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  • Writer's pictureRobert von Hoffmann

VH Standard Merger Arb Fund - Monthly Letter (March '24)

VH Standard AM - Monthly Letter (2-24)
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Spring time arriving with sun over a field
With our monthly letter for March coming out, we look to enter the spring time.

With the results for February, the fund has had negative performance for back-to-back months. While we’re not pleased, this is not outside of the norm for merger arbitrage strategies. To put these results in perspective, the HFR Merger Arbitrage index, which we benchmark against, has had 11 years over the last 20 when the index had periods of back-to-back negative returns – 15 times with two or more months, 5 of those 15 times going to three or more months, and only 1 of those 15 times did returns go negative for four or more months, which was during the Summer of 2011. Of these last 20 years, the HFR Merger Arbitrage Index has only had 1 year with a negative year-end performance, which was during 2008. That’s quite a feat!

Merger arbitrage has a lot of great qualities, and this return profile is one of them. We hope over time that we are able to execute and prove ourselves as first-rate managers capable of competing against this benchmark.

With that said, during the month of February we got back to seeing deals close in our portfolio with 5 total deals completed. We expect this to continue during the month of March with the quarter-end being a common closing timeline for companies involved in transactions. The main detractors for the month were DocuSign Inc. (DOCU), Sequans Communications (SQNS), Capri Holdings Ltd. (CPRI) and Olink Holding AB (OLK). The main positive contributors for the month were ImmunoGen Inc. (IMGN), Sovo Brands Inc. (SOVO), and Splunk Inc. (SPLK).

Our job is to manage the “unknowables” and to manage the risk around this. During February, we saw two situations, one good and one bad, that we think we managed appropriately, although to varying degrees and results. On the one hand, we saw a deal signed with a substantially higher bid in the Whole Earth Brands (FREE) situation that we wrote about in our first letter last August. The other situation was the Sequans Communications (SQNS) tender offer that failed due to a triggered clause allowing Renesas to walk freely from the contract. We’ll discuss both situations and how we managed risks in more detail.

Whole Earth Brands (FREE) Transaction

In our first letter to our investors, we wrote about this transaction. It was a pre-deal situation where we felt it had a strong probability of getting to a signed deal and potentially for a much higher price. At the time of our first letter, we wrote this:

“Even though there is no DMA in place with the FREE transaction, we like how friendly the approach is at first appearance.

We tend not to focus too heavily on the upside, but it warrants discussion here. The initial proposal came in around 8x Adj. EBITDA, which is in comparison to some of the larger Consumer Packaged Goods (CPG) companies that currently trade at around 14x average without the takeout premium…. Additionally, the leverage employed at FREE makes for a very significant price increase if another company were to bid only 9x Adj. EBITDA, equivalent to somewhere in the high $5’s per share of FREE, up from the initial proposal of $4 per share.”

This upside potential was obviously taken to heart, as FREE has signed the deal at $4.875 per share, an increase of 21.8% above Martin Franklin’s original proposal of $4 per share. Of course, we couldn’t tell the future and, in this scenario, it was hard to discern the likelihood of it being a friendly approach from Franklin, what the final price would be if they even could agree to a deal, and how long the process would take to iron out. That’s our job though, as managers of this portfolio – to manage the unknowable outcomes and take a conservative approach to our risk exposure.

In the end, we made the assessment that this transaction was worth the risk exposure and established a position. What we wrote in August was “A lot of good things could happen here, so we felt it made sense to take shares from current shareholders and assume the risk of a deal failure.”

Overall, we were mostly flat on this situation due to it being a very small position and some forced selling when market pressures brought shares of FREE down to our $2.75 downside during the middle of the process. We continued to hold a small position up until the announced DMA, where we made back some of the realized losses from the forced selling. That’s our risk discipline at work, and you should know how that is handled even in a contradictory situation like this – a position that we liked, that had some active downside management, and that our P&L is essentially flat even with a huge bump in the offer.

Sequans Communication (SQNS) Transaction

In the other scenario, we held a marginally small position in the SQNS shares. This was a French company listed as a US ADR, with a Japanese acquiror using a foreign tender offer structure – something we have limited-but-some expertise in. On top of that, there were a few other factors that caused concern for us: 1) an illiquid stock prior to the transaction, which affects the downside, 2) a cellular IoT company with esoteric technology that has a difficult-to-understand revenue stream, 3) minimal sell-side analyst coverage, which makes it difficult for management to tell the company’s story in a deal break scenario, which in turn affects how efficient the market will be at valuing the shares, 4) a microcap deal size valued at $250 million, which leaves the shares out of index buying and causes a liquidity issue in the event of a deal break. These factors made us hesitant to take on exposure, and we decided to limit our risk to an estimated 0.20%-0.25% of our AUM at risk in a deal break. For us, big companies buying tiny companies like Sequans are historically successful transactions, so we decided to take on that exposure, albeit only a small amount.

As the deal progressed, there were a number of tender extensions with Renesas trying to obtain regulatory approvals for the transaction, and on February 12th, they received the approval from the French Foreign Direct Investment (FDI) regulator. Unfortunately, on February 15th, they received a tax ruling from the National Tax Agency of Japan which confirmed that consummation of the merger would trigger a taxable gain to the acquiror and would be deemed an Adverse Japanese Tax Ruling – a small one line condition to closing with a right to terminate. On February 23rd, Renesas walked away from the deal.

This foreign structure, the Japanese tax ruling, and the many factors affecting the standalone company are the reasons why we held an extremely small position by our standards of risk. After the deal was terminated, it was evident that we were right to maintain a smaller position. Our downside assessment was between $1.75-$2.25 per share based on where the company had traded prior to the deal announcement. The lowest SQNS shares had traded in the 6 months leading up to the deal was $1.86/share, and it mostly traded between $2.10-$2.40. After the deal, shares plummeted significantly lower than our assessment of downside to between $0.80-$0.95 per share. With no real buyers in the space and no sell-side coverage to tell the story or explain the valuation, there became a significant liquidity issue in the market for SQNS. We estimated that around 10-15 million shares were held by merger arbitrageurs – that’s a lot of selling.

As of February 29th, we lost approximately 0.52% of our AUM in our SQNS position. More than we wanted to lose, but also factored into our decision when we established a position with essentially minimal AUM at risk.

Opposite to the FREE transaction, this was a situation that we did not like very much, had significant downside issues, but ultimately it was a very large company buying a small company, so we decided to take on minimal risk exposure.

We think it’s important that you understand how and why we lose money, and how that impacts the equity of your investment. It obviously does not benefit us from a marketing standpoint to talk about our losses or to discuss a huge offer bump where we ended up flat; however, as investors, it’s very important that you understand our thinking in these situations.

Plenty of great deals close. We can talk about those all day, but it wouldn’t do you any good.

“Great things are done by a series of small things brought together.” – Van Gogh

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