Arb Fund turns 1!

Happy Anniversary!

The Vertex Arbitrage Fund had its 1st birthday on October 31st!

The first year return was 4.00% (Class F), in line with our expected range of short-term rates plus 4-5%, albeit at the lower end of the range. The monthly returns for the first year were as follows:

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Year

2014 0.27% 0.39% 0.43% 0.64% 0.04% 0.64% 0.26% 0.07% 0.10% -0.28%     2.59%
2013                     0.59% 0.78% 1.38%

Highlights of the first year include:

11 positive return months

  • Low volatility (1.08% annualized)
  • Low beta to equity markets
  • Downside protection during the volatile markets of the last 3 months

Looking Forward

As we look forward to the next year, we are particularly excited by the environment for merger arbitrage. During the month of October, most of the merger arbitrage spreads in our universe widened considerably due to hedge fund de-risking (see Shire details below for the cause) and general market volatility (the highest since 2011). Arbitrage spreads are currently at some of the widest levels we have seen in years; low-risk transactions that in September were yielding 4% are now closer to 7%.

source: UBS

Looking Back

There were a number of challenging situations this year in merger arbitrage. May saw the failure of Hillshire’s takeover of Pinnacle Foods, August was dubbed “Arbageddon” due to a number of proposed mergers collapsing, and in October we had the collapse of the Shire/AbbVie deal, which was the largest merger failure in history. It was one of the more difficult years we’ve seen in arbitrage in our careers but we’re satisfied that our risk management process prevented meaningful capital erosion.

The $50 billion acquisition of Shire by AbbVie was announced in July. In September, the US treasury tightened their stance on inversions (a deal structure used by Shire/AbbVie by which the acquiring party uses the merger to also re-domicile outside of the US to capture tax benefits). On the evening of October 14th, AbbVie notified Shire that its board intended to reconsider their recommendation for the merger, effectively killing the deal.

Given the uncertainty around the impact of the new treasury regulations, Shire offered an arbitrage return of roughly 35% annualized prior to the deal breaking. With this return profile and management’s supposed commitment to the transaction (and the nearly $2 billion cost to them walking away), we felt it was prudent to have a position.

As with all our positions, our approach to sizing the Shire position focused on keeping the potential loss in the event of deal failure to 1-2% of the fund’s NAV. Given that both the Shire and Covidien/Medtronic transactions had the same inversion risk factor, we considered the two deals combined as one transaction and sized accordingly in the portfolio. Perhaps, the only silver lining to this event was that it demonstrated that our risk management process works, as the loss was well within this range.

The Takeaway

Recent M&A activity has been excellent (although we’d expect a slight pause after the recent market volatility). Whereas the first half of the year was dominated by mega-deals, we are now seeing lots of mid-cap ($2-15 billion) M&A activity which is helpful for building a highly diversified arbitrage portfolio. We are currently invested in 40 arbitrage positions. Despite recently suffering one of the worst periods in merger arbitrage history (the Shire collapse), the prospective return environment is about as good as we have ever seen it.

Cheers!

#untilnexttime