CIBC and Vertex - One Arbitrage Team
Les Kom: Welcome listeners to today’s podcast from the Kom vanderMaden Advisory Group at CIBC Private Wealth Management, Wood Gundy division. This podcast is one in a series of concise presentations on relevant topics in the modern world of wealth management. The Kom vanderMaden Wealth Advisory Group embraces a pension style approach to wealth management as we study and apply best practices across the spectrum of financial issues that are important to our client family’s success and dreams. Today’s financial topic comes from the investment management area of our practice. Specifically we are going to discuss one of the alternative investment strategies we use to improve our clients prospects for pension-style returns yet with lower volatility compared to traditional portfolios. This alternative investment strategy is known as merger arbitrage investing and to discuss this alternative strategy more fully we are very pleased to welcome today our guest conversationalist Craig Chilton, Portfolio Manager at Vertex Merger Arbitrage fund. Craig, good morning.
Craig Chilton: Good morning and thank you for having me.
Les Kom: It’s our pleasure. Let’s start by asking you a very basic question. What is merger arbitrage investing? And how does it work?
Craig Chilton: So merger arbitrage is a strategy of generating returns by investing in public companies that are in the process of being acquired. So our focus is on already announced friendly definitive deals, we aren’t speculating on deals that may be announced and we aren’t chasing rumors. Importantly the arbitrage return is dependent on the takeovers being successfully completed and it’s not a function of whether equity markets are going up or down. So this arbitrage return is generated by buying the targeted company at a discount to the price the shareholders will receive from the acquiring company when it’s successfully consummated. This discount that we try to capture is called the arbitrage spread. So let me give you an example, a typical one is where a company is being acquired solely for cash, let’s say $100 per share. In this case we’d simply try to buy the company at a discount to that deal price so that it makes the return attractive given the length of time it will take to close. So in this $100 cash example if we expected it to take six months to close then buying the target at $97, or a 3% discount would generate a return of approximately 6.2% on an annualized basis. So that’s a simple example. If the acquisition terms also include stock of the acquiring company then we pre-sell or short that amount of stock as a hedge against owning the targeted company since we don’t want, we simply want to lock in the arbitrage spread we don’t want to take any directional risk related to the acquired stock going up or down. So that’s an example of one of the company that would be in our portfolio and we try to develop a diversified portfolio of a number of these situations, usually two to three dozen.
Les: Thanks Craig, that’s interesting and I noticed one of your comments was that it does not depend on the direction of equity or bond markets. Let me ask a follow-up question, what if one of these mergers that you’ve referenced, or takeovers, does not in fact close, the deal does not close as expected? What happens in that case to the investment?
Craig: Well that is certainly the biggest risk in merger arbitrage, that a takeover fails. If one fails we would sell the stock and likely realize a loss on that investment, however it’s important to note that just because one takeover fails that doesn’t imply a higher probability that any other takeover will fail. If they are all unique, so we describe this as idiosyncratic risk. Furthermore, keep in mind that we own a portfolio of these takeover stocks, where even a large position usually represents less than 10% of the overall NAV. So if one does fail for whatever reason the actual impact to the NAV felt by the unitholders is typically much less, might be in the order of 1% to 2%.
Les: Alright, let’s move away from individual transactions back to the broader markets. We all know that all market investments fluctuate, they often fluctuate daily and in our industry we call the degree or the amount of this fluctuation, we call that volatility. So a couple of questions for you Craig regarding volatility. First of all, and you’ve already alluded to this, does this strategy fluctuate in line in the same direction as the general stock and bond markets fluctuate?
Craig: So firstly, the volatility of a merger arbitrage portfolio in total is typically less than that of bonds and much less than that of equities. The primary reason behind that is that when a friendly deal is entered into there is a legally binding merger agreement that makes it difficult for either party to walk away from, outside of extenuating circumstances like regulatory rejection. Even more importantly than that the level of volatility relative to other assets is uncorrelated. So in other words the returns generated from merger arbitrage aren’t generally moving in the same direction at the same time as equities or bonds.
Les: Okay, that great, you’ve actually answered what was going to be my second question as well which is, how volatile is this strategy? And what I’m hearing you say is that the volatility of this strategy is significantly less than the volatility of traditional stock and bond markets. And as to the first question, it is not dependent on the direction of stock and bond markets and hence your use of the word “uncorrelated” or low correlation which is a great thing to have in a portfolio. Low correlation is what we here consider true diversification and risk control. Alright, let’s move on and talk about interest rates for a moment. We know that traditional investments like stocks, and bonds for that matter they can drop in value when interest rates rise. So our question is, does the merger arbitrage strategy also lose value if interest rates rise?
Craig: One of the very attractive features of merger arbitrage investing is that prospective returns for the strategy generally increase as interest rates increase which is the opposite of how it works for a typical bond portfolio. Now the reasoning behind this is because arbitrage investors aim to capture a return greater than the risk-free rate. So as government bond yields are increasing the discount we seek to capture in the merger arbitrage spread must also grow. Furthermore, since takeovers average three to four months to complete there is very little duration to the portfolio and it turns over quickly. So if interest rates are rising what we have happen is, as one deal closes and we add a new one to the portfolio it’s priced at the new higher rate and so in this matter the whole portfolio quickly turns over and reflects the higher interest rate environment. As a result what you end up with is a portfolio that looks a lot like a floating rate bond portfolio and rises in sync with rising interest rates.
Les: Very interesting and clearly very different from traditional stock and bond investment strategy behavior. Let’s move to the last question Craig. In our practice, pension style asset is in order to protect and grow our clients hard earned wealth we, unlike pension funds, we also have to consider the tax impact of different strategies so when we deploy your merger arbitrage strategy in a taxable account, just a regular investment account that is exposed to tax how are the investment gains of your fund taxed?
Craig: Since merger arbitrage investing generates its returns primarily from trading stocks, we generate capital gains rather than ordinary income like the coupons on bond investing. And furthermore any income the strategy does generate can be written off against fund expenses generally leaving only capital gains for unit holders.
Les: Well as our listeners will know I’m sure, capital gains are the most attractive form of taxation. We all try to minimize tax and capital gains are highly effective at minimizing tax. Craig, thank you very much. You’ve answered all my questions this morning. We hope our listeners found value in today’s podcast and that our conversation today with Craig illustrates how blending alternative investment strategies, some of which by the way were simply not available in the past like merger arbitrage investing, how blending these alternative strategies in with traditional investment strategies can result in a smoother more enjoyable yet still very rewarding investment experience. If you or someone important to you are currently not taking advantage of this pension style approach and you would like to have a conversation about whether it could make sense for your particular situation simply be in touch with us by phone at 613-783-7808 or via email at les.kom@cibc.com This concludes todays podcast from the Kom vanderMaden Wealth Advisory Group at CIBC Private Wealth Management. Thank you for listening.