Donostia is an analyst at an event-driven hedge fund who focuses on long/short ideas across the capital structure. We emailed with Donostia about how regulators have changed their definition of competition as part of antitrust review, how merger arb returns should be measured, and whether the type of buyer impacts the likelihood of deal closing.
Seeking Alpha: Can you walk us through your investment decision making process for merger arb and event-driven ideas, from how you source them to execution?
Donostia: For the merger arb strategy, I focus mainly on announced deals, so it is relatively straightforward in terms of sourcing. There usually isnt a rush to set an arb spread or position on the day of announcement of course, there are exceptions (competitive process, long telegraphed deal where potential regulatory issues/approvals known), but more often than not, you would prefer to see the contract (usually takes a day or two) and wait for the official handover from long-only/fundamental investors or short sellers covering (i.e. thereby driving spread tighter than it would be). In the interim, we are trying to understand why there is a spread and what risks we are underwriting (i.e. MOFCOM/China approvals, anti-trust, buyer vote, weak contract/buyer). You should have a good idea of what risks are contributing to the spread and then can compare it to the rest of the available universe. For example, currently, all deals with MOFCOM approval pending are trading at elevated spreads (MSCC/MCHP, CAVM/MRVL, NXPI/QCOM, ORBK/KLAC, OCLR/LITE, COL/UTX) the risk/reward for each of these MOFCOM sensitive names differs, and you would be better suited by being larger in a name which presents the most attractive risk/reward. Pretty simple for the most part.
SA: How important is it to do fundamental analysis on the acquirer and target? Your thesis on NxStage Medical (NASDAQ:NXTM) is a case in point.
D: Fundamental analysis is critical in the process, especially for the longer duration deals where a thorough anti-trust review is expected. Since you wont be getting much guidance from management, and there will unlikely be conference calls, a lot of the valuation will fall upon relative value metrics. As such, its important to have a good feel for any peers and the sector overall. I think the ongoing situation with NXPI has highlighted that reliance on just peer comps was wrong without having some sense with where you were in the overall cycle for the Semi space.
I think NXTM is definitely a case where you need to rely on fundamental analysis; not only for assessing the market-implied probability but also in the event the deal breaks, and you are left holding a company which hasnt been run as a standalone company for a while. I think often that reality contributes to the current deal spread. For example, would you want to own AKRX (chance of bankruptcy and term loan trading below par) or Time Warner (NYSE:TWX) (fundamentals plugging along but a high-quality name with chance of other potential buyers)?
In the case of NXTM, we are focused on the Home-Hemodialysis (HHD) market in which NXTM is the major player. We arrived at our break price of $19 vs. the unaffected (day before deal announcement price) of $23-24 after spending some more time on industry dynamics. Our conclusion was that the HHD market would likely face additional pressure as there was no guarantee that NXTM would be able to maintain their >95% market share. As such, we felt a sum of the parts analysis which incorporated some decline in the NXTM HD and PD business.
Given its dominance in the HHD market, we thought it was appropriate to apply a 3x multiple on revenues despite the potential headwinds as this would also incorporate a potential boost from the approval of NXTMs PD machine. Based on potential market penetration and the gradual shift towards PD overall, sell-side analysts believe that the PD segment alone could represent $5-8/share in value.
SA: How do you determine how long until a deal closes? What factors can delay this process? If a deal is delayed, do you exit or continue to hold?
D: When a deal is announced, the acquirer will normally provide details on needed approvals and closing guidance. Common regulatory approvals required are HSR/US Antitrust, FTC, FCC, EC, MOFCOM, CFIUS, State PUCs. There are plenty of precedents here, and you can have a good initial estimate of timing for each approval based on when filings are submitted and how thorough of a review you might expect. If it is a horizontal merger between two US companies that would result in total competition decreased from 4 to 3 companies (ex. S/TMUS), then you would likely expect a long review given the clear competition issues.
A new wrinkle has been that in addition to horizontal mergers, vertical mergers are also receiving extra scrutiny. This has resulted in longer 2nd Requests which are on average 4-6 months. In these instances, regulatory bodies are often looking for structural vs. behavioral remedies this often entails finding a buyer for assets/business segments to be divested which will add to the timeline as the DOJ/FTC often will have to vet a buyer before signing off.
Another example of delays weve seen a fair amount this year has to do with CFIUS and MOFCOM. In the case of CFIUS, weve seen a number pull at refiles this is when an acquirer realizes it will not get CFIUS approval after the initial 30-day review and subsequent 45-day follow-on review. Rather than letting the clock run out, the buyer will pull its application after some consultation with CFIUS and refile after incorporating some feedback. Naturally, this usually creates some volatility in the spread or target stock as two or more pull and refiles usually signal that something is wrong with the buyer/remedies.
This year at least, delays in deals have become the norm. Many arbs have found their closing estimates far too aggressive, and we are now seeing elevated spreads reflecting this (i.e. wider gross spreads to account for diminished IRRs). Given the leverage employed in this strategy, cost of capital should be deducted from the IRR to get a more accurate view. Alternatively, viewing the IRR as a spread above a risk-free benchmark (usually some term of LIBOR in line with estimated deal duration) is a better way of viewing risk/reward across the investable universe in merger arb.
Deciding to add or reduce because of a delay comes down to the nature of the delay not trying to sound pedantic, but an unexpected pull and refile (ex. SNI/DISCA) can sometimes provide a great buying opportunity. I wish it were more precise. But a clear example of this is the TWX/T or the AKRX/FRE which both went through/are about to go through litigation. Sometimes, it’s better to reduce and reassess as more details come out in the case of AKRX, it was key to see both the complaint and rebuttal before adding or reducing the position size.
SA: Can you discuss where and how regulators have changed their definition of competition as part of antitrust review? Are there any industries (or companies) that effectively cannot consolidate for various reasons?
D: As mentioned in the prior question, there is now extra scrutiny for vertical mergers – a relatively new development. Normally, regulators are more concerned with horizontal mergers (i.e. buying a competitor or peer in the same industry). This has made things pretty difficult for many arbs, to say the least. As such, now, any deal with a potential vertical component will likely face a 2nd Request/extended review moreover, they will likely require a structural remedy, usually in the form of a divestiture. As long as Delrahim at the DoJ holds the position, we can assume that Vertical Mergers will be guaranteed a close review.
SA: How should merger arb returns be measured? Are there any downsides to using IRR?
D: Given this is supposed to be a market neutral strategy with low volatility hard to believe, given the action of late! – merger arb returns should be measured based on risk-adjusted returns. I think you also need to look at how a merger arb portfolio is structured. This really isnt a measure of returns, but looking at hit rates and max drawdowns for broken deals also provides some insight into how a manager thinks about risk/reward. Given that the downside for many deals is in the 20-30% range, a manager can only stomach so many broken deals without requiring more risk on other deals to get back to even. Avoiding the landmines (and thus, being able to change your mind when the information changes) can be a crucial skill in merger arb.
SA: Does the type of buyer (strategic vs. financial) impact the likelihood of the deal closing?
D: Again, it will depend on how the contract is structured. Large strategic buyers who are repeat buyers do provide some comfort, but as we saw in ALR/ABT, sometimes, a CEO doesnt care about his reputation if he wants to get out of a deal.
I think with rates rising and leverage set to become an issue in the near year or so, you have to look at LBOs/Private Equity buyers with a bit more scrutiny. You want to know if the target is in an industry that is their core competency, how big of an equity check they are writing, how big the equity check is relative to a reverse termination fee (if any). To the best of your ability, try to put yourself in the shoes of the buyer: How big will the target be relative to the AUM? Does the target fit with any portfolio companies? Do some of the managing partners have operational experience in the space? Usually, these types of questions are more pertinent to smaller and mid-sized LBOs vs. Mega-Fund LBOs. A good example of this recently was Siris Capital and their offer to buy SNCR. Siris made a tentative offer to buy SNCR for ~$18 after building up a ~6% stake in the open market following SNCRs CFO and CEO leaving after only 3 months and a 50% decline in SNCRs price. Learning a bit more about Siris from publicly available information, one could deduce that they really were interested in SNCR just for Intralinks (a recently completed acquisition by SNCR). After due diligence, Siris became aware of some material issues in SNCRs core business. Without delving too much into the minutiae, Siris decided against buying SNCR whole for Intralinks. Instead, Siris opted to structure two separate deals:
The purchase of Intralinks outright for a cash consideration A private placement to recapitalize the SNCR RemainCo
Private equity buyers will usually try to find a way out, restructure or angle for a price cut if things go belly up. This isnt to say that other buyers wont have buyers remorse (ex. AKRX and Fresenius). But understanding the language in the contract is critical particularly concerning regulatory efforts (Hell or High-Water, Reasonable Best Efforts etc.) and reverse termination fees and under what circumstances the fee would need to be paid to the target company. Sometimes, private equity buyers can be a bit strategic with end dates and termination dates they have negotiated in the contract.
SA: What traits do you look for in a pre-event name? Are there any that stand out now as examples?
D: I try to avoid pre-event names, to be honest. There are times when the downside or risk/reward are attractive, and its a company you would want to own otherwise in a sector that has some strong characteristics. I think also vetting the source of the rumor for a buyout is also helpful. A source from the Wall Street Journal or Bloomberg carries a bit more weight than from some of the other publications catering to the Merger Arbitrage/Event-Driven community.
LADR was an example of a pre-event name we were comfortable holding, given that it is set up well for rising rates, was trading below adjusted book value, and was run by a stellar management team. LADR was trading in the mid-$14 at a discount to its book value and with a >8% dividend yield that was well covered. The stock traded to $15+ when Related Fund Management announced they had offered to take LADR private.
We had been familiar with LADR previously and were comfortably underwriting their Core REIT business, which we viewed as stable and with minimal expected volatility with regards to earnings. The issue with LADR had long been that its conduit/securitization business was lumpy (albeit extremely profitable) and thus made it hard for most institutional investors to get comfortable with the business model. Essentially, investors cant decide if LADR is a traditional mortgage REIT or something else. LADR CEO Brian Harris summed it up nicely on the last earnings call:
We spend a lot of time meeting people and investors that run with first and last names and we tell our story to them and we give them the value proposition about internally managed company with a lot of internal ownership. We’ve never raised secondary capital. We’ve got an ironclad balance sheet, and we go through all the checkmarks that we do to run a safe company. But deep down inside, I do believe, half of this market is driven by three factors, market cap, dividend and average daily volume. And I don’t think that those algorithms that make those purchases, no if you own subordinate debt or senior secured, they don’t know if you’re internally or externally managed. And I think that they pay attention to rising interest price to book value, and I think they pay attention to dividend increases on a regular basis.
But I think we’ve we’ve been walking around here at Ladder, questioning, how do we make something happen? And finally, you just have to sit down and realize, we’re REIT, and REITs are perceived to be an out of favor asset class, when rates are perceived to be rising. There are plenty of REITs that do very well, while interest rates rise. And that is a fact that I think everybody on this call knows. But I don’t think a lot of those algorithms take that into account. And you will see sometimes where, the bond market is available at 6%, but a REIT might raise money at a dividend rate much higher than that. So why would they do that? That’s typically an externally managed REIT, that’s in the assets under management model.
But I don’t think that that the algorithms are picking that up. So, I think as I said last year, we went to great pains to set up our balance sheet and our asset liability set to make sure that we could really optimize our earnings power. We’ve got the right product mix. I think the analysts and our investors do understand that, and I think we’re in the self-help model now, because I don’t think we can wait any more to reward our shareholders. I don’t think we can wait for the efficient market theory, because if the Fed says they’re going to raise rates four times, REITs are going to go down. Now I understand why residential mortgage REITs go down. I don’t understand why mortgage servicer would go down, nor do I understand why a REIT with a lot of exposure to LIBOR assets goes down, but down they go.
Well, when Related Fund Management and LADR ended talks of an offer at $15.00, the stock sold off indiscriminately and provided a great opportunity to add to a solid rate sensitive name with a well-covered 9% yield and a management team that owns 12% of the company and is aligned with shareholders. It would have been nice to get an improved offer of say $17 which is still below what we think LADR is worth but we were happy to add to the position on the pullback.
SA: Whats one of your highest conviction ideas right now?
D: Well, clearly LADR in the pre-event/special situations space. Among the announced deals I am positive on some of the smaller names such as CAFD/Capital Dynamics and NXTM/Fresenius. I am also positive on AKRX/Fresenius, but you need to size that one conservatively, given the downside is hard to gauge I am using around $6-7 for a break price, but there are some who think $0 cant be ruled out.
The current gross spread on AKRX is ~160% with AKRX at $13.05 vs. an offer of $34.00. AKRX has already filed a complaint in Delaware Court to enforce the contract and force Fresenius to close the deal. Fresenius has also filed a rebuttal to AKRXs complaint. Both the complaint and rebuttal are chock full of propaganda as you would expect. AKRX is claiming they have met all obligations and that Fresenius is dragging its feet with regards to the regulatory (FTC) approvals. Fresenius is claiming that AKRX has not fulfilled all its representations and warranties (R&Ws), specifically, the following MAC qualified representations and warranties:
Section 3.05 – (p. 107 in DEFM 14A) – Company SEC Documents; Undisclosed Liabilities Section 3.06 – Absence of Certain Changes Section 3.08 – Compliance with Laws; Permits Section 3.18 – Regulatory Compliance (Subsections A through G)
Of these R&Ws, it seems that Section 3.18 is the most pertinent. But the difficulty for Fresenius is that it needs to prove that the breach of these R&Ws alone or in aggregate would amount to a MAC (Material Adverse Change) in the business. I am of the view that Fresenius has not made the case a MAC has occurred and will have difficulty doing so. Fresenius is alleging widespread fraud (Case No. 2018-0300-JTL, Akorn, Inc., v Fresenius Kabi AG, Quercus Acquisition, Inc. and Fresenius SE & Co. KGaA) at AKRX based on the revelation that the VP of Quality Assurance allowed fabricated data from a 2012 ANDA to be resubmitted in response to a CRL from the FDA, which is for a drug AKRX acquired the branded version of in 2013. For Fresenius to get out of this deal, they will need to prove that fraud has to come from the very top (i.e. Management promoting systemic fraud). Given that John Kapoor is associated with AKRX, this is definitely justified. But in reviewing the transcript from the motion to expedite the hearing, Fresenius lawyers were reluctant to admit that 4 or 5 people were mentioned in the disclosure letter as part of the scope of discovery allowed per Section 8.12 of the contract. Given that there were 5 small ANDAs that were allegedly doctored/tampered with, it would be hard to imagine top-level management pushing for knowing fraud again, on such a small ANDA/potential market. If this was Restasis, it would be a different issue, but so far, we have not heard that from Fresenius.
Restasis is a pipeline product for AKRX which has a substantial addressable market. The current progress on an ANDA for Restasis is unclear as AKRX (and other generics) does not normally comment on its pipelines. However, sales for branded Restasis were ~$1.4 billion last year in the US. There are multiple filers for generic Restasis (effectively generic eyedrops/ophthalmic solutions). As for most generic drug manufacturers, getting to market first is crucial – perhaps, Fresenius believes the potential FDA investigations could delay Restasis coming to the market. If this were the case, then you could argue there has been material impairment to the pipeline. But if you were Fresenius, wouldn’t you already be screaming this from a mountain top? or at the very least, alleging that this item was up in the air? I guess we will find out.
I plan on writing an article about the AKRX situation as things develop. There is still a lot going on, but I think it is definitely one of the more interesting merger arb names out there.
Thanks to Donostia for the interview. If you’d like to check out or follow their work, you can find the profile here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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: Check with individual articles or authors mentioned for their positions. Donostia is long CAVM, TWX, TMUS, LADR, NXPI, COL, AKRX, NXTM and short MRVL, T, S, UTX.