Roy Behren: How a Risk Specialist Unlocks Market-Neutral Returns

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1:24And now to the top analysis of today's markets. How to profit from merger arbitrage on three ideas.

1:37We're doing things a little differently on Three Ideas today, looking at merger arbitrage with Roy Barron. He's the co-president and CIO of Westchester Capital Management. Roy, welcome to the show. You specialize in merger arbitrage. We haven't ever done that on the show before. And so I think instead of asking you about your global macro outlook, I think it's important for folks to understand exactly how you do this. Many people will be familiar with it, but actually executing is something quite different. So let's take a step back and just walk us through the steps before we actually get into your three ideas, Roy.

2:12Well, thank you, Sam. It's nice to be here. I appreciate you having me on. Merger arbitrage is a very specific niche type of investing strategy. It involves investing in the shares of companies that are involved in mergers and acquisitions and other types of corporate reorganizations with the goal of profiting from the successful completion of those transactions. Not necessarily from the appreciation of the companies involved, although they will typically appreciate, but from the completion of the transaction, which is why it falls into a category called market neutral investing or absolute return investing.

2:49So typically when a transaction is announced, the stock will trade up because transactions are typically announced at a premium to where the stock was previously trading. And it will approach the deal price, but it won't trade all the way up to the deal price because there may be some uncertainty about whether the deal is completed. There may be some uncertainty as to the timing of the transaction or other types of factors, such as the shareholder vote, the regulatory approvals, and things like that. And all of those uncertainties cause the stock to trade at a discount to the deal price. That discount is known as the arbitrage spread.

3:22and that arbitrage spread is the amount of profit that we make if the deal is completed. So you can understand that if the deal is completed, whether it's in a down market or an up market or a sideways market, the investor or the arbitrageur in our case will realize that arbitrage spread as the profit. And that's how we make our money. And that's why it's market neutral. The market goes down. The deal is completed. We still make our profit, which is the amount of the arbitrage spread. You're very well respected in this field. You're very well known in this field. And so my curiosity is, I've been doing the preparation for this edition, is what's the edge that you have that others don't?

4:00Many people can look at a deal, whether it's Microsoft Activision, and we saw what happened with regulators here in the UK, and say they think this deal is going to close. But obviously, you see some type of edge in yourself and your team. So what's the edge? there are a number of edges that can be had i mean all of the all of the information is publicly available information so it's really what you do with it and how you analyze it my own background for example is i used to be a lawyer i used to be a you know a actually used to work at the securities and exchange commission and my partner mike shannon used to be an investment banker our lead analyst used to be a fundamental analyst at a major bulge bracket firm and when a deal is announced, we have to look at all the different possibilities of timing, of transaction completion, the types of approvals that are needed, and the things that can get away of the transaction actually being completed, such as an antitrust approval, or in the case of a drug deal, an FDA approval.

4:59All of those things are various factors that we need to handicap the probability of being received. And then we look at the market and see where it's trading and see if the market is appropriately discounting those factors or those approvals or those contingencies. So we've been doing this. I've personally been doing this since the mid-1990s as my partner, and all the members of our team have been doing it for decades. So would you say your edge is the brainpower that you have? You have the experience here, and you're looking at something, and you're more sure than the market is that this deal is going to close, this acquisition is going to happen?

5:33I would say that's true. I mean, There's a matter of judgment. It's a very qualitative process. There's some quantitative calculations that we use to determine whether we're getting paid an appropriate amount for the risk that we're taking and whether or not the market is appropriately pricing in the various risks. But at the end of the day, it's really a judgment call to decide whether or not the transaction is appropriately reflected in the market in terms of the price it's trading at versus the transaction price. Then also in terms of constructing a portfolio. The portfolio really needs to be diversified because in many instances, the amount you stand to make is going to be little compared to the size of the potential drawdown or your downside, or it's known in the industry as the value at risk, the VAR.

6:17And so you have to make sure you have a very, very high batting average. Just before we get into the first of your three ideas, Microsoft Activision, as I mentioned, is the one that's on so many people's minds, especially because the UK rejected the deal. So walk us through, was that a deal that you were going long on? And how do people cope when something doesn't go through? How did you see that? And how do you look at it in hindsight? It's a good question. And that's an example of the type of research that can add value to a process. I mean, if you look at it, you think, okay, Microsoft's buying Activision, they own Xbox, they're buying a game maker.

7:00What's the problem with that? Why could regulators possibly have a problem. But in reality, if you delve further into it, the regulators didn't have a problem, in particular, the CMA, which is the UK regulatory authority that blocked the transaction, didn't have a problem so much with the consoles as the potential growth of the cloud gaming industry. Cloud gaming is very, very new. And they were worried that if Microsoft controls a bunch of quote-unquote must-have games, such as Call of Duty, et cetera, that they would then be able to dominate the industry, they'd be able to force the providers to use their own cloud service for data transfer and storage, and it would be an anti-competitive transaction.

7:41That's the standard that most regulators use. If a transaction would thwart competition or foreclose competition, then regulators would like to either kind of control the transaction by imposing conditions or block it altogether. And in this particular case, Lena Khan at the FTC actually filed suit to block the transaction. The EU may still approve it, but the CMA, which has a very, very long process and is very difficult to overturn, has decided that it's anti-competitive and they would like to block it. So they have denied approval for it and Microsoft and Activision have said that they're going to appeal.

8:21They're contractually obligated to do so. So we'll probably see some appeal papers in the near future, but it's unclear whether they will see it all the way through. That remains to be seen. Were you surprised by the CMA's denial? We were not surprised. The stock was trading at a significant discount, but during the pendency of the transaction, the fundamental value of Activision increased. They reported good earnings. It became more of a valuable company, and the stock traded up from the low 70s into the mid-80s. It's currently trading at about 75. We had a position because we thought that the transaction would kind of percolate as the regulators were reviewing it and looking at it and the parties were filing their papers.

9:02So we were set up long stock and short 75 strike calls. And that's in our public filings. It's been publicly disclosed. Right now, the stock is trading in the neighborhood of 75 or 76. And it remains to be seen where it will go to if the parties decide not to file. But we think that they will file an appeal and the stock will stay roughly treading water until that plays out. They may still decide to terminate the transaction. But your view is that you think that it will happen in the end? No, no. To be honest, I think the deal is DOA. I think, you know, it's such a long, involved, complicated and difficult road to travel that I don't think they'll be able to overturn the CMA denial.

9:45CMA is the name of the antitrust regulatory authority in the UK called the Competition Markets Authority. But I would also point out that the FTC in the US has sued to block it. That's an administrative case. And that is going on right now. Microsoft is currently fighting that. But again, you know, pursuant to the terms of their merger agreement, they have to resist these types of legal entanglements up until what's called the termination date. So we'll see what happens at the termination date of the transaction. the parties will either have to continue litigating and extend the merger agreement or terminate altogether.

10:18And so I think it's worth just noting that you're hedging this by shorting these calls. That's something that's quite complicated for a group that's not like yours to do, for some of the individual investors sitting at home. Certainly many Real Vision viewers would be familiar with it. But I think it's worth noting that so people realize exactly what they're getting into, because these three ideas are quite different from the other ones that we've done on this program in the past. I think that's a very good point. I mean, the way we invested in that deal is sort of a chicken's way of doing it because it was a$95 transaction.

10:51The stock was trading in the 70s and started trading up all the way to 80 because of some good fundamental reports, their quarterly reports, their performance, et cetera. And we would only lose money if the stock traded below 74 because we got paid a dollar in premium for the 75 strike calls. So we were a little bit scared and our antitrust council warned us that the CMA was likely to have a problem with the transaction. But if you were long, if you were straight long Activision, you stood to make more money than we did if the deal was successfully completed. But we played it in a more conservative manner in that we would only make that one dollar as long as it stayed above the strike price of the call, which is 75, at May expiration, which is on May 19th.

11:35Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

11:48well thanks for laying that out for us and let's jump into your first idea and that's going long horizon therapeutics it's amgen that's looking to acquire them if we just take a step back and look at the stock price of long horizon i'll focus on that for here because this is what you're going long so that's what's interesting here now this had a pre-announcement price of 85 dollars and 50 cents. They're offering$116.50. Today, it's trading at$111. So there's still a difference there between$116.5 and$111. For anyone who doesn't know Horizon Therapeutics, it's a biopharmaceutical, which makes medicines, essentially.

12:32Walk us through this position. And just to note, of course, you have a position here, and you think that this deal is going to go through? Yes, we think that the transaction is highly likely to be successfully completed. Amgen is an experienced acquirer. They're much bigger. They have the money to purchase Horizon. There's no financing issues. There's no shareholder issues. This is a cash transaction. In the case of a cash transaction, an arbitrageur will just buy the shares of the target company and not sell short the shares of the acquirer. If we were receiving shares of the acquirer, we would sell short the number of shares of the acquirer that we expect to receive upon deal completion.

13:13But in this particular case, we're getting paid cash. So the arbitrageurs investment in this particular case would just be to buy shares of Horizon at$111 or$111.25, wherever it's trading right now. And then when the deal is completed, we would receive$116.50. That difference, the$5 or whatever it is, is known as the arbitrage spread. Now, on a gross basis, if you look at it and say, well, I'm only making 5 % or whatever, that may look different to somebody who invests on an annualized basis. Because if you make that 5 % over the next two months, then that's 30 % annualized per year. So we're not making this investment because we think that Horizon is going to go to the moon.

13:58It's not going to quadruple like Google or Apple. All we need is for that deal to be successfully completed. So if the market goes down and Amgen trades down and Apple and Google trade down, we're not going to lose money as long as the deal is completed. We will still make that$5 per share. One thing I would note, though, and I would say this about all the deals that we recommend, is that the upside-downside profile is fairly asymmetric, meaning that we stand to make less money than we stand to lose if the deal is not successfully completed. Because as you mentioned, it was trading at$85 before the deal was announced.

14:33So that means that in terms of risk management, the way that we would manage a portfolio would be to buy a diversified portfolio of these particular investments. Now, I'm giving you three ideas, and they're all great. And we think they have a high likelihood of working out. But in terms of managing a fund or a portfolio, in order to mitigate that single event risk, we run a diversified portfolio. So we're not going to have 50 % of our book just in this one deal or in another. And as you talk about these annualized rates, one thing that jumps out at me, the question I always ask on the show is what's your time horizon?

15:07Rao, Maggie, whenever they do interviews on the platform, and they just, we stress this so much at Real Vision because timing is everything. When you go in, when you come out is everything. And this is a very, very different field because the time horizon, it could be much, much shorter than other, you know, if you're waiting for Tesla to go up, however many years you might be holding that stock, waiting for tech stocks to recover, you may not have and most likely won't have that type of time horizon here. So when you look at the time horizon here, what is your calculation? Are you hoping that it closes as quickly as possible?

15:45Are you hoping that it drags out? And how do you think about your time horizons in this case? So that's a good question. And that's part of the puzzle that we need to solve. The transactions typically need all kinds of regulatory approvals. If you look at a public utilities deal, they need a bunch of different states' approvals. If you look at a drug deal, they may need FDA approval. They may need antitrust approval in a variety of countries in which they operate technology. For example, a broadcasting deal may need FCC approval as well. So what we do is try to handicap the amount of time that the transaction is expected to take.

16:20Of course, we would like to get our money sooner rather than later, because if we're going to get$116.50, we want to get it sooner because the longer it takes, the lower the annualized rate of return is. But either way, we play the cards that were dealt. We try to handicap how long the review will take. We speak to antitrust counsel. By the way, this is one of those things that when Dave Letterman talks about stupid pet tricks and he says, don't try this at home or whatever, it's very difficult for an amateur investor to tick all those boxes and speak to an antitrust counsel, a communications counsel, a drug counsel.

16:56because you need to have all that information in order to appropriately analyze the investment's probability as well as the timeframe. And in this particular case, they have most of their approvals already. We're waiting for a final U.S. antitrust approval, and we're expecting this to close within two months or so. The company is still guiding us to first half of the year. And if it closes in two months, although you're making 5%, as mentioned before, that's 30 % annualized. So you really have to have the resources to be able to do the deep digging on this stuff. And Roy, what is your, I won't say worst case scenario here, because we can always think of the worst, but what would be a pretty bad scenario here, but you think is within the realm of possibilities?

17:39Obviously, that's not what you think is going to happen. But what could happen here where you'd say, whoa, this is not going to plan? What do you think the most likely scenario of a bad scenario is? So the worst thing that could happen would be a regulatory blockage of the deal. They'll say you can't buy Horizon. They're therapeutic devices. They're rare disease treatments are too important for you to buy them. You're going to monopolize it. You're going to raise the prices on everybody. And we're just not going to let you close the deal. In that case, the transaction would be terminated and the stock would trade back down to what we call a standalone price or its fair value price, which is typically where it would be trading prior to the deal being announced.

18:21In this case, we go back down into the 80s. So you have maybe$5 of upside and you have whatever it is, you know,$25 of downside, which is kind of typical. We think, you know, we think that this is very, very likely to be completed. We think it's, you know, well into the 90s, over 90 % likely to be completed. And it's probably trading at, you know, I want to say it's probably trading at like 75 % implied in the market based upon where the stock is trading right now. So we think it's underpriced, it's inefficiently priced, and that if it's completed, you can successfully make a nice annualized rate of return.

18:55But the other potential outcome is that it gets delayed. And maybe there's some litigation, or maybe they decide to grant the FTC additional time to review it. So if it takes twice as long, if it takes four months instead of two months, then the annualized rate of return goes down, although we still make that$5 as long as the deal's completed. You make it sound very easy, but I'm sure every deal doesn't always go to plan and that the backup, the hedge doesn't work. I mean, walk us through that a little bit, because from what you say, it sounds like you've got every base covered, but we know that doesn't exist.

19:28Right. You can't create a risk-free investment because if it was risk-free, you wouldn't make any money or you'd make less than a T-bill. In this particular case, the risk that we're taking is the risk that the deal would be completed and the stock trades back down. You can't hedge away things like deal failure risk. You can't hedge away the risk of fraud, natural disasters. A number of years ago, we invested in an oil refinery deal, and the refinery was hit by a hurricane. It destroyed the refinery. Nobody could have predicted that, but that's the risk that you take. In the old days, they used to call the strategy, risk arbitrage.

20:04Now they call it merger arbitrage. Same thing, but you are taking, those are the risks that you take and that's what you're being rewarded for. Otherwise, you wouldn't be able to make money on these investments. And I'm sure that after that storm hit, it caused you some pain. Yes. You know, the funny, here's an interesting point is that merger agreements govern all the rights of the parties, the obligations, the contingencies and things like that. And there's a clause inside all merger agreements that's called the material adverse change clause. That says that if something material happens that's bad on the part of either party, then the other party can walk away.

20:38And so before September 11th, there was no mention in there of terrorist acts. After September 11th, you had provisions in the contracts that said that this contract is still enforceable even in the event of a terrorist act. It shall not be considered material adverse change. And after that hurricane that I mentioned to you, there were clauses inside that that said that natural disasters are not considered, or acts of terrorism, are not considered material adverse changes for the purpose of terminating the agreement. So it's an evolving type of technology and strategy that we need to be aware of in terms of the drafting of these agreements.

21:19So we've seen it, you know, we've seen a whole evolution of them over time. And as a matter of fact, right now, there are provisions in merger agreements that say that pandemics are not grounds for termination of the agreement. Let's jump into your second idea, and that's going long. Aerojet, Rocketdyne Holdings, they're looking to be acquired by L3Harris. I should say L3Harris is looking to acquire them. Let's just take a step back and look at where this has been trading prior to rumors of a potential transaction. It was trading at about$42.50. There is an offer in for$58 per share. And today it's trading around$56, a little above$56.

22:03So just about $2 difference from what they're offering. If you don't know the Aerojet company, this is an aerospace and defense company. Just walk us through a little bit about these two companies and what you know about them, why you think it makes sense. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

22:29Well, this is an interesting one because Aerojet Rocketdyne had been previously in a merger agreement to be acquired by Lockheed. And they made their filings and due to antitrust concerns, the transaction was terminated. It wasn't apparent at the time that the Department of Defense supported the transaction. They're the most important player here. They're the biggest, excuse me, they're the largest customer. And, you know, unless they kind of give the thumbs up on a deal, it's not going to get a defense deal. It's not going to be approved by the Federal Trade Commission. So that deal was terminated.

23:05Shortly thereafter, a smaller competitor, L3 Harris, announced that they were buying Aerojet Rocketdyne. The reason why deals are often terminated or blocked by regulatory authorities is because either they're going to dominate a particular product line. In this particular case, it was rocket engines, or they may foreclose competition in other areas, i.e. products that use the rocket engines. In this particular case, L3 is a better buyer, in our view, because they don't compete with Aerojet Rocketdyne in any areas. There's no overlap in rocket engines, and we haven't heard any objection from either competitors, customers, or the Department of Defense yet.

23:49In fact, the investor relations contact over at L3 Harris right now has stated to analysts that he believes that the Department of Defense does not object to the transaction. So that's very important. I mean, as you can tell from our conversation, one of the main considerations and analysis that we do is with regard to regulatory approvals, because that's what's going to hold up a deal that's going to control the timing, and that can block a deal. There are other things that can block a deal, such as a shareholder vote, which we have here. This is a great premium. Nobody's going to vote it down.

24:26The failure of financing. Financing is in place here. So if you look at all the targets that need to be knocked down for a deal to be successful, these guys have them lined up pretty well. Most importantly, again, I would stress is that they don't compete with each other, and the Defense Department has not objected to the transaction as of yet. So we think it's going to close probably early September or so. It's trading at about a 3.5 % gross spread. And if you annualize that, again, which is how you look at it, because we want to compare apples to apples. We're always comparing deals that have a month to go with a deal that's got six months to go, a deal that has a year to go.