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  • Writer's pictureRobert von Hoffmann

VH Standard Merger Arb Fund - Monthly Report (August '23)

Updated: Feb 2

VH Standard AM - Monthly Report (7-23)
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Welcome to the inaugural VH Standard Merger Arb Fund monthly letter to investors. I’m happy to say we had a solid first month of returns. Rather than focus on returns, I’d like to use this letter to explain the investment strategy in our merger arb fund. While I won’t offer a full overview here, I will try to paint the full picture over time with each letter that I write, keeping things brief but impactful. On the occasional month, I’ll just address the results of that month. If there’s an important insight on a specific transaction, I’ll try to convey VH Standard’s viewpoint. And on a rare occasion, I’ll write a much longer letter with more on our philosophy & strategy. Either way, expect this to be a fluctuating format for a letter that gets better over time.

To start things off, we officially funded the account on Monday, July 10, 2023. We’re starting with our own money for two specific reasons, even though it’s a small amount relative to most funds. The first reason is we wanted to get our track record started, so that you can become familiar with the return profile and structure of the portfolio. This will make it easier to convey the strategy more effectively.

Secondly, we are enthusiastic about the overall environment for merger arbitrage investing. The current regulatory landscape with government agencies taking a more aggressive stance on mergers has made spreads more attractive than usual, while the anti-trust laws haven’t changed much. To illustrate this point, the HFR Merger Arb Index is down (2.73)% on the year, as of July 31, 2023. This same index has not had a full negative year since 2008 when it was down (5.37)%. Before that, it was 2002 when this index had a negative return for its first time since the inception in 1990. It was down (0.87)% in 2002. We like that kind of statistic.

On top of that, the rapid rise of interest rates over the last year has increased spreads as the risk-free rate became more attractive and the costs of leverage went up. In our view, both factors make the merger arbitrage investment currently very attractive as we expect the historical actuarials to continue to play out for the most part.

For our first month of operation, the VH Standard Merger Arb Fund had a gross return of +0.34%, and a net return of +0.28%.

Activision (ATVI) Transaction

This was a great moment for us at VH Standard Asset Management, so it had to be written about. After a long road going through every little step to launch the fund and with a few delays, we finally received word from Interactive Brokers that our account had been officially approved on July 10th. We funded the account that night – one of the transactions that we felt time sensitive about was this one, Activision-Microsoft. The last day of court was on June 29th and we knew that Judge Jacqueline Scott Corley could issue her ruling on any day in the weeks that follow. We couldn’t have asked for better timing. Our first trade of the portfolio was ATVI on July 11th in the pre-market, immediately bringing our risk to 0.5% Downside % of AUM at a price of $82.93 per share.

Great moment for us, but we established a position for a different reason than having the view that the ruling would be in favor of Microsoft. Part of our investment philosophy is to take on exposure to transaction risk. That’s what we were doing here. Most merger arb investors will have a concentrated portfolio with hand-selected deals that they are investing in based on deep-dive research where they feel they know the outcome. We’re different in the sense that we’re looking to build a portfolio of definitive merger agreements (DMAs) that is more akin to an insurance operation with written premiums (our expected profits when the deals are completed) and catastrophe losses (our expected losses when deals fall apart). The economics aren’t the same as insurance because we’re holding equities and putting up the capital at the outset, but this is our perspective here at VH Standard Asset Management.

When it came to the Activision-Microsoft deal, being exposed to the deal risk was a must. The competitive landscape for gaming is fairly fragmented with consoles: Sony’s Playstation as the largest console, Microsoft’s Xbox, Nintendo’s Switch, Meta’s Oculus, and a few others such as Google Stadia and Valve’s Steam, as well as a number of young VR competitors; with publishers: Sony, Microsoft, Nintendo, Meta, Tencent, Valve, Activision, Electronic Arts, Take-Two, Ubisoft, CD Projekt, and a number of small publishers. Then you have distribution through both cloud and hard copies purchases, which Microsoft and Sony both have their own cloud platforms for video game purchases and Valve’s Steam is used by over 130 million monthly active users. Simply writing each of these names shows how dynamic the gaming industry is. This is not your classic 3-to-2 acquisition, where a market is reduced from an oligopoly to a duopoly.

So, we had to be exposed to the transaction risk here. Like I said before, we immediately went to risking 0.5% Downside % of AUM in this deal. Later that day, Judge Scott Corley issued her ruling in favor of Microsoft – a small win to start things off. Instead of initially selling the position and realizing gains, we assessed that there were minimal conditions left to effect the merger and Microsoft could ringfence the UK assets to close the deal despite the UK CMA ruling against the acquisition. There was also an end date of July 18th for the DMA, which meant the companies would either extend (likely with an additional small dividend to appease ATVI shareholders) or close the deal outright on the 18th, figuring out a solution with the UK CMA later in both scenarios. By July 14th, we had increased our exposure to 2.4% Downside % of AUM, our largest position, and we continue to believe that the risk here is very attractive based on the spread (“written premium”) we’re receiving and the increased likelihood of a deal completion after Judge Scott Corley’s decision on July 11th. All in a short week.

ForgeRock (FORG) Transaction

After going through a review of the FORG downside, we decided that the deal risk for this transaction was too compelling and was being mispriced by other arbitrageurs. We initiated our position at $19.53 per share, bringing our Downside % of AUM to 0.90% immediately on the first day of our portfolio, which we followed up by increasing our position a week later at $20.22 per share, bringing our Downside % of AUM to 1.43% at an average share price of $19.76 and using a conservative downside of $15.00 per share. We felt compelled to take on this exposure to the transaction risk in FORG for two reasons, analysis of the market definition and a potentially higher downside price.

On the regulatory front, we made the assessment that the market definition being considered by the Department of Justice (DOJ) for ForgeRock and competitors is simply too narrow. Thoma Bravo already owns two main direct competitors, Ping Identity and SailPoint, which were both acquired during 2022, and who ForgeRock names specifically in their 10-k filing as direct competitors who provide a subset of functionality across identity, access and governance. This narrow definition is how the market would be deemed too concentrated; however, ForgeRock also names Okta (market cap of ~$12 billion) in this subset, as well as legacy providers Oracle (market cap of ~$315 billion), IBM (market cap of ~$130 billion), and CA Technologies (acquired by Broadcom in 2018 for $18.9 billion). ForgeRock mentions Microsoft briefly as well because they offer a full suite of IT solutions, including their Authenticator for identity & access. To put this in perspective, the three acquisitions by Thoma Bravo combined equal to $12 billion, smaller than every potential competitor named in ForgeRock’s 10-k.

Additionally, narrow market definitions like this have not fared well for the regulators in a courtroom, so we think our assessment is strong. We also believe that this places a better limit on our downside, as there would likely be a strong case for ForgeRock and Thoma Bravo if the DOJ were to sue to block the deal, which is a possibility with Thoma Bravo already controlling two main competitors. It’s our view that FORG would likely not trade down to a full deal break price if this were to happen, giving us room to reevaluate.

Next, we had to assess the full deal break with FORG trading freely again on the public markets. Analyzing comparable companies, or “comps”, we use OKTA and CYBR as our best comps (green), and AVGO, IBM, and ORCL as our similar-but-not-great comps (yellow).

The first thing we considered is the % change of the comps since the deal was announced. In an ideal world with perfect comps and a correlation of 1.0 prior to the announcement, the downside of the target would be the pre-announced price multiplied by the percentage change of the comps. While this may not be perfectly accurate, it serves as a useful tool in our toolkit. See below:

The average % change of the green comps equals to a +28.0%, which implies a downside for FORG shares at $20.40, up from the $15.94 share price on the day before the deal was announced. Using all comps, we see an average % change of 53.6%, which implies a downside for FORG of $24.49 per share. We feel that using all comps would be too aggressive, so we take that with a grain of salt.

If we move on and review the relative value of the FORG vs. comps, we get a slightly similar picture.

In this case, we use EV/Revs because it’s the best metric for companies with a similar earnings power and growth profile. Once again not perfect, but there tends to be some consistency between how downsides are measured versus how they trade on the day of a deal breaking. I usually draw a comparison between this process and the mechanics involved in valuing an IPO.

The implied EV/Revs multiple for FORG is 8.7x, based on all comps, and 7.8x, based on best comps. This implies a downside of $26.34 per share, and $21.00, respectively. Historically, FORG has traded at a discount to comps, so we bring that down to a 6x multiple, which would imply a $18.63 per share downside at almost a 25% discount to best comps.

Overall, we viewed the downside as likely to be somewhere between $18 and $19 per share, which would mean the market was pricing FORG with a probability of closing between 12% and 30% when we initiated our position. We liked this pricing given our assessment of the market definition and the room it afforded us to be conservative with our downside.

Whole Earth Brands (FREE) Transaction

A proposal situation that we decided to invest in during the first month was Whole Earth Brands, Inc. (FREE). For the most part, we don’t like investing in or “insuring” proposals until the DMA has been signed. The statistics behind proposals are much less appealing to us in the business of taking on risk exposure to deals falling apart. Nonetheless, this deal makes sense on a lot of fronts, but we remain cautious with only a ~0.10% expected downside % of AUM at risk, at the end of July.

A few details about the FREE transaction. Martin Franklin and one of his holding companies, Sababa Holdings, made a proposal to acquire the rest of the shares outstanding at $4 per share. As a little history for Franklin, he ran a company called Jarden, which was successful for years as an acquisition platform that owned those Ball mason jars everybody loves. The current Chairman of FREE is Irwin Simon, a Jarden board member with Franklin during that same period, and the CEO of FREE is Michael Franklin, Martin Franklin’s son, who’s now on leave because of conflict of interest. So 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. So, there’s room for a topping bid that would still be accretive to these strategic acquirors. 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.

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.

Thank you for reading. We look forward to continuing to build this portfolio.

* Kraft Heinz Company, General Mills, Kellogg’s, Campbell’s Soup Company, Hormel, and Conagra.

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