7 Fat Years Of Event-Driven Investing, Part II
Summary These have been great years for event driven investing. But how much of that is just a strong market? What should we do next, even if the market is weak? In Part I , I discussed my investments from 2008-2014. While they were seven fat years of event-driven opportunities, we had the wind at our back due to a strong equity market recovery coming out of the financial crisis: What is now called Pimco Income Strategy Fund II (NYSE: PFN ) in 2009 Loral Space & Communications Ltd. (NASDAQ: LORL ) in 2010 Ocean Shore Holding (NASDAQ: OSHC ) in 2012 What is now called Gramercy Property Trust Inc. (NYSE: GPT ) in 2013 Our best long idea for 2014, Sanofi-aventis (Value Right) (NASDAQ: GCVRZ ), should have been pretty uncorrelated with the equity market. However, it could have benefitted from good investor liquidity in a smooth year for the S&P 500 ( SPY ): (Our best long ideas for 2008 and 2011 were both acquired). What should we do in the future if we no longer have the wind at our back that we did in these years? What if the equity market is flat to down over the next seven years? 7 Potentially Lean Years Of Event-Driven Investing from 2015-2021 We are not counting on getting any help from the overall equity markets over the next seven years. The US market cap is a high percentage of its GDP, having briefly reached an attractively low percentage in 2009. So here are some of the categories that we are focusing on to continue to invest with a positive expected value but without the expectation of any help from the S&P 500 ( SPY ). Mutual Conversions One of the strategies that we intend to pursue over the next seven years is investing in mutual conversions. The SEC has a helpful introduction on the basic mechanics of such conversions. These are relatively insensitive to the overall market’s direction. For one example, we own just under 10% of Ocean Shore ( OSHC ) which has more than doubled in value since we bought it. Two earlier of our mutual conversion investments, CMS and OBA , were both acquired for substantial premiums. The same fate may await OSHC shareholders within the next few years. Contingent Value Rights Contingent Value Rights/CVRs is a second category of ideas that we intend to continue pursuing regardless of the markets’ overall direction. CVRs are options that are issued by the buyer of a company to the sellers of that company. The CVRs specify events that let the sellers get paid additional value. Introduction A contingent value right or CVR is a right issued to shareholders of an acquired company that contractually conveys additional benefit if a specified event occurs. Such events can include milestones related to regulatory approvals, sales, manufacturing, or assets under management/AUM. It is a useful tool for a value investor’s toolkit. One of my favorite current investments is a CVR that I recently acquired for less than twenty-five percent of its expected value. Acquirers For buyers in mergers and acquisitions, CVRs make it much easier to present their shareholders with a deal that is immediately accretive to earnings. Also, the risk of unknowable binary outcomes that could be career threatening can be offloaded. The major negatives include the fact that the public market generally values CVRs at a deep discount. That makes CVRs suboptimal for multi-bidder situations. In one recent example, Valeant (NYSE: VRX ) competed against Actavis for Allergan (NYSE: AGN ). VRX’s offer, which at one point included a CVR, lost out to a cash and stock offer from Actavis. There is also additional cost and complexity associated with CVR agreements. They can slow a deal’s progress because the SEC generally takes longer to review proxies for deals that include CVRs. Also, publicly-traded CVRs require a separate registration process. Targets For M&A targets, CVRs offer the ability to hang onto substantial upside while transferring a business to a corporation that can operate more efficiently. Typically, a small development stage pharma company has no or few salesmen while large commercial pharma companies have thousands. Once a drug is ready for the market, it usually makes less financial sense to hire salesmen when one can simply sell to a company that already has salesmen. However, founders often want to fully realize the value of what they build. CVRs can serve both goals. CVRs also allow targets to project confidence in their business’ prospects. It can be a good tactic for the people with inside information to present that they want to hold onto upside. Additionally, it can be tax-efficient to push off part of a deal’s value into subsequent years beyond the sale, when most insiders realize tax-inefficient windfall gains. Advisors Deal advisors can benefit from CVRs, too. The lawyers can bill for the time they spend crafting the CVR agreements. The bankers can use CVRs to push off contentious issues during deal price negotiations. Before 2008, most CVR discussions were simply negotiating tactics. The CVR itself was usually negotiated away before deals were announced. After 2008, CVRs increasingly made it into definitive merger agreements. They were instrumental to closing gaping bid-ask spreads between the buyers and sellers. After equity markets declined in the financial crisis, buyers wanted to be opportunistic in buying long sought-after targets. But targets wanted premiums on top of recent highs. Whether or not the market thought they were worth what they were trading at before the crisis, boards and managements often mentally accounted for those market prices. They did not want to bow out without winning them back. CVRs filled this space between what the market could bear and what targets wanted. Investors CVRs can almost always be worth $0.00. In this regard, they are similar to buying options. Substantively, they tend to represent the most controversial, most marginal part of a merger’s consideration paid to a target’s shareholders. Target company shareholders offered CVRs frequently give them little thought and avoid owning them without regard to their economic cost or benefit. In most cases, they represent a small fraction of a deal’s value. If one is getting a large premium based solely on cash or stock, one might simply take the opportunity to sell with a big gain without bothering with the minutiae associated with detailed valuation work on specific merger securities. Mutual fund managers are not really paid much to squeeze out positive expected values in absolute terms, so this kind of work would be a lot of uncompensated or lightly compensated trouble. For some holders including all index fund managers, the CVR is not even in one’s mandate. They have to sell to avoid violating the agreements with their investors. CVRs have other problems for investors. Their agreements include duty requirements of the buyers that are weak and difficult to enforce. In some cases, CVRs were created to carve something out of a merger that the buyers explicitly believed was worthless. So why do I even bother with CVRs? I bother because there are also positives for investors. One can exploit narrow mandates of the incumbent shareholder base to pick up positions in CVRs for low prices indicative of the non-economic nature of the sellers. Specifically, I tend to use limit on close/LOC purchases of CVRs at prices representing deep discounts to intrinsic value. While the M&A buyers may not be highly motivated to maximize CVR values, it would often be impractical to strategically miss milestones. This is especially true with sales milestones at companies with large numbers of salesmen who are individually incented to maximize their compensation through high sales. Milestones are not always based upon a buyer’s skepticism that payments would be made. In many cases, they are designed to split the upside on likely outcomes. Understanding a deal’s background and key players can help in categorizing CVR payments as those based on splitting the difference versus buyer calling the target’s bluff in negotiations. Another positive for investors is the fact that few great business operators are also great asset allocators. Sadly, when great businesses take off, they frequently plow their profits into far less great subsequent ventures. But with CVRs, they just need to perform and then they send the proceeds back to the investor to reallocate that capital. In equity investments, such return of capital often requires shareholder activism. With CVRs, no pressure is required – the businessmen do what they do best and the investors get to do what we do best. In short, this is a security that tends to be mispriced, is completely uncorrelated with the public markets, and results in a return of capital. Throughout the history of investing in CVRs, there has been every possible outcome – from total losses (as is common when buying an option) to gains of several hundred percent. The extreme winners pay for the extreme losers with more than a little left over. They do something else as well – they demonstrate how little information is correctly priced into the market in such obscure securities. One of my favorites is Casa Ley. Casa Ley Safeway (NYSE: SWY ) was a complex transaction involving a spin-off, lengthy antitrust review culminating in a substantial divestiture package, a cash payment, and two CVRs. Towards the end of the deal, there were opportunities when the Casa Ley CVR had high liquidity and low prices. SWY was deleted from the S&P 500 (NYSEARCA: SPY ) on the January 26th close. It was deleted from the FTSE and MSCI on the January 29th close. Managers of respective index funds had to sell on those specific trades. Price-sensitive CVR buyers bought on each of those markets. On the earlier date, there were 27.6 million shares available and on the latter date there were an additional 2.675 million available. The deal risk was approaching zero. One key member of Safeway’s deal team left on a ski trip in the middle of these days, which would be quite unlikely if there were problems with the deal. At the time, I owned over $10 million of Safeway, but wanted to get closer to $25 million at a marginal price of around $0 for the CVR. I placed various lowball LOC bids to add and ended up with another $2 million of the $15 million that I ideally wanted. In terms of sizing these positions, I try to keep each CVRs at less than 0.1% of my portfolio so as to avoid the complexities of having to constantly mark them to fair value. When the positions are immaterial, I can hold them at cost. While our cost basis was much lower (in fact, negative), the final trading price for Casa Ley was the equivalent of $0.15. But what is it worth? Safeway’s estimate is that it is worth between $1.00 and $1.40 per right. Using Kroger (NYSE: KR ) as a comparable company, it could be worth around $1. But, it is not Kroger. It has Mexican Peso risk, geographical risk, and a majority holder. So I fair value Casa Ley at just over $0.50, discounted for time, liquidity, and the probability-weighted payouts. The business earns about $0.05 per year. It is very difficult to imagine a bear case much beneath $0.50. After the deal closed and non-tradable CVRs were issued, there were offers to swap the CVRs for $0.30, which would have been a gain of 100% from the prior day. Holders willing to sell were asking $0.60. Most valued them around $0.70. For tax reporting purposes, Safeway intends to report that the fair market values of the CVR at the time of the merger for Casa Ley is $1.0149 per right based on third party valuations. If Safeway is unable to sell Casa Ley in the next few years, rights owners will be paid a fair value, which will probably be a range around that amount. Squeeze-Outs Squeeze-outs are when the majority shareholder of a given company wants to eliminate minority holders by acquiring their shares. In many instances, this has been a lucrative situation for minority holders. A favorite potential squeeze out of mine is Crown Media (NASDAQ: CRWN ). As I first introduced the idea, CRWN owns two properties: the Hallmark Channel and the Hallmark Movie Channel. This inventory is too small to be optimized as a standalone publicly-traded company. It would be far more efficient to be either private or the target of a strategic acquisition. Over 90% of the equity is owned by Hallmark Cards, Inc. It would be reasonable for the majority owner to squeeze out the minority shares and de-list the stock in order to save on expenses unless they sell it to a larger competitor. This holds true regardless of overall market gains or losses in the years ahead. I have focused on additional squeeze out opportunities on Sifting the World . What wouldn’t you invest in? I am willing to break with convention in order to invest with safety and to avoid tying my fate to the overall market’s direction (especially from here). The ideas above are frequently outside investors’ mandates and comfort zones. Good. I am explicitly looking for areas that fit outside of narrow mandates. One gets long lists of things that people would not invest in for arbitrary, non-economic reasons. To define the question a bit further, I want to place some constraints: legal, honest, financials written in a common language, and accounting under a common standard. I am thinking only of investments that are both permissible and analyzable. Within that universe of opportunities, what wouldn’t you invest in, were a given security trading at a price that appears to meaningfully diverge from its value? I ask in order to get the lay of the land in terms of what “just isn’t done.” Bankrupt companies? Tobacco? Gaming? Firearms? Stocks under $5 per share? Leveraged companies? Late filers? My answer: nothing . There is nothing that I would not buy for the right price (under the constraints enumerated above). The expected value of one’s portfolio is a result of outcomes and sizing but it is also limited – voluntarily limited – by your mandate. As for me and mine, I want to maximize expectancy and therefore minimize the arbitrary limitations on our mandate. At the same time, we love counterparties with constrained mandates. What are your constraints? Stated another way: if you could invest in whatever you like, what would you dedicate your time, energy, and money towards? In practice, how does that diverge from what you spend your resources on today? In polling friends at large money managers, the typical response is that they spend between 5-20% of their money under management on investments that they think are the best (had they no audience but their selves and no goal but +EV). The rest is for institutional reasons, typically career preservation and reputation management. The problem with investing is that many of the investments that are most institutionally defensible have virtues that are the most obvious and priced in. Happily, I’ve been able to preserve an environment that is dictated by expectancy: first and foremost our downside, then our upside and probability of each potential outcome. The simple task of trying to make sense of the world is hard enough work. It is nearly impossible to do it while simultaneously trying to appease arbitrary irrelevant goals simultaneously. Trying to actually make sense can be so different than trying to look like you are making sense that the two will frequently end up on opposite sides of a trade. We will end up liquidity providers for counterparties who have to show that they are in the latest fad or out of the latest scare, because that is what they are paid to do. Some things just aren’t done… and we love to do them for the right price. At the right price, I would buy anything. My overriding focus is on positive expected value and I would go anywhere in search for +EV. If that search takes me far afield – especially when I can’t count on market returns – then so be it. Where All The CEOs Are Above Average Another reason why we focus on some obscure types of event-driven opportunities is that M&A, in and of itself, does not durably create any value. Garrison Keillor characterizes his fictional Lake Wobegon as the town “where all the women are strong, all the men are good looking, and all the children are above average.” Their stance on their strength and looks is unknown at the time of this writing, but it is clear that Fortune 500 CEOs are convinced that they are above average Fortune 500 CEOs. This impossibly high self-assessment can be extremely expensive for their investors. How can we measure CEO’s above averageness? It is actually pretty straightforward. First off, how much do they think, on average, other companies’ equities are worth? The answer is that these CEOs have pension funds and other investment vehicles in which they can buy or sell stock and in recent years none have been paying above market prices for equities that they don’t control. At the same time, they have continued to pay substantial premiums for the equity of other companies in mergers and acquisitions when they get to control those companies after the deal. These premiums can only be partially explained by potential cost savings; most of the premiums are for control. In fact, in a number of instances, there are merger negotiations featuring arguments between two management teams regarding who should get control and, thus, be paying the control premium. In such cases, the cost savings are constant so the only subject is who gets control. How can both be right? How can all buyers’ management skills be worth a substantial, often 20-30%, premium over all others? Is this crazy or is something else going on? And what can we do about it as investors? Maybe there is a perfectly reasonable explanation. Perhaps the mergers and acquisitions are themselves valuable. They put different businesses within one firm where they can cross-sell their products. They can learn from each other and adopt best practices. Merger announcements typically come with a press release, slide presentation, and conference call featuring the deal rationale, which is typically upbeat and exhaustive. Do merger rationales have merit? Not much. Other than cost savings, on average mergers and acquisitions are of no net benefit whatsoever. Within a year, value is eroded (other than by cutting costs where that is both an explicit plan and the plan is achieved). All of the “soft” purposes can be easily contracted between different firms without the payment of any premium above the market price, as is necessary in M&A. This belief in above averageness burns brightest during multi-bidder situations. The entire topic involves CEOs asking themselves the question of how much above the market price they should pay in order to get to control another company, frequently a competitor, and wrest it from the control of one of their peers. This is a question that is fraught with peril. Financial advisors to the CEO are compensated based on the consummation, not the success, of a deal. The press is ready to pronounce one the “winner” and the other the “loser.” Typically, both are extremely competitive people who have reached their place in their companies by consistently being in the first category. In such circumstances, price is no object, especially when it is only one’s shareholders who pay that price. Within a year, the highest bidder in multi-bidder corporate auctions has equity that is massively underperforming the other bidders. Large write-downs are frequent, commonly dwarfing the size of the deal premium and in several cases dwarfing the size of the deal itself. So, managements habitually overpay to control other companies and doing so has no redeeming features for their investors. They might do it because they think that it would be better to be the CEO of a larger company, but in many instances they are relying on the belief that they are above average. But excluding the hope that they could all be above average, what are we to do? I think that the start is to recognize that shareholders have a different interest than our managers and that we are the owners and should act like it. We can support M&A as the buyer in only the rarest circumstances, and expect those circumstances to be based upon an unusual opportunity to extract cost savings in excess of any premium paid. We can be on the constant search for control premiums to collect as opposed to pay. We can keep our companies in an ongoing strategic review to always maximize shareholder value. Most importantly, we can insist that managers compare any plan to the alternative of returning capital to their shareholders. A manager wants to pay a 30% premium so that he can control another company. How about buying his own equity instead? No matter how sure a manager might be that he can justify paying a massive premium, he is probably buying the company from a CEO who himself was sure that the company was already run by someone who was above average. Conclusion Regardless whether the equity market is up, down, or sideways over the next seven years, I want to generate strongly positive returns for Rangeley Capital Partners as well as Sifting the World members. Three ways of achieving that goal will include conversions, rights, and squeeze-outs. They have had strong returns on average and do not depend upon the markets’ direction for those returns. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long LORL, OSHC, SWY, CRWN, GCVRZ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital. Rangeley invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our investors, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.