We’re very pleased to say that we had a positive gross return of +1.66% for December, bringing our gross returns to +8.14% for the first 6 months of operations. Net returns for the month were +1.58%, closing out our net return at +7.63% for the year. In December, we completed 11 deals, bringing our total completed deals to 44 since our inception in July. Most notably, our position in Seagen (SGEN) closed, yielding a positive contribution of +0.43% to portfolio returns for the month.
Something important to think about - we constantly talk about the idea that we’re “compounding completed deals,” and over time, we believe you will start to see what we mean by this. If you had invested $100,000 at our inception, you would be going into 2024 with a balance of $107,632. When combined with our portfolio’s hurdle rate of 7% for new deals, you start to see the power of what we’re doing here at VH Standard. For 2024, that hurdle rate would have become 7.53% on that original investment, which is truly powerful when the risk profile of the portfolio hasn’t really changed all that much. The factor that has changed is the time spent invested. We believe this is the very beginning signs of compounding at work.
This is exactly why we aim to compound completed deals by investing in M&A transactions with a high probability of closing and spreading our risks across a portfolio of uncorrelated transactions. Over time, we think that our hurdle rate on our original investment will become much higher than the current portfolio hurdle rate. For this reason, we at VH Standard have also invested in the fund – an investment that we plan to add to in the months ahead.
WHAT’S MORE IMPORTANT, MANAGER OR STRATEGY?
As a firm, closing out our first calendar year has answered a lot of questions for us. Although still in its infancy, we established the approach and believe we have proven that we can implement a high-quality merger arbitrage strategy. In 2024, we hope to take that a step further and prove that we are one of the better managers in the merger arbitrage space, as well as a high-quality steward of investors’ capital. Our aim is to become the type of manager that we personally would feel comfortable investing alongside for the long term.
Last month, we mentioned a few additional questions that we’ve been actively thinking about. One of those questions was “is the strategy more important than the manager?” The feedback we have heard from others is that the manager is more important. We think that makes sense, with poor quality managers being incapable of executing the strategy in a way that effectuates the desired outcome. However, we think it’s just as important to choose the right strategy that aligns with the desired outcome from the start. We’ll quote Warren Buffett a couple of times in this letter to make the point on both sides.
In the first quote, Buffett spoke on the strategy, or the business model, being important to get right. He said, “when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” In our view, a poorly devised investment strategy, left in the hands of high-quality managers, will fall apart over time. The reputation of the strategy will remain intact.
With that said, here are some of the right characteristics that we believe an investor should look for in a high-quality strategy:
A clearly defined strategy with guidelines, rules, and procedures.
Risk assessment protocols and tools for monitoring that risk.
Evidence-based process for creating profits, income, and/or capital appreciation.
Business model or investment universe that allows this process to be repeated time and time again.
A robust strategy that works under shifting market conditions.
Liquidity characteristics that match the duration of the investments within the strategy.
Utilizes a long-term perspective on either long or short-term approaches.
We believe that merger arbitrage fits these characteristics, starting with it being a clearly defined strategy. When done correctly, it’s the investment in different securities of companies that are involved in M&A transactions, whether that’s mergers, acquisitions, tender offers, asset sales, or a variety of other similar transactions. These investments are typically held for between three and five months, on average, and generate an absolute return upon completion of the transaction. Any deals that fail to be completed generally have a significant % loss on each share held. If done right, the merger arbitrageur makes profits on the completed deals, netting out the losses from the failed deals, and ends up with an absolute net return.
Historically, 95% of deals are completed, so it’s on the manager to size the investments appropriately with the aim of producing net returns on the strategy, while limiting the loss from failed deals. Because of this, a skilled manager will have set up guidelines and rules that help structure the portfolio appropriately, and an experienced one will know how much risk is likely too much on any given transaction. This approach utilizes historical data, which provides an evidence-based process for creating profits. A few boxes checked for merger arbitrage.
The need to know how much downside risk there is with a specific transaction requires tools for assessing and monitoring that risk. Since there are significant losses that come from failed deals, a skilled merger arbitrage investor will have to be constantly aware of their downside, even though it rarely happens. For us at VH Standard, we focus heavily on the downside, analyzing the potential risk of loss in a failed deal scenario on a live basis, while applying additional conservative overlays to the process that allow us to view multiple downsides in under various circumstances. This helps us manage the portfolio with what we believe is a proper assessment of risk.
The universe of deals aspect is dependent upon deal activity, which has ebbs and flows depending on the market economy; however, these periods of slow-down do not tend to last longer than 8-12 months on average. At VH Standard, we have the added benefit of remaining small, while the larger funds’ deal activity is more dependent on large scale M&A transactions. We can operate in a universe where all deals have a transaction value under $500 million, while the larger funds would find it harder to keep fully invested in a world with no transactions above that. That’s a considerable plus in our opinion and makes our strategy more flexible. With that, we believe this is a robust strategy that can survive and thrive throughout the business cycle under various economic landscapes.
Overall, liquidity in M&A transactions is typically very high, providing investors with access to their cash throughout the process, while volatility in the overall portfolio tends to be on the lower side, as the price follows the likelihood of completion with minimal correlation to the stock market. This depends on the risk profile of the investment manager and their portfolio structure, but we at VH Standard aim to have a portfolio with excessive liquidity to match our monthly liquidity for fund investors.
For our twist on the long-term perspective, we are taking our statistics and guidelines and investing in M&A over the long-term from the perspective of “insuring” transactions are completed for the shareholders who sell shares to us. Similar to insurance, we must make sure that we have ample equity to handle losses, as well as limiting any position from exposure to significant risk of loss. If we can do that, we believe that this strategy will lead to compounding on the absolute net returns over time. It might look slow at first.
Finding the right manager, on the other hand, can be incredibly difficult. That’s the reason so many believe that the manager is more important than the strategy. It’s easy to write all the criteria for a high-quality strategy; it’s much more difficult to implement that strategy with successful results. As Warren Buffett said in his 1984 Berkshire Letter to Shareholders:
“Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)” – Warren Buffett
Since most managers have incentive to provide a less-than-optimal decision-making process, it’s easy to understand why it’s so difficult to find the best of the best in any particular strategy. We may not outperform the market or every other merger arb fund every year, but we hope you never think of us as a lemming. And we hope you know that we will always try to make the “intelligent-but-with-some-chance-of-looking-like-an-idiot decision” because it’s our money, too.
Thank you for reading. We look forward to continuing to build this portfolio. If you’d like to have a conversation, feel free to reach out.
“Great things are done by a series of small things brought together.” – Van Gogh
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