lack of certainty here, and the substantial potential downside in the event that there’s no deal, we’re staying on the sidelines right now.
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