Arbitrage Risk Management

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While a very high percentage of announced M&A deals close successfully, occasionally there are deals that fall apart. We strive to avoid deal failure through careful investment selection. Nevertheless, one risk in merger arbitrage is that the announced merger will lead to an opportunistic, hostile bid for the acquiring company itself.

This dynamic recently played out in the arbitrage portfolios of our Vertex Arbitrage Fund and Vertex Fund.

In mid-May, Hillshire Brands announced a friendly acquisition of Pinnacle Foods. The transaction was viewed negatively by Hillshire shareholders who disliked the diversification of their pure-play branded meat producer into adjacent food categories (frozen vegetables etc.). Hillshire shareholders viewed their company as a compelling acquisition target because it was the last remaining pure-play branded meat producer of meaningful size available to a roster of potential acquirers; the proposed transaction with Pinnacle would make an acquisition of Hillshire less attractive to these buyers.

When the Pinnacle Foods acquisition was announced, the views of Hillshire shareholders were widely known and merger arbitrageurs quickly gave the deal a relatively wide berth. The arbitrage spread was pricing-in a roughly 80% probability of deal success (compared to a more typical 95%+). In our research, we noted there is a roughly 3% probability of shareholder opposition in strategic deals where a vote is required and the two companies are similar in size. Additionally, the probability of an interloping bid for the acquirer is also 3% (also in strategic deals of similar size), meaning there was a combined 6% probability of deal failure based on historical experience.

With the spread pricing in a much higher probability of an interloper than we deemed realistic, we purchased Pinnacle at ~$34 and shorted Hillshire at $36 (fully hedged on deal terms). The implied annualized rate of return was approximately 25% when we initiated our position. In addition to setting up the spread, we felt it was prudent to purchase out-of-the-money call options ($38 strike) on Hillshire in the event that a hostile bid did emerge. We sized the entire position so that in the event of hostile bid for Hillshire, losses to the fund would be limited to approximately 50bps (0.50%).

In late May, Pilrgim’s Pride announced a hostile bid for Hillshire at $45 per share. Hillshire stock immediately traded to $45 and Pinnacle fell to $31. Importantly, we quickly unwound the position (covering the Hillshire short exposure and selling Pinnacle), crystallizing our loss. We felt it was prudent to rapidly exit the position because there was continued uncertainty about whether Hillshire was now fully in play. Just two days later, Tyson announced a $50 bid for Hillshire and it is now trading at $62 after another round of bidding.

There are many takeaways from this episode that we think are useful for highlighting some aspects of our arbitrage strategies: It’s important to emphasize that we have a large number of merger situations in the portfolio at any given time: usually 20 to 30. Any given deal break is a manageable component of the overall portfolio. A corollary of the first point: we typically size our positions so that any given deal break will be a roughly 100-150bps loss to the fund. Because we were acutely aware of the risks in the Pinnacle deal, we positioned it with an even smaller weight, ultimately costing the fund 50bps. Arbitrage returns are driven by repeated sampling of a probability distribution. The fact we thought the odds of a deal break were closer to 6% when the market was implying 20% doesn’t necessarily mean we were wrong (about the probabilities). We add value through the way we implement our positions; we don’t always just buy the target and hedge the acquirer. We may buy or sell options if we think that improves our risk/reward. We might short deals. We might express views through bonds. In this case, our hedge of using call options on the acquirer added significant value to the fund. When things do go wrong, rapidly re-assessing the position is important. These are event-driven situations where news flow can occur rapidly.

#untilnexttime

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For information on this update or the funds we offer, please contact a member of our sales team:

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Noel Dattrino, VP
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James Wilson, VP
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Michael Lindblad, VP
416.200.4457

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Janine Breck
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John Lowe
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Dave Wallin
604.681.5183

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Naomi Fisher
604.681.5615