The Six-Foot-Tall Man, Vertex Arbitrage Fund/Plus

Wall Street legend Howard Marks has an often quoted adage: Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average. Its moral is that investing success requires not just surviving on average – the key is surviving the lowest points.

The merger arbitrage market has recently gone through a period of great volatility that has tested one’s ability to keep their head above water. We discussed in our first quarter commentary that a number of current positions require approvals in China and that the heightened tension between the US and China was leading to an increased worry that the Chinese antitrust regulator might block deals as retaliation. In particular, the deal for Qualcomm to acquire NXP Inc. (for $127.50 cash per NXPI share) was a very large arbitrage position for many. At the end of April, it was trading at $105, almost a 20% discount to the deal price and below what many thought NXPI was worth even in the absence of the deal. When NXPI reported weak quarterly earnings on May 2nd, the stock fell a surprising 12% further, causing even more acute pain. As a result of this dislocation, we know of a half dozen arbitrage funds that either were liquidated or were forced to dramatically reduce risk during this time, placing the entire arbitrage market under extreme stress. Of course others may have been able to embrace the risk with a “go big or go home” approach. But sometimes, you do get sent home, or worse, you drown.

 

 

Bruce Newberg reminds us thatImprobable things happen all the time, and things that are supposed to happen often fail to do so.” We have consistently emphasized that our approach to risk management is to size positions so that a surprise event never threatens to impair capital significantly. In other words, we manage risk to always survive the lowest points – at no time should a single negative event cause a loss of more than 2% to the Arbitrage Fund (or equivalently 4% in the Plus version). Our baseball analogy is that we are trying to hit singles and doubles, rather than swing for the fences at the risk of striking out. Our risk mitigation approach to the NXPI situation was to aggregate all of our exposures to “Chinese approvals” and limit the worst case outcome to a loss of 2% of NAV. As a consequence of this prudence, despite the recent turbulence, the Funds were never in negative territory on a year-to-date basis.

We have learned over time that politics and arbitrage can be a toxic mix, and there are recent examples where newly implemented government policies ultimately killed transactions (the Abbvie acquisition of Shire in 2015; the Pfizer acquisition of Allergan in 2016; more recently in Canada, the acquisition of Aecon by a Chinese entity was blocked by the federal government under rarely exercised national security concerns).The current US administration is particularly prone to whiplash-inducing policy reversals and contradictions. No matter what one’s view on what a government decision “should be,” we think it unwise to have the hubris to take significant exposure to a wildly variant outcome, of which no one can know what the outcome “will be.” This reminds us of the Charlie Munger adage that Acknowledging that you don’t know is the dawn of wisdom.

Signs that market swells are easing is evident in some recent events: Microsemi recently received Chinese antitrust clearance to be acquired by Microchip and geopolitical tensions appear to be cooling. At the end of May performance for the Funds is:

May 31, 2018
1-Month
Return
Year-to-Date
Return

Vertex Arbitrage Fund F

  0.88%
  

  1.37%
  

Vertex Arbitrage Fund Plus F

  1.75%
  

  2.75%
  

One point we’d like to underscore about the “arbitrage” fund space is that the approach to this investment strategy can vary wildly. Our commitment is to provide investors a market-neutral portfolio which produces tax-efficient, positive annualized returns. We are confident making this claim due to the following factors:

  • we focus on merger arbitrage events and do not stray into less predictable areas,
  • our risk management protocols are designed to cap volatility and preserve capital,
  • we limit leverage to prudent levels (some managers borrow many times what we do),
  • the source of return is primarily tax-friendly capital gains,
  • the outcome isn’t exposed to interest rate risk,
  • a management team of specialized practitioners, combining 40 years of merger arbitrage experience.

The fact that you have entrusted us with your capital is a responsibility we take very seriously so we hope that this note helps to further enhance your understanding of our investment process.

As always, we appreciate your questions or feedback. Please reach us at: 604-681-5787 or invest@vertexone.com