We believe that we are well positioned for any volatility in the markets during the coming months. Our cash position, uncorrelated strategy, and general risk-averse approach provide us with this benefit as we look forward.
At the end of July, our portfolio’s net exposure was at 77.9%, while our long exposure was 86.6%, providing us with ample cash and liquidity for opportunity. We held a substantial amount of cash throughout July, while only investing in a couple new positions large enough to be worthy of note: Morphic Holdings, Inc. (MORF), a tender offer which promptly closed on August 16th after only 39 days and a position where we felt comfortable holding shares with an exposure as high as 2.34% of our total portfolio equity at risk in a deal break scenario; and Enstar Group Limited (ESGR), an insurance/reinsurance company focused on run-off strategies that entered into a definitive merger agreement with Sixth Street on July 29th.
The reasons for us holding a significant portion of our portfolio in cash and liquidity are:
1. Deal Activity: We want to be positioned to take advantage of any increased deal activity in the months ahead. This would allow us to spread out our risk among a larger number of uncorrelated transactions while maintaining our portfolio’s hurdle rate. For each new deal announced, various dynamics move in a way that benefit us.
For instance, we already have the advantage of operating a smaller fund, which increases the universe of deals available to us compared to a larger fund (an advantage we believe we still have at our fundraise target of $75MM in AUM). As deal activity increases, so does this advantage. Right from the start, we have a greater value of choice, as we can invest in the same deals that they do. However, as each new small deal gets announced, our universe of investable transactions typically grows by one, while bigger funds may have liquidity restraints or market cap thresholds preventing from including these new transactions in their universe. Excluding competition from those with scale over us is a positive, and we believe this results in a better risk-adjusted return profile. Just to note, of the deals we’ve tracked since 2015, there has only been 1 transaction that has failed to be completed with a market cap under $100MM - we can still fish in that pond, they can’t.
Going forward, we want to position ourselves to strengthen these advantages as much as possible, especially in a scenario with an increase in deal activity, which we believe is very possible in the months ahead. This depends on a few ever-changing economic factors that we’ll refrain from discussing at this point, but we think circumstances are currently aligning in our favor.
2. Opportunistic Investing: For the HFRI Merger Arb Index, there has been at least one negative month between August and October during 10 out of the last 15 years, going back to 2009. If at any point over the coming months there is increased volatility or a downturn in the markets, we want to be positioned in a way that we can take advantage of short-term inefficient prices for the best transactions. This is a rare opportunity, but at times market volatility can force other merger arbs into selling shares high-quality transactions at prices well below where we think they should be traded. One of the reasons for this is that many other merger arb funds run levered portfolios – therefore, they will more likely be selling during volatility, rather than buying. Out of the ones that are not selling, it’s difficult to be an incremental buyer when the risk you're taking is currently growing from an already full-sized risk position, which happens as deal downsides worsen, following the market down.
With our unlevered portfolio and conservative approach to managing transaction-level risk, we typically have ample room to be an incremental buyer during those type of periods. We also tend to have the stomach for it, and even look forward to it.
During the first week of August, there were a handful of transactions that we believe fit this bill nicely, and we look forward to sharing an updated Top 10 Holdings at the end of August to show where we’ve invested some of that cash and liquidity. As of August 19th, we continue to have a substantial amount of net cash and liquidity, as deals have continued to close during the month. We’ll provide a more appropriate update in our next letter.
One fact that can’t be overlooked is the potential for a negative return in the HFRI Merger Arb Index due to failing transactions, rather than market volatility. Although this may be the case in some of those historical returns, it’s not without the understanding that a failed deal can cause some merger arbs to sell other positions in their portfolios at discounted prices. So, while we may not see general market volatility causing the attractive prices in the shares of M&A related securities, which would be ideal, the premise remains that some shares may be available at attractive prices for opportunistic buyers who have cash on hand.
3. Patience: Lastly, we are currently getting an attractive yield on our net cash just to be patient going forward. It doesn’t reach our current hurdle rate of 7%, but we’re okay with that for now. One of our mottos is “an even-tempered approach to change.” We believe that our current position in cash exemplifies this motto and signifies our intention to put it into practice.
If you’d like to have a conversation, please feel free to reach out.
“Great things are done by a series of small things brought together.” – Van Gogh
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