There are advantages to being small. We’ll lose them down the road when we’re a bigger firm. For now, we’re enjoying being nimble. There have been situations available to us that wouldn’t be available to a multibillion-dollar hedge fund. They may be able to buy a few shares just like us, but for us that’s a large portion of a full position; For them, it’s a drop of water in the sea. We’re much more mobile, and we’re using that to our advantage as we believe it can increase returns with less risk.
For example, a small deal with a well understood 95% likelihood of being completed, a $25 deal price for the target, and a $18 downside would most likely trade around $24.50 per share (all other deal factors simplified). This equates to a 2% gross spread, and somewhere between 4%-8% annualized spread depending on the timing. That’s also a 93% implied probability of closing, which makes up for the cost of funding – otherwise, you’d likely see the target shares trade around $24.65 per share with an implied probability of closing around 95%.
In real life, we see a different picture. One that we can take advantage of. Simply add a long-only holder that holds a substantial percentage of the shares, say around 10% or so, into this equation. This happened in both the CCF transaction and the CTG transaction, where we were able to take advantage of a shareholder looking to get out of their shares at a discount to what would be efficient prices. Those larger shareholders made dollars per share and weren’t worried about cent differences. In CCF, we were able to get 75% of our position at $125.65 per share during end of day trading hours. While in CTG, we were able to get 16.6% of our position at an average of $10.17 per share and attempted to get an additional 66% at $10.10 per share but were unsuccessful. If we were successful in getting those CTG shares at $10.10, that would have brought our average price down to $10.18, well below our assessment of efficient pricing being between $10.30-$10.35 per share. Just to note, our current average cost for CCF is $125.78 per share and for CTG it’s $10.24 per share – great prices for both in our opinion. Large funds can’t move as quickly as we can in these situations.
Another example. During July, we took shares of Sculptor (SCU) at an average price of $10.8525 originally thinking we were getting this same benefit of being small – we assessed the efficient price would be around $10.95-$11.00 and someone was selling below that. Fortunately for us, a shareholder group including Dan Och came out during August in opposition of the Rithm deal being completed at the current transaction price of $11.15, stating that it undervalues Sculptor and sending the share price much higher than the $11.15 agreed upon price. After that development, we were able to purchase more shares of SCU bringing our average cost per share to $10.98, an efficient price to us if the deal were to close at the original $11.15 and no bump in price occurs. As of September 7, 2023, a second consortium consisting of billionaire asset managers proposed an offer of $12.76 per share of SCU. This is the beauty of our small size that can’t be replicated by a multibillion-dollar fund – the market cap for Class A shares of SCU is only around $300 million, with most of that tied up already by insiders and institutions.
Of course, there are disadvantages to being this small, as well. Information flow from the sell-side banks and brokerages is the most apparent one. We won’t get the first call when news breaks or new information becomes publicly available – this helps the larger funds when the market is moving fast on a specific name. However, this disadvantage doesn’t faze us that much. Judgement of the information is not gained through scale, and patience most certainly isn’t easily attained when you’re constantly inundated with new information and fast opinions on that information. I’ve seen this firsthand and think it’s contradictory to our belief that a disciplined, even-tempered approach to changes is the safest way to compound wealth over time. We saw this during August with the closing of the ForgeRock (FORG) transaction, which we wrote about in our previous letter. We were at no disadvantage there.
Two other disadvantages of being small in most economic scenarios, the availability of opportunities and margin-increasing benefits, are flipped upside in our area of M&A transaction arbitrage. Our small size clearly gives us access to a greater number of deals. VH Standard can invest in (or “insure” as we like to think) the completion of public company deals that are sub $100 million and still have that small investment impact our returns. Large funds would have a difficult time competing with us on this impact (see graph below; source: Preqin Pro, June 27, 2023) without taking greater liquidity risk or buying the whole companies themselves first, which most aren’t mandated to do. On the other hand, we still participate in large deals and can make a quality assessment of those deals from our years of experience working for a multibillion-dollar fund. This has been evidenced by our relatively large positions in the Horizon Therapeutics (HZNP) deal and the Seagen (SGEN) deal, which both had positive news flows during August. As of August 31, 2023, our average costs were $102.36 per share for HZNP and $194.86 per share for SGEN. HZNP closed the month at $112.74 per share, while SGEN closed at $206.07 per share.
Secondly, the margin-increasing benefits of scale, or negotiating power, generally doesn’t get passed along to the investors in this business. In most large funds, the scale of the operation makes the manager’s compensation go up exponentially, rather than seeing the investors’ returns go up. Along the same lines, the more established hedge funds do not regularly outperform the younger/newer hedge funds. If scale were to benefit the investors, you would see the largest hedge funds having outperforming returns. We believe this is furthered evidenced by the chart on the next page that shows early life cycle hedge funds outperforming the established hedge funds over six of the last seven years (source: Preqin Pro, June 27, 2023).
Lastly, I should talk about the large disadvantage of our incredibly small size that will fade as our AUM grows. And hopefully this will paint a better picture of the operations behind the letters. This is currently a one-man team. Although I have a number of people offering feedback, suggestions, and criticisms in daily conversations that I believe are of immeasurable value, there are still a few areas where my attention may be needed at any given moment. It can be difficult to balance the triage process when two equally important tasks need my focus in a timely manner. As the AUM grows, we will look to build out the team to try to mitigate the risk here. In the meantime, I will do my best to make sure that your returns as an investor and our risk management always takes precedent.
These advantages and disadvantages will obviously change a lot as we begin to grow. This is something that VH Standard will continually think about over the years and try to find the optimal level for investors. The one thing that VH Standard will not lose is our “investors come first” mentality – after all, I’m an investor, too. And we can never allow our thinking to flip to where marketing comes first. Fundraising and marketing is important, but it doesn’t benefit the investor.
RESULTS
We had a gross return of +2.74% for August, which brings our gross return to +3.09% year-to-date. Net returns for the month were +2.66%, bringing our net return to +2.94%, with a 1% management fee structure. Over the month of August, we had a realized gain contribution of +1.05% to the portfolio (+17.7% on the capital invested) from the closing of the ForgeRock (FORG) transaction, as well as two realized losses contributed from the Silicon Motion (SIMO) and Tower Semiconductor (TSEM) transactions, which we discuss below to give you insight on how we think about broken deals, the hardest part of what we do. Noteworthy unrealized gain contributions came from the Horizon Therapeutics (HZNP) and the Seagen (SGEN) transaction, which moved positively on news that the FTC was withdrawing its request for an in-house trial related to its challenge of the HZNP transaction.
Silicon Motion (SIMO)
On July 26, 2023, the transaction between SIMO and MaxLinear (MXL) received a long-awaited approval from SAMR, China’s State Administration for Market Regulation. The shares of SIMO went from $52.20 per share at the prior close trading all the way up to between $92-$95 per share on this news. With the deal value around $104 per share for SIMO, there was still spread. At the time, it was speculated that the absence of a joint press release from the two companies was cause for concern. We felt that this this transaction had gone through a long journey to get approvals and it was worth purchasing some shares of SIMO given the spread - so we bought shares at $92.60 per share. Remaining overly cautious about the deal, this brought our assessed downside in this transaction to almost 0.60% of AUM.
Later in that same day, MXL decided to walk away from the deal, citing a Material Adverse Effect (MAE) and other certain contractual conditions not being met by SIMO. In our view at the time, we felt that the argument for an MAE was not strong enough to be enforced in court. For us, SIMO was partially covered in the Definitive Merger Agreement’s (DMA) definition on a MAE, specifically clause b) on general changes in economic, business, labor and regulatory environment, and clause h) on any failure by SIMO to meet any revenue, earnings, or other financial projections and forecasts. The more likely reason for MXL walking away from the deal was that they could no longer cover the $93.54 per share cash portion that they owed SIMO shareholders without going bankrupt. A lot had changed while they waited for SAMR approval.
With that assessment, we decided to sell half of our position in SIMO at $62 per share on the news that MXL was walking away. This helped to lock in 50% of our downside and reduce the risk going forward as this deal becomes a work-out situation in a courtroom. The reason we didn’t sell the entire position was that we felt there was still a decent likelihood that the two companies could revise the deal structure with a different compensation mix or price reduction. On August 16, 2023, SIMO decided to terminate the deal and seek damages in court. This approach made a lot of sense for SIMO and their shareholders, but for us, it no longer was within our realm of expertise. We decided to sell the rest of our position on August 16th at $56.63 per share and realizing a final loss of approximately (0.33)% of our AUM, a much better outcome than our initial assessed downside of (0.60)% of AUM.
Tower Semiconductor (TSEM)
TSEM was a similar situation in that the two parties were waiting for an approval from SAMR for a long period. TSEM was being purchased by Intel (INTC), and with semiconductors being in focus for the tense relations between the United States and China, there was hold on China approving the deal. We were cautious, as political risk can be somewhat of a black box. However, these situation do find resolutions at times, and we felt comfortable “insuring” the transaction with Intel as the purchaser. We purchased shares at $38.29 and brought our assessed downside to 0.33% of AUM.
On August 16th, we sold our entire position at $30.95, realizing a loss of (0.18)% of our AUM, a good outcome from a risk management perspective. We sold our position because the merger agreement was no longer enforceable at the end of August 15th. Fortunately for us, we didn’t have to risk a substantial amount of capital on these two deals because there were better alternatives available to us. Another situation where our small size benefitted us in the previous months.
We’re small for now, but we won’t be small like this forever.
Thank you for reading. We look forward to continuing to build this portfolio. If you’d like to have a conversation about anything, feel free to reach out.
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