Investors learned the perils of investing alongside @MichaelDell when he engineered a $24 billion leveraged buyout of @Dell in 2013 that undervalued the technology company he founded. Now Dell, the CEO and controlling shareholder of privately held @Dell Technologies, might be at it again. There have been reports that Dell Technologies, which is highly leveraged, is considering a merger with cash-rich @VMware (ticker: VMW), a company in which Dell Technologies holds a roughly 80% stake. The possibility of such a transaction isn’t sitting well with two investor groups: the owners of the 20% of VMware not held by Dell, and the owners of a Dell Technologies tracking stock for VMware ( DVMT) that was created when Dell bought EMC for $67 billion in 2016 and got EMC’s controlling stake in VMware. Share of both VMware and the Dell Technologies tracking stock fell sharply Monday after a CNBC report that Dell is considering a merger with VMware, the virtualization software company now valued at about $50 billion. The better value of the two stocks could be the Dell tracker, which finished at the day at $74.80, down $7.94, or 10%. VMware plunged $24.95, or 17% to $125.15. While there is uncertainty about how the tracker would be treated in a Dell/VMware combination, it now trades at a steep discount of 40% to VMware, offering a margin of safety. Some think the better trade is to buy the Dell tracker and short VMware to capture that differential, which had been around 35% until it widened sharply on Friday. “Given the discount, I see it [the arbitrage trade] as carrying limited risk,” says Keith Moore, a managing director and event-driven strategist at FBN Securities. The Dell tracker has a current market value of nearly $15 billion based on about 200 million outstanding shares. The VMware (ticker: VMW) selloff today follows a 9% rally last Friday to a record close of $150. The stock rallied on reports, including one in the Wall Street Journal, that Dell was considering buying out the public holders of VMware. Investors in VMware have gone from optimism about a potential deal for VMware at a premium to uncertainty about how a possible merger with a highly leveraged Dell would be structured and how the new stock would trade. VMware had rallied more than 50% in the past year amid hopes that it was positioned as an attractive cloud-computing play, based in part on its alliance with Amazon Web Services. ADVERTISEMENT The Dell tracker has been hit even harder than VMware. On Friday, the tracker fell 7% despite a rally in VMware; the two stocks normally move in lockstep. The drop in the tracker reflected an unwinding of a popular arbitrage trade among hedge funds in which the funds were long the tracking stock and short VMware to capture a spread that has lately averaged about 35%. The divergent moves in the Dell tracker and VMware forced many funds to unwind their positions, selling the Dell tracker and buying VMware. ADVERTISEMENT A Dell/VMware merger would create a potentially unwieldy combination of VMware, a software company with about $7 billion of cash and a market value of $50 billion, and Dell, with estimated core debt of more than $40 billion. Given the market reaction today, VMware holders aren’t happy about the idea of a reverse-merger deal. It is also unclear whether the public VMware holders would be allowed to vote on such a deal. William Blair analyst Jason Ader wrote today in a client note that “after two years, our understanding is that according to Delaware law [VMware is incorporated in Delaware] Dell could pursue a ‘short form’ merger for VMW without prior action by the board [because Dell controls more than 90% of VMW’s voting shares], and there is no duty to pay a ‘fair price’ in such event. If this happens, a minority shareholder’s sole remedy is to seek appraisal of the VMW shares [non-voting shares are entitled to appraisal rights in a merger to the same extent as voting shareholders].” ADVERTISEMENT Dell’s voting interest in VMware exceeds its economic ownership due to ownership of high-vote shares. The two-year period referenced by the William Blair analyst ends in September 2018. A simpler strategy for Dell would be to simply go public on its own and leave VMware remaining as a public company. Dell could try to buy out VMware holders, but that would run counter to its strategy of the past year in which it has bought back shares of the Dell tracker using proceeds from sales of VMware stock back to VMware. ADVERTISEMENT It’s unclear what would happen to the tracker if Dell combines with VMware in a reverse merger, simply goes public, or seeks to buy out the VMware public shareholders. That uncertainty is weighing on the tracking stock. Dell can’t distribute the underlying VMware shares to the tracker holders before 2021 without a significant tax penalty, according to New York tax expert Robert Willens. Bloomberg is reporting that if Dell merges with VMware, the tracker shares “would be subsumed in the newly combined Dell-VMware.” Dell, Bloomberg wrote, “hasn’t decided if it would swap them for shares of the new company or acquire them with cash.” The tracker holders could have some protection in a Dell/VMware merger. According a report by the UBS Special Situations group on Friday, Dell would have to pay a 20% premium to buy out the tracker holders within one year of an initial public offering, with that premium falling to 15% in the second year and 10% in the third. It’s unclear whether a merger with VMware would constitute an IPO. It’s possible that an activist investor could surface in the tracker and try to ensure that tracker holders are protected in any going-public transaction involving Dell. The company attracted activist investor Carl Icahn back in 2013 when Dell sought to go private, with Icahn arguing – correctly, as it turned out – that the buyout offer undervalued Dell. There is still considerable uncertainty about Dell’s plans for VMware, but Dell could face shareholder resistance if it tries to engineer a deal that shortchanges both VMware’s public holders and the Dell tracker investors.
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