The results for October 2023 were not what I wanted them to be, but we’re also not any less enthusiastic about the prospects for merger arbitrage in the months ahead. If anything, these types of months typically make us more excited about the future.
During October, we had notable unrealized losses from three transactions: VMWare-Broadcom (VMW, discussed below), Spirit-JetBlue (SAVE), and iRobot-Amazon (IRBT). Each one of these transactions is still ongoing and we are actively managing our risk exposure. While VMW is an exceptional company, the other two were sized with the understanding that they might encounter financial strain as standalone companies, if the deals were to break.
While it’s not lost on us that unrealized losses are very real and the impact on emotions can be intense, we do not make our decisions daily based solely on the changes in the stock price. Over the long term, our intention as a firm is to:
Invest in M&A transactions where the likelihood of closing is high.
Manage risk appropriately based on proprietary deal analysis.
Spread out our exposure across a portfolio of uncorrelated transactions.
Complete over 95% of transactions that we invest in.
Limit our realized losses to a size that does not affect the profitability of our portfolio.
Ultimately, aim for the compounding of completed deals.
It’s our opinion at VH Standard that when looking at potential investments, you should be looking for situations where you can put capital to work, and the investment will generate cash flows that can then be reinvested at the same or greater rates over the long-term. This is the basis for compounding. Our aim is to make our merger arbitrage fund a vehicle for compounding in a similar way.
This approach differs from that of most money managers, who aim to trade frequently or allocate their portfolio to maximize short-term returns or year-end gains, often overlooking longer-term prospects and the following year. In contrast, we’re simply trying to compound completed deals over the lifetime of our fund, while focusing heavily on minimizing the risk of realized losses from broken deals. The way we see it, the more we compound completed deals, the more we generate cash flows which can then be reinvested as we recycle the capital into new deals. It’s as simple as that, despite the investment world’s tendency to overcomplicate things.
VMWare-Broadcom Transaction
The VMWare (VMW) transaction was looking like it was ready to close during the month of October. The two parties had received most of the outstanding regulatory approvals over the summer, with reviews still pending in China and South Korea. At the beginning of October, news reports came out that approvals were expected to be granted over the following weeks; however, on October 17th, additional reports came out that delays from China’s anti-trust regulator, SAMR, were now likely.
This delay made the situation more complicated than a traditional M&A transaction for the arbitrageur, as shareholders had to elect to receive either stock or cash compensation on October 23rd, with the expectation that the deal would close on October 30th and shareholders would receive their pro rata share based on election results. At the time, electing for stock was worth approximately $215 a share of VMW and electing for cash was worth $142.50 a share; a no brainer that we had to elect stock for our shares. What complicated the decision was that once shares have been tendered for stock compensation, they become untradeable. The other option, not electing at all, would allow shareholders the freedom to trade their shares; however, if the deal closed on the 30th, those shareholders would receive the $142.50 per share in cash.
Fast forward to October 30th, VH Standard elected for stock, the tendered shares are being held with Interactive Brokers and are untradeable, and our current mark-to-market on our tendered shares is priced off the outstanding VMW shares that chose not to elect, which accounts for approximately 4% of total shares outstanding. Should the companies decide to release all tendered shares and reopen the election period, non-electing shareholders may qualify for stock compensation. Consequently, these traded slightly above the $142.50 cash price on October 31, 2023, the value at which our tendered shares were marked at month-end.
If the deal closes as is, we stand make a substantial realized gain with the pro rata compensation for our tendered shares being approximately $182.50 a share. While multiple outcomes are still possible, our assessment suggests that the most likely scenario is the deal closing in its current state before the merger agreement expires on November 26th. A few other potentially positive outcomes may also happen, so it’s fortunately not a binary situation from here on out. In the case that the deal falls apart due to China blocking the transaction, we’ve been conservative in our downside assessment of VMW.
If you’d like to discuss VMW or the other two notable unrealized losses, I’m available for a conversation.
RESULTS
We had a negative gross return of (1.33)% for October, which brings our gross return to +2.88% year-to-date. Net returns for the month were (1.41)%, bringing our net return to +2.56%. During the month of October, we saw 7 deals completed, as well as a notable unrealized gain from our position in Sculptor Capital (SCU), which contributed +0.35% to the portfolio returns. As mentioned before, we had notable unrealized losses with VMW contributing (1.03)%, IRBT contributing (0.29)%, and SAVE contributing (0.22)% to the portfolio returns. We believe our portfolio is set to complete a substantial number of transactions over next two months, furthering our goal of compounding completed deals over the long-term. I look forward to sharing more with you in the following months’ letters.
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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