Transactions Mentioned In This Letter: Enstar Group Limited (ESGR), Capri Holdings (CPRI), McGrath RentCorp (MGRC).
“Anyone who’s tried to build a business has probably learned that you walk a thousand roads, each the beginning of strategic possibilities and relationships, only a few of which come to the meeting-of-minds and let’s-do-this handshake stage.”
- Horizon Kinetics, “The Old New Horizon Kinetics - Going Public Buy Staying the Same”, July 1, 2024. (Link Here)
We’ve been blessed to walk one of those thousand roads with a few of you, as readers. To us, merger arbitrage is a powerful addition to anyone’s portfolio, which is why we believe in our strategy in the first place. It’s important to us that you’ve chosen us as the manager of your merger arbitrage allocation, and for the few who asked us to lower the minimum investment, we’ve been happy to do it. Providing access to this strategy and its benefits is the main objective of our firm.
When we think about the power of merger arbitrage, the first thing that comes to mind is the diversification that it brings to a portfolio. Diversification is a buzzword or an illusion in most cases, so some of you reading this might be contributing merger arbitrage into that bucket. In truth, diversification of uncorrelated assets shouldn’t be seen as just a buzzword. There is a reason that the old-fashioned stocks-bonds-cash portfolio has survived such a long history - each one of those investment categories offers something different than the other two. Recent financial theory has begun adding real assets, private equity, and private credit into that mix. Why? Because they also offer something different than the other categories. It’s our firm belief that merger arbitrage employed the way that we do it at VH Standard can one day be seen as a category of its own, much like these others. The more you get to know it, the more you see its differences.
Merger arbitrage, even though its history dates back to Warren Buffett’s early days, is still relatively misunderstood today. There are merger arbitrageurs that run concentrated portfolios, doing detailed analysis on the likelihood that risky transactions will ultimately be approved, expecting to achieve higher returns for the relatively high risk they’ve taken. There are other merger arbitrageurs that only buy the relatively safe transactions, expecting to receive decent returns above the risk-free rate, while leveraging up significantly to make the returns worthwhile. Somewhere in between these two styles is us, mixing our portfolio between higher and lower risk transactions, while actively managing deal-level risk, portfolio risk, and any other correlated risks that we may find, whether it be geopolitical or macroeconomic or other connected strings. We don’t like leverage, so that’s not really a part of this strategy - we may utilize it at times, but only when the situation lacks incremental buyers, and we feel there is an inherent advantage given to us for doing so. It’s rare, though.
RESULTS
During September, we had a net return of +0.06% for our investors, bringing the year-to-date net returns to (0.83)%. Although flat, I am happy to say that we have now had 5 positive months in a row for investors. The strategy typically has less volatility than most other strategies; however, it’s expected to compound over years, while month-to-month returns shouldn’t always expect to be positive.
We had one deal, MGRC, which failed to be completed during the month. The fund had a realized loss of (0.50)% contributed from this position. In hindsight, we could have done a better job analyzing the downside, as we saw the stock price for MGRC almost fully recover to our average cost by month end. We tend to take a more conservative approach to estimating our losses in a deal break scenario.
In this situation, that conservative nature hurt us. However, in most cases, it helps us limit our risk of permanent capital loss.
On a forward note, while I can’t comment on the October returns yet, there was negative news in the CPRI-TPR transaction and it’s likely that we will have a material realized loss in that position. On October 24th, Judge Rochon made her decision to issue a preliminary injunction, blocking the two parties from merging based on direct head-to-head competition and rejecting the idea that women’s handbags are discretionary items. Instead, Judge Rochon made the judgement that women’s handbags are essential items, where consumers cannot choose to forego purchasing specific brands in the case of an unreasonable price hike. We don’t agree with the ruling, but that’s why we manage our risk.
Enstar Group Limited Transaction (ESGR)
ESGR is our biggest position in the fund, so we feel it’s necessary to tell you why we have such an outsized position in the transaction. For starters, it’s an insurance company that is being purchased by a large asset manager, Sixth Street, for $338 per share. Insurance company transactions tend to take longer than typical M&A, but these types of transactions also have a very strong success rate. We like the second part a lot.
The next part is the downside we see in the transaction. If the deal were to break, we’re estimating that the shares would trade down to $250 a share for risk management purposes. Due to the nature of merger arbitrage, we can establish a fairly large position, as a percentage of AUM, since this would be about a 21% drop from where shares were trading at our time of purchase. The average transaction sees a purchase price with a 33% premium to the undisturbed share price, which is the price where the target company was trading prior to any deal announcement or rumors - in this example, you have a 20% drop in a deal break scenario. To illustrate, company A trading at $10 a share gets an offer at $13 and trades around $12.50. If the deal breaks, those shares would drop from $12.50 a share back down to $10 a share, a 20% loss. The reason ESGR is exceptional here is that the shares were trading at $305.47 on June 28, 2024, which happens to be the date that the company uses in their documents as an undisturbed share price. So, ESGR only got a 10.6% premium for the takeout offer. Exceptionally low premium.
If the shares only have a $20 downside (at $300 a share), assuming the business has remained intact since June, then we can take an abnormally large position since our main measurement for risk is the potential realized loss as a percentage of our total equity. We could technically have a position size of 32% of our portfolio, while only risking 2% of our total equity in a deal break – if the $300 per share downside price is real. This gives us substantial margin for error, which we truly value a lot.
For the upside, there are a whole host of factors that we like; however unlikely some may be. In the event that the deal closes at $338 per share by the end of the second quarter in 2025, estimate that we’ll have an annualized return of somewhere between 7% and 8% on the capital invested in ESGR shares. This is the most likely outcome, given the strong success rate and the average timeline for all insurance transactions in our database going back to 2015.
Additionally, at the announcement of the deal, there was a “go-shop” period of 35 days where the target company was allowed to solicit other potential acquirers, looking for a higher price. This ultimately ended on September 2nd, without any interested parties looking to make a higher offer for ESGR. Understandably, we would have liked to see more interest; however, we are happy with the deal progressing as is on a normal timeline.
Besides the “go-shop” there are a few other potential catalysts for excess returns. The first one is a quicker timeline. We typically don’t expect target companies to be able to clear all conditions faster than historical averages. It wouldn’t make sense from an investment perspective to tighten timelines; we’d effectively be shrinking our hurdle rate because of hopes and wishes. The ESGR transaction fortunately provides us above hurdle rate returns with an average timeline. However, there are compensation incentives for management to close the transaction on an accelerated basis. We aren’t counting these dollars yet, but we’d gladly receive them early, if possible.
A more likely factor is the 10.6% premium offered to shareholders. This is well below average 33% premium for deals, and under Bermuda law, all ESGR shareholders are given “appraisal rights” for this transaction. If we vote against the transaction and it still proceeds, we can exercise our rights under Bermuda law to seek a higher price for our shares. It then comes down to the appropriate valuation for ESGR shares and what constitutes fair value. Often, shares will trade for a premium above the deal price as buyers with expertise see a route to a higher compensation. This is currently happening in shares for Endeavor Group Holdings (EDR), which has a deal price of $27.50 a share while trading at $29.25 a share. Although it’s a slightly different scenario, this is the game.
Here’s where it gets interesting for us. Historically, ESGR management has been able to compound shareholder returns at around 7.5% annually for the last 10 years. So, with $305 as a starting point per share, the expected 5yr return for ESGR would get to about $420 per share. By the end of next year alone, the share price would be about $340 a share. Past returns obviously do not guarantee future returns, but it’s an exercise. And in this exercise, would you give up the future returns past 2025 for $338 today? Would you give up the future returns past 2025 for $338 in June of 2025? It’s kind of hard to rationalize that.
On the following page, you’ll see projections that the management team made for ESGR going forward. This was included in the proxy statement issued to all shareholders, so that they could make a reasonable decision on fair value when voting their shares in relation to the transaction.
To break things down, the offer of $338 per share is equivalent to $5,100MM in book value. With 15.23 million shares outstanding, the management adjusted book value would read as $377.80 per share ending 2024, $406.55 for 2025, $444.60 for 2026, $493.05 for 2027, and $554.10 for 2028. At the undisturbed date, ESGR was trading for about 80% of management’s adjusted book value. Apply that discount to the 2025 book value and the 2028 book value - you get about $325 per share in 2025 and $450 per share by 2028. This is higher than our prior exercise where we got to $420 per share by the end of 2028, and these are management’s internal projections, not ours.
Finally, the S&P 500 Insurance Select Index is up about +15% since this transaction was announced. The Dow Jones Select Insurance Index is also up about +16% in that timeframe, while the S&P Composite 1500 Property & Casualty Insurance Index is up about +17.5%. These indices are not perfect comparisons, but it’s interesting to frame these against the +10.6% that Sixth Street is offering as a compensation for the takeout.
The vote is coming up on November 2nd, so we have to consider how we feel about the valuation of our shares, but it feels like a lot of value was left on the table here. Which makes us wonder, why did management agree to this price? This question adds a wrinkle to the whole story. We think the answer to that question lies in the fact that the management team is rolling over equity into the new company through a Rollover and Support Agreement. So, it’s not that management feels the time is right to sell for themselves – just for the shareholders.
We look forward to seeing this transaction play out in the months ahead. If you’d like to have a conservation, please feel free to reach out.
“Great things are done by a series of small things brought together.” – Van Gogh
Disclosures: This Presentation (the “Presentation”) is for informational purposes only and is intended solely for the persons receiving it; any reproduction or distribution is prohibited. This document does not constitute an offer of securities. Such an offer may only be made by means of a private placement memorandum. The information contained in this summary is not complete and is qualified in its entirety by the reference to the more detailed information contained in the Confidential Private Placement Memorandum of the Fund. An investment in the Fund subject to a variety of risks and is speculative. There is no assurance that the Fund will achieve its investment objectives. Prior performance is no guarantee of future returns.
* Contribution to the portfolio is calculated as the cumulative realized gains or losses from positions related to the transaction divided by the fund’s assets under management at the beginning of the month in which either the portfolio exited the investment or in which the transaction was completed, whichever month comes first.
All information provided in the presentation are as of September 30, 2024, unless stated otherwise.
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