Traditional value investing requires a patient approach, as the timing of the “value unlock” in the investment is uncertain. Value investors therefore require a “margin of safety” or a deep discount to the intrinsic value in order to compensate the investor for the willingness to wait an uncertain period for the rewards. Event-driven situations, on the other hand, are focused on realising investment returns in a relatively short, pre-determined space of time – mostly based on our view of the timing of a specific event or a catalyst.
Catalysts are usually binary in nature, so the upside needs to be multiple times higher than the downside risk. On entering these investments, we only commit once we have found an opportunity that offers a substantial margin of safety. This is a game of “heads I win, tails I don’t lose much.”
Although finding these opportunities and fully assessing them requires deep research, there are certain scenarios that tend to dish up these opportunities more often than others. The key here is that we only enter these transactions when they are available. The worst thing we can do is to force or fabricate an opportunity.
Merger arbitrage
Every so often, one company attempts to take full or partial control of another company via a structured transaction. These can be friendly or hostile transactions, well-communicated or announced as a surprise, with payment in any combination of cash and shares. Basically, the structures employed are limited only by the creativity of the investment bankers involved. In other words, there are almost no limits to the form of the transaction and therefore no cookie-cutter approach to investing.
Most transactions are conditional on various approvals and acceptances by a complex array of parties. And very often, the timing is not exact. This normally means that securities on one side of the transaction trade at a price which implies a level of uncertainty – and therefore a potential return to an investor. Most of the time, these implied returns are mediocre and much lower than our objective. In those cases, there is nothing for us to do, especially since the downside in the event of the deal failing is normally substantial.
However, sometimes the target is a company we already know and like and would not mind owning for the fund if the transaction fails. Normally, we expect the price of the target to drop substantially on a failed bid.
An example of a strategy we employ is the option structure we put in place on Activision Blizzard based on the Microsoft merger. In this case, the market has priced in a significant probability of the transaction not closing. Microsoft’s offer price for Activision is $95 per share, but the share price has been drifting lower since the deal was first announced. This is despite the parties having received all shareholder approvals, as they are working their way through regulatory approvals in various countries around the world. Obtaining these approvals is a laborious, expensive, and noisy process.
We have bought $80 call options, which were funded in part by selling out-of-the-money put options. This basically provides us with levered upside when the transaction closes (we estimate this to happen before June 2023) and in the case the transaction fails, we will own Activision Blizzard at a very attractive price. This was all achieved for almost no capital outlay from the fund’s side.
Asset unlocks
In an asset unlock, the management team of a company (either by its own volution or under pressure from an influential shareholder) announces its intention to unlock shareholder value by way of corporate action – selling assets, an unbundling, or a return of capital.
The potential to generate substantial returns lies in the mismatch between what the market thinks the underlying operations are worth and what they are actually worth. This differs from a deep value strategy in that the structure of an asset unlock opportunity allows that company to force the realisation of value independent of the shareholders’ opinion when it sells off parts of the business and returns cash to shareholders. These are typically holding companies with several underlying assets.
The mispricing of the share can be a result of the market failing to accurately recognise the sum-of-the-parts value of the company, or through indiscriminate selling by shareholders as the strategic reversal of the company fails to meet its stated goals. Another example is illiquidity in the stock that fails to attract larger market participants to exploit the value mismatch. In such a case, our positioning in the market as a smaller fund works in our favour.
An example is Etion Limited, previously called Ansys Holdings. The company owned a range of decent assets but has been under-appreciated by the market for a long time, mostly because of an uninspiring performance and because it was a small cap. Eventually the board announced their intention of selling or liquidating the underlying assets with the aim of returning the capital to shareholders. The process has been ongoing for the past 2 years and is bound to conclude in the next 6 months.
Investors who bought the share at about 10c a piece on the back of the announcements, would subsequently have received 33c in capital distributions and dividends, and the share price currently trades at 54c/share. We expect a final liquidation distribution of about 58c/share in the next 6 months. That’s a total return of more than 8 times your original investment in under three years.