
Transactions Mentioned In This Letter: Capri Holdings (CPRI), Hawaiian Airlines (HA).
During August, we had a net return of +1.19% for our investors, bringing the year-to-date net returns to (0.89)%. It’s been a fairly long year for merger arbs; however, we’ve been able to string together 4 positive months in a row. Back in the first quarter, we discussed how the strategy can go through periods of negative returns, similar to a “hurricane season” for insurance companies, but we believe that we construct our portfolio and manage our risks in a way that the returns will tend to normalize over time. As proof that we believed in this strategy’s approach, we used the GP’s balance sheet cash to invest in the fund at the start of February, May, and again in July - each one of these investments have made money, even though our YTD net return is still negative. In fact, there is currently only one month where an investor in our fund would have lost money from the start of their investment, and that’s investors that came in on January 1, 2024.*
We think this is a good sign that our investment strategy is working, although it’s been a challenging year.
Capri Holdings-Tapestry Court Case
On the Capri-Tapestry front, the trial heads into closing arguments on Monday, September 30th. I continue to expect this transaction to ultimately proceed, in line with the general premise we laid out in our May ‘24 Letter to Investors. After reading the court documents and trial transcripts, we believe the majority of new information since our letter has only deepened our resolve that Judge Rochon will likely rule in favor of the transaction. In our opinion, the evidence suggests that the combination will have a minimal impact on the competitive landscape of the market for handbag brands, regardless of market share concentration. In court, the companies’ attorneys showcased multiple areas where the FTC presented a flawed and inconsistent market definition. This is something we suggested in our May ‘24 letter, stating that the FTC is taking on an extremely hypothetical case with limited precedence and numerous assumptions that would have to be proven in discovery (something they should have done before filing a suit to block the deal). The companies’ defense merely had to disprove the FTC’s market definition, which I believe they proved it to be unreliable for analysis. If you’d like to know more about the court case, feel free to reach out - happy to chat whenever.
With that, we believe it’s highly likely that the Judge will rule favorably, denying claims that the companies’ merger would violate Section 7 of the Clayton Act. As mentioned above, the FTC’s relevant market definition is impossible to accurately place, had rampant errors, and used flawed methodology that incorrectly estimated a number of competitor revenues. The FTC also attempted to define the market as “accessible luxury” by simply stating that it includes only the brands held under the merging companies. To the FTC, accessible luxury is separated from other “mass market” brands because they lack the luxury image (which is just brand equity built up over time through investment and marketing). From Brown Shoe vs. the United States, “The overarching goal of market definition is to ‘recognize competition where, in fact, competition exists.’” You can not separate the mass market brands when they’re clearly a viable competitive option for consumers purely because they lack the brand image. There are many other factors that go into analyzing substitute goods, and the FTC’s approach is overly simplistic.
The FTC also tried to separate the two markets on price range, stating that the price range for the relevant market should be $100-1,000 per handbag. The companies rebutted that two of the three merging brands have average sales prices under $100 per handbag. The defense also showed evidence of 100s of competitors in that price range between $100-1,000 per handbag. So, to us, it’s very likely that the FTC failed to support their case on the very first step of analysis, defining a relevant market.
However, there’s still the possibility that the Judge may rule unfavorably in regard to a violation of Section 5 of the FTC Act. The FTC uses the Merger Guidelines of 2023 that their own administration wrote in December ‘23 (after the deal was announced) to suggest that the companies are in violation of unfair competition by merging two direct head-to-head competitors. Although the two parties are direct competitors, to block the transaction on this standard alone would be precedent setting, causing tidal waves through the business world and effectively giving the FTC power to block all strategic M&A transactions between competitors. Private equity would have some issues with all that dry powder they currently hold.
You should know, we have been actively managing our risk throughout the timeline of this transaction. It’s not in our strategy to take on excessive risk in any one transaction, regardless of how flawed we believe the FTC’s case is. We remain steadfast in applying the law of numbers and compounding over the long term through completing deals in an uncorrelated portfolio.
Hawaiian Airlines - Alaska Airlines Transaction
During August, we gained a significant positive contribution from our position in the Hawaiian Airlines transaction (HA), which had an $18 a share buyout in cash. Towards the end of July we decided to increase our exposure to this transaction by simultaneously doubling our long position in the public equity for HA shares at an average price of $11.945 per share, alongside purchasing puts with a strike price of $10 that protected our downside. We felt this combination effectively skewed the risk-reward in our favor and that the two markets were most likely not pricing both instruments appropriately. In this scenario, our potential loss was close to $2 a share and our potential gain was close to $4.50 a share, including the cost of the puts. Without the puts, our potential loss would have likely been around $8-$10 a share, while the gain would have been a little over $6 a share at the $18 purchase price. In effect, we were able to turn a 40/60 odds scenario into a 70/30 odds scenario by utilizing this structure to our position.
The main reason this opportunity became available was that the companies had entered into a timing agreement with the Department of Justice on Mar 27, 2024, stating that the merging parties would not complete the transaction any earlier than 90 days after certifying substantial compliance with the regulators. On May 7th, the companies certified substantial compliance, kicking off the 90 days from the timing agreement and lining up August 5th, 2024 as a significant date. With this date set, we had a good grasp on the timeline and felt comfortable taking on the options exposure to lock in our synthetic downside. The parties extended this timing agreement a few times, but ultimately allowed the companies to proceed on August 20th. At that time, there was still an outstanding approval from the Department of Transportation, and we decided to exit almost 85% of our long position at an average price of $17.68 per share. We sold the last portion towards the end of the month at an average price of $17.36 per share.
Overall, we had a significant realized gain from this position, contributing +0.37%* to our portfolio’s equity with what we believed to be substantially minimized risk.
Historically, when companies certify substantial compliance with regulators, there is a good chance of the deals being completed. It’s pretty rare that companies go this route because it tends to show a mutual disrespect between companies and regulators; however, this has changed under the current FTC and DoJ, as multiple transactions have been forced to certify substantial compliance when regulators refuse to give an official approval, knowing that they likely don’t have grounds to block the transaction either. Since that’s become a gray area for investors, it’s also become an area of opportunity for us this year.
The Hawaiian Airlines transaction completed for $18 per share in cash on September 18th, 2024, upon receiving approval from the Department of Transportation, fulfilling all regulatory requirements for the deal.
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
* 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.
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