By Gareth Abley, Head of Alternative Strategies, MLC
Investing in alternatives can cover an extremely broad range of investments, including everything from infrastructure to gold bullion. While you may have heard of these kinds of investments, there are other even less-conventional ways to deliver returns for investors which may surprise you.
The goal when investing in alternatives in our Low Correlation Strategy is to find investments that do three things. Firstly, to generate attractive risk-adjusted returns in their own right. Secondly, to deliver these returns in a manner that is lowly correlated to mainstream asset classes, particularly equities. And thirdly, we want the strategies in our portfolio to be lowly correlated with each other. If you can complete this trifecta, the return stream can be pretty compelling.1
The challenge is finding investments that meet these criteria – and this is not easy. We meet a lot of smart people who tell clever stories and have great track records… and yet we know that most of them won’t deliver attractive future returns. We also know that there is no ‘cookie cutter’ method for determining what will work. Indeed, anything that looks like a ‘no-brainer’ is often too picked over and past its use by date… whereas strategies that induce some level of discomfort often prove very rewarding. This means we need to be open-minded, sceptical, and willing to tread off the beaten track.
One strategy, which is a good example of where this mindset can lead is merger appraisal rights. This exists due to a little-known legal statute in Delaware (where a large proportion of US companies are incorporated), which is designed to protect a target company’s minority shareholders from being disadvantaged during a takeover. This sounds counter-intuitive as the vast majority of takeovers see the acquirer pay an attractive premium to shareholders. However, in a very small minority of cases an acquisition can be done ‘on the cheap’.
To protect shareholders against this risk, minority shareholders can exercise ‘merger appraisal rights’. This involves petitioning to the Delaware Court that the sale process was flawed and that the takeover price was too low. The Judge will hear both sides make their valuation arguments and make an assessment of the ‘fair value’ of the company at the time of the takeover.
What makes the opportunity particularly interesting, is that in addition to any uplift in the share price awarded by the Judge (or agreed in any settlement prior to reaching court, which happens approximately 50% of the time), the shareholder pursuing merger appraisal rights also receives statutory interest of cash+5% pa while this process plays out.2
A good example is the recent case of Dole Food Company. In November 2013, the 90-year-old Chairman and CEO, David Murdoch (who already owned 40% of the stock) took the business private at US$13.50 a share. The Judge’s ruling on this case, issued in July 2015, details 108 pages worth of corporate intrigue. It describes how Murdoch sought to drive down the share price prior to launching his takeover and then inappropriately influence an ‘independent’ takeover committee. His goal – which he would have succeeded with, absent the merger appraisal statute – was to buy at an unfairly suppressed price. As a result, the Judge awarded those who had exercised their merger appraisal rights a 20% premium to the takeover price, plus their cash+5% pa statutory interest.3
There are many important nuances to the strategy that can influence the outcome, and like any investment – it is not a risk free strategy.4 At the same time, merger appraisal rights align well with the three key criteria we want for any investment in our Low Correlation Strategy, particularly:
a) It has a high chance of attractive returns via two sources. Firstly, a high probability of an uplift in price if the right deals are selected and prosecuted skillfully – we use a specialist manager to do this. Secondly, the tailwind of the cash+5% pa interest. Downside risk is also low – as it is unlikely the Court will award a lower price than someone has already agreed to pay.
b) Low correlation to equities. Once the appraisal rights are underway, there is no exposure to equity market risk. This is because the award is based on an assessment of the fair value of the company as a going concern at the time the takeover closed.
c) Driven by idiosyncratic risks ie risks that are uncorrelated to anything else in our portfolio.
While there are no free lunches in investing, it is possible to uncover attractive opportunities like these. We will continue to seek these types of unique investment opportunities, particularly as we believe these kinds of return characteristics will be more valuable than ever in coming years if the low return environment plays out as expected.
1. The Low Correlation Strategy has delivered returns of cash+4% net of all underlying manager fees, with a correlation to equities of 0, and a volatility of 4% (a quarter that of equities) since August 2008. Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market.
2. The law recently changed to allow the acquirer to pay out the merger price in full to the shareholder pursuing merger appraisal rights, and leave them with the appraisal claim and 100% cash, in lieu of paying the statutory interest. Where the cost of capital is higher than cash+5%, which it is for many private equity firms and acquirers, they are likely to pay the cash+5%.
3. Delaware Court of Chancery Memorandum Opinion: In re Appraisal of Dole Food Company Inc, dated 2 July 2015.
4. Deal break risk and the credit risk to the acquirer are two of the main risks. While there are different ways to manage these and other risks, they can’t be eliminated.
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Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market.
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