Castlerigg Merger Arbitrage UCITS Fund

Best Performing Risk Arbitrage Fund

Originally published in the February 2013 issue

Tom Sandell’s Castlerigg Merger Arbitrage UCITS fund has scooped the top UCITS Hedge award for the second year running, in the merger arbitrage category. In 2011 Sandell won by virtue of having preserved capital in a challenging year for the strategy, while in 2012 his fund propelled returns into double-digit territory with a gain of 10.95% in the Euro class or 11.34% in the GBP class, towards the top end of the fund’s 8-12% return target. Assets in the fund have just reached $110 million, roughly trebling year on year.

An improving climate for corporate activity has helped. The fourth quarter of 2012 saw M&A volumes jump by 35% in Europe and by 63% in North America, according to Dealogic and Citi. Sandell, who has been investing in mergers globally since 1989, cites huge corporate cash holdings of $3.5 trillion as one driver for deals. Additionally, private equity firms have $500bn of un-invested, un-levered capital to deploy. He also argues that given anaemic economic growth, buying revenues is easierthan generating hard to come by organic growth.

As well as announced merger and takeover deals, the Castlerigg fund invests in various other types of corporate events including equity restructurings, recapitalisations, post-reorganisation equity, Dutch tenders and buy-backs. Spin-offs and split-ups can also be bought, which are often the precursor for merger activity. An equity bought after it exited bankruptcy became Castlerigg’s best performer of 2012. A management buy-out (MBO) at chemicals company TPC Group was proposed in August at $40. The management closed the deal by matching a competitive bid from Blackstone which drove the price higher to $45, almost double Castlerigg’s original entry point of $26. Another deal where initial terms were sweetened was ARCT – American Capital Realty Trust, merging with Realty Income.

Compuware was also a trade where Sandell originally invested as an equity special situation before the firm was subsequently put into play. The spin-off of Covisint made Sandell think that $8.5 was too low a share price, and a letter urging greater focus on maximizing shareholder value was sent to the firm. Activist hedge fund Elliot concurred, making an offer at $11.  Compuware is currently trading near $12. Another investment was Dutch logistics group TNT, bought after it announced plans for a recapitalisation and spin-off, which later became a bid target. Fortunately Sandell sold the stock before the European Commission blocked the takeover. Sandell is tactically astute in booking solid profits when the risk/reward of a trade starts to deteriorate.

Activism attracted Sandell to Family Dollar back in 2011. Activist investors Pershing Square and Trian’s involvement, plus a recession resilience and margin expansion story looked compelling. Sandell held the position for around a year, exiting at a substantial profit.

January has started well for M&A. Sandell remains bullish, based on companies being loaded up with cash, and valuations remaining very reasonable. But not every deal meets his criteria. The spread on Heinz, being bought by Warren Buffet, is just too tight, as are most mergers in Japan where low interest rates depress spreads. Emerging markets, and some countries such as Greece, are avoided for different reasons related to their risk profile.

Small caps also rarely find their way into the fund. Sandell feels mid caps between $500 million and $3 billion are the sweet spot, offering adequate liquidity and more scope for competitive bidding wars than mega caps.

All in all, Sandell expects 2013 will be better than 2012, as we move into what he terms “the second inning of the cycle”. His fund has already gained 3% in January, and he is confident enough to be using 10% leverage to invest in additional opportunities (no leverage is ever used at position level).

The fund is up 4.11% YTD.

Fund manager: Sandell Asset Management
Portfolio manager: Tom Sandell