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  • Writer's pictureRobert von Hoffmann

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



VH Standard AM - Monthly Letter (4-24)
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It’s been a tough start to the year, but we believe the best time to invest in a strategy is when the risk is mostly priced in, and when the market lacks a certainty about where the future is headed. In this letter, I’ll focus on the Capri Holdings transaction as an opportunity that we think fits that description. For us in merger arbitrage, there might be opportunity when regulators believe society’s ability to buy a specific set of brand name handbags should be protected, as if these brand name handbags are a necessity to a functioning civilization. I’ll do my best to remain objective in this analysis, as you would expect from the manager of your capital.


RESULTS

During the month of April, our gross returns were negative at (1.90)%, with a negative net return of (1.99)% for the month, bringing our year-to-date net return to (4.12)%. Most notably for the month, the exposure to the CPRI transaction had an unrealized loss of (1.20)% contribution to the portfolio, followed by smaller but unrealized losses in the JNPR, MGRC, SP, and AXNX transactions – each no bigger than (0.22)% contribution to the portfolio.


Tricon Residential-Blackstone Transaction

On April 12, a Dow Jones report was released discussing the Canadian government’s intention to update measures that will limit private equity’s activity in the Canadian housing market. This would likely focus on single family rentals, as noted in the report. In response to the news, Tricon Residential’s (TCN) share price plummeted on fears that the Canadian government may use their power through the Investment Canada Act (ICA) to block Blackstone from purchasing TCN, which had yet to receive ICA approval.


For a quick background on the Investment Canada Act, it was put in place to ensure that investments into Canada by non-Canadians are to the benefit of Canada’s economy, as well as protect Canada from national security risks (similar to CFIUS in the United States). In the past, the act has been used to block a handful of transactions that had proposed to put critical infrastructure, valuable resources, or essential assets in the hands of foreign companies with questionable alignments.


The Tricon acquisition by Blackstone would likely fall into the first category of the act relating to providing a benefit to the Canadian economy; however, the main discrepancy that we saw was that TCN owns a large portfolio of assets, with 84% in the U.S. and 16% in Canada. On top of that, this 16% consists mostly of assets in the Toronto region and focuses on extremely large multi-family residential buildings inside the city limits. That’s not the focus of the Dow Jones’ report that was released on April 12th. On the other hand, all of TCN’s single-family rentals are focused on the U.S. Sun Belt region, which is outside of the purview of the ICA. Effectively, in our assessment, this transaction avoids much of the Canadian government’s focus on private equity ownership of SFR in Canada and wouldn’t be receiving increased scrutiny.


After analyzing the situation, we felt it was still very likely that TCN would receive ICA approval and Blackstone would be free to complete the transaction. With this, we increased our position by 50% at a price of $11.00 per share, bringing our risk to 2.66% downside % of AUM. The deal received regulatory approval from the Investment Canada Act on April 25th, and subsequently closed on May 1, 2024.


Capri Holdings-Tapestry Transaction

Quite the headline worthy story with this one. The new FTC is going after a fashion deal, which hasn’t happened in decades! On one side, you have a public opinion that it’s great to see regulators being tough on corporations who are looking to create monopolies and harm consumers. On the other hand, you have a public opinion that this FTC is inept, loses every case they take on, and immature in their views. As is usually the case, the truth is somewhere in the middle.


This FTC has formally filed a complaint on 40 different transactions in this new era over the last 4 years. Of those cases, 5 have gone to court and the FTC has lost 4 of those court cases. So, yeah, they do lose a lot. This is because they issued new merger guidelines (Link here to press release) and they’re looking to test these guidelines out in court. It’s also because their new merger guidelines are not based in previous case law, and definitely have not been made into law through legislation from Congress. So, it’s an uphill battle for them.


The other side of the story is they’ve obtained 21 divestiture packages and 3 behavioral consent settlements out of these 40 complaints, while allowing those 24 transactions to be completed after a newly structured deal. They’ve also had 11 transactions that have ended completely with the parties abandoning their acquisitions, as the companies didn’t see court as a viable approach. So, the FTC has made some progress in their approach, and they have some wins to speak on.


This all leads us to the Capri-Tapestry (CPRI) transaction, where the FTC filed a complaint with a lawsuit to block the deal. Under this FTC team, we’ve seen this stage of the transaction play out with a 70% completion rate – 4 court wins by the companies, 21 divestiture packages, and 3 behavioral remedies. So, which side will CPRI end up on, the 70% completed or the 30% failed? There are a lot of nuances to answering that question. We’ll try to be as unbiased as possible, while making you informed enough to understand the risks.


WHAT’S IN THE FTC COMPLAINT?


On April 22nd, the FTC officially filed its suit to block the transaction (Link here to official complaint). Inside this complaint, we see the angle that the FTC is using to prove the merger as an anticompetitive transaction – relevant market definition in the handbag market labelled to be “accessible luxury,” which was taken from a piece of marketing material released by the companies. The FTC does not provide any additional details, such as price ranges, a definition for what quality means, whether men’s handbags are included, or who the other competitors are in this space besides the parties to the transaction. It’s difficult to assess this market definition, especially as most relevant data is also redacted from the public view, so a lot of assumptions need to be made.


Additionally, the FTC gives an inkling on their approach as to why this transaction may be anti-competitive and unlawful from their perspective. They write, “a merger is unlawful if it substantially lessens competition between the parties independent of the analysis of market shares, as recognized by the 2023 U.S. Department of Justice and FTC Merger Guidelines”, which we know is promulgated by the FTC and DoJ, but also outside of their authority to make into actual law. It’s merely a guideline to companies considering new transactions on what to expect from regulators.


In this statement, it should also be noted that FTC writes “independent of the analysis of market shares,” which might suggest the redacted market share numbers being lower than previous cases with harmful concentration. Trying not to make assumptions, but this would be in line with our analysis that the combined entity would control ~40%-45% of the market for women’s handbags priced between $100-$400, not including resale markets, counterfeit products, or black-market sale of stolen goods, which would substantially lower this percentage. Traditionally, ~40%-50% does not have an undeniable impact on the Herfindahl-Hirschman Index (HHI), the formula used to prove concentration of market share, so this must be further analyzed and the relevant product market has to be defined.


In order to define a relevant product market, all parties either have to agree (not going to happen) or a number of tests and formulas have to be provided in court that prove each entity’s competitive impact and the existence of substitute handbags and/or products; the main test used is the SSNIP test which assumes a monopoly and then analyzes the effects of a price increase, while adding one additional competitor after each price increase to see the overall impact on demand. If you no longer have a diversion of sales to the recent additional competitor, than you have found your boundaries for a relevant market definition. After that, you run an HHI test on this relevant market to see the calculated impact and can decide on the level of concentration in that market.


The FTC hasn’t provided enough information to tell if they’ve done this analysis, yet.


WHAT’S IN THE COMPANIES’ RESPONSE?


Here’s where things get interesting. The companies answered the FTC’s complaint formally (Link here to official response) and, as expected, they went straight towards disproving every claim from the FTC, however vague those claims were.


The companies start with, “The FTC mistakenly believes there are only three options for a consumer seeking a high-quality handbag in whatever price range the FTC ultimately settles on for its untenable ‘accessible luxury’ handbag market: Tapestry’s Coach and Kate Spade, and Capri’s Michael Kors. Indeed, the FTC’s Complaint incredibly goes so far as to decry that these three brands constitute a ‘duopoly’ in that market.” The companies are essentially stating that the FTC has deemed the only market participants to be the merging companies. We know that Tory Burch and Longchamp should both be included as competitors, although that could still constitute a concentrated marketplace with the 5 brands. The FTC doesn’t mention the other two, which adds to the story that the FTC’s complaint lacks clarity.


Following that, the companies go on to state many flaws in the FTC’s review process, including not producing a single testimony from a consumer, a manufacturer, a competitor (apparently because there are none), or the companies themselves. This would either suggest that this will be done in discovery, meaning that the FTC believes wholeheartedly that they’ll find something to strengthen their case down the road, or that the FTC didn’t follow through with a comprehensive analysis during their lengthy review process. Either way, regulators should have this work done prior to filing a complaint to block a merger. And if they did, why didn’t they share the information in the complaint?


The companies also go on to address the approach of using the Merger Guidelines as a determinant of unlawful mergers. They state, “The FTC attempts to bandage the holes in its case by claiming the loss of head-to-head competition is enough of a basis alone to block the Transaction. Not true. There is no legal support for the theory that loss of head-to-head competition, absent an undue concentration in a properly defined market, can violate Section 7 of the Clayton Act.” This sets up the case for resting on HHI calculations to determine what is too much concentration and what defines a broad enough market.


Lastly, the companies talk about the FTC’s complaint’s lack of clarity around presenting actual market share numbers and calculations for their own HHI assumptions. The FTC stated that the merger will result in “considerably more than 30% market share,” which is above what the FTC would deem as too much concentration. The companies see this as a weak argument; however, the FTC was able to win their court case against the acquisition of IQVIA by Propel Media on this exact basis. It doesn’t pass the initial sniff test, but it doesn’t mean it will be thrown out come September.


WHAT’S OUR TAKE?


Our overall view is that this transaction will eventually be heading to court and that the merging companies have the edge there. There’s a possibility that they settle prior to the court, with an easy path to completion likely being the divestiture of Kate Spade to keep competition in the marketplace. Of course, this would increase Tapestry’s market share, so they might see it as a viable option; however, the companies would rather not divest anything, based on their initial comments and response to the FTC complaint. There’s also a possibility that the companies will decide to abandon the deal, but I think this is extremely unlikely to happen.


Regarding the case, as it stands, the companies have the upper hand in the court room. There hasn’t been a fashion deal challenged in decades (for good reason) and the competition is typically fierce with 100s of brands constantly battling to be top of mind for consumers. Fads come and go. Brands go extinct. And to state that any one brand has a “monopoly” during a point in time where everyone is wearing their products, feels at the surface to be lacking an understanding of basic economic reality – sure, it kind of makes sense given a single snapshot analysis at one point in time.


Additionally, we’ve investigated the Brown Shoe Co. vs. United States from 1962 and the Leegin Creative Leather Products, Inc. v. PSKS, Inc. from 2007 to gather further insights into how this might play out. The Brown Shoe Co. case found a few things on product market definitions in the fashion industry: i) that medium-priced shoes do not occupy a different market than low-priced shoes – potentially, setting up Capri-Tapestry to introduce the mass market handbags into their relevant market definition, as well as higher priced luxury handbags; ii) that there’s no reason to make a distinction based on “price/quality” or “age/sex” beyond the classification of “men’s, women’s, and children’s” – also potentially introducing the 100s of other high quality brands into the relevant market definition; and iii) that the vertical nature of the 1962 acquisition would lessen competition due to the impact on manufacturers from Brown Shoe Co’s production & retail capabilities – Capri & Tapestry don’t have a substantial manufacturing footprint, and therefore this is a positive, but the distribution channels available to Capri & Tapestry may present a hurdle in the court room.


The other court case, Leegin Creative, presents a ruling on the inclusion of discount marketplace participants as part of the relevant market definition for retailers. Although it was a case focused on alleged price-fixing strategies and is overall not related, the ruling on market definition is helpful to think about.


Lastly, a $300 handbag can be considered both an inferior good and a luxury good, depending on the consumer’s income levels. The FTC would likely have to separate lower-to-middle income individuals from middle-to-upper income individuals in their pursuit of defining the relevant product market, which would help to remove the “inferior good” label. Inferior goods typically have very competitive economics associated with responses to price changes and it would likely be hard to argue market concentration using the SSNIP test for an inferior good.


So overall, we see this court case to be stronger for Capri-Tapestry than it is for the FTC. It’s hard to ignore the redacted information in the FTC’s complaint and the general lack of hard-hitting evidence against these two fashion companies; however, they made be withholding documents that are damning to the merging parties’ case. In light of the lack of evidence, we would have to make substantial assumptions in order to see how the FTC has a strong case. On the other hand, the merging companies have provided some strong evidence, and our initial analysis tends to be in agreement with most aspects. So, we rest with Occam’s razor – when deciding between two competing theories, the most likely to be correct is the one with the least assumptions in the simplest form.


Until the FTC shares information that can prove “accessible luxury” handbags do not compete with luxury handbags or mass market handbags, we will side with the theory that the fashion world is incredibly competitive, and always has been. In this case, we estimate that the merging brands would only have about 7% market share of the overall handbag market. Not very concentrated.


Nonetheless, we will continue to manage our risk appropriately.


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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