Merger arbitrage

Despite various headwinds, 2018 was a vintage year for M&A – the third largest ever with $4.2 trillion of announced deals globally – according to Schoenfeld, who was a proprietary event-driven trader at banks for 20 years before founding PSAM. “This activity was partly due to pension funds and private equity firms more actively initiating control investments. They most recently include Dutch pension fund PGGM in Europe, giant pension funds in Canada and leveraged strategic infrastructure investors such as Brookfield.” 

Merger arbitrage generally carries a heavy weighting in PSAM portfolios and serves as the ballast due to the idiosyncratic nature of the strategy. Merger spreads, in some cases, have moved wider due to political and regulatory risk. “US and China are the most obvious focus of concern,” observes Schoenfeld. “China had been an active acquirer in the last four or five years, focused on oil and technology, but recently technology has been under close scrutiny in many countries, influenced by the US’ concerns and some acquisitions have been blocked. The recent Huawei focus has exaggerated the impact. It is not only the expanded remit of CFIUS [The Committee on Foreign Investment in the United States] for inbound US acquisitions that has been impacted, but China’s antitrust agency SAMR has also hindered purchases of companies with significant revenues locally. The NXP Semiconductors/Qualcomm deal last year was the most high-profile casualty of the Chinese authority’s reach.” Schoenfeld sees some risk of the EU becoming more protectionist, too. “Europe has already sought to protect its technology sector from US dominance and this tendency may have further to go,” he predicts. Though there have been no official changes in competition policy, the zeitgeist of politics is moving in a xenophobic direction with far-Right nationalist political parties getting more votes. There will also likely be a change to the [EU] Commissioner of Competition.

The textbook description of merger arbitrage characterises the strategy as selling puts on, and seeking to minimise, deal breaks. A modest risk premium can be extracted by following a substantially or entirely rules-based approach that minimises deal breaks in a probabilistic way and exits positions upon a deal break; both discretionary and systematic managers are doing this. But for those managers like PSAM who carry out fundamental valuation and serious regulatory analysis, a share price swoon upon a deal scupper or temporary setback can spell opportunity. 

Longer timeframes for deals to complete are also contributing to widening spreads. Schoenfeld notes that, “regulatory delays can mean some acquisitions are taking a year or more to consummate despite a successful shareholder vote and companies are being criticised by holders such as PSAM for carrying out shareholder votes prematurely. The US is somewhat unique in requiring its shareholders to approve well before regulators have blessed a combination. In recent cases, the terms, while attractive at the time of the vote, may no longer be attractive for the target after spending years in the hands of the regulatory agency. Boards of directors have no recourse to withdraw their support unless the contract has expired. It’s clearly time for contracts to reflect that longer dated deals must be re-underwritten by boards and their shareholders or penalties added to the shareholders’ terms for significant delay”.

Competitive bidding wars are one type of deal that can provide outsized unleveraged returns. “Anadarko, for instance, is a substantial position and thus far we are happy with how we have traded it,” says Schoenfeld. “We have been watching Chevron for decades – it has been a behemoth of an acquisition machine buying Texaco, Gulf Oil and Unocal – overcoming competitive, litigious and geopolitical issues to do so. We were not surprised to see Chevron trump Occidental’s offer and were pleasantly surprised that Occidental cleverly engineered a bid that could avoid the need for a shareholder vote, by using preferred stock funding from Berkshire Hathaway. We expect to see more acquisitions in the energy space, possibly including assets in the Permian basin, as private equity firms vie for prized assets. In Europe, the bidding war for the UK’s Sky was an example of a position that we thought could turn into a bidding war at the time of investment, which then came to fruition in 2018.”

PSAM will occasionally short deals where spreads are too tight, the risk/reward is very skewed, and a low chance of counterbidding exists. “These situations pass our risk/return framework very infrequently and in most instances, we forego them to focus on more attractive risk-adjusted return opportunities,” says Schoenfeld. Broadly, PSAM expects “merger deal flow will continue to be driven by technological disruption, the search for earnings growth and the search for business diversification, rationalisation and scale,” he adds.

Omar Sayed, portfolio manager of Asian and European Equity, who joined PSAM in 2011, will contribute an article digging deeper into the specificities of European and Asian event driven opportunities – where PSAM has been active in markets such as Italy and Australia – in a forthcoming issue of The Hedge Fund Journal.

Synergies between strategies

PSAM’s culture is to actively encourage crossover amongst the firm’s three strategies. That kind of collaboration is rewarded, and firm-oriented remuneration incentivises teams, who are not siloed, to share ideas.

“Valuation is a moving target that changes with the sector, and if a merger deal such as ATT/Time Warner has been delayed for two years, it is quite possible – especially during a bull market – that the original offer price may have fallen behind the latest price target. After the US sought to block the ATT/Time Warner deal, PSAM’s Head of Special Situations, Rich Bilotti, believed Time Warner was no longer fairly priced, because the valuation of peers had moved up significantly in the interim. There was only a brief window of opportunity to exploit this however,” says Schoenfeld. There are other examples of internal synergies. “When the distressed team are looking at a debt for equity swap, they will seek the opinion of the special situations team for valuations particularly if a private firm is going public in the process. Often during liability management exercises (where companies are exchanging debt that is to mature in the short run for longer dated paper with more attractive characteristics) companies will demonstrate a keen understanding of their market positions and we may tend to migrate down the capital structure into the equity as a special situation investment,” says Schoenfeld.

Credit instruments are also utilised if they offer a better risk/reward to express a view on corporate events such as mergers. “This happens most often when a private company has public debt but no public equity. It was a threatened credit downgrade that originally sparked our interest in Vivendi a few years ago as a sum of the parts investment while unbeknownst to us at the time, Vincent Bollore was also building up a stake,” Schoenfeld adds. 

Spin-offs and asset sales: partial not pure M&A

“Special situations involve a deep fundamental dive from both a value and catalyst perspective. Naturally, these positions have softer events, more beta than the other strategies in our portfolio so depending on the price of volatility, may be hedged by a one delta basket, put strategies, generic index overlays or various combinations,” says Schoenfeld. Conglomerate break-ups are a stock in trade for PSAM. Tax law and accounting rules have always been important considerations and recent changes to them could be pivotal for some types of deals. These “sum of the parts” valuation anomalies have been well documented by academics for decades, but they may persist longer than expected partly because passive, index tracking and benchmark-conscious investors do not pay enough attention to them until highlighted by the sell side and/or activist investors. PSAM seeks valuation discrepancies of at least 15% in addition to a discrete catalyst to be included in the portfolio.

PSAM’s process blends regulatory, legal, capital markets and tax analysis, where the firm seeks out winners and losers from US tax reforms, which have reduced the headline rate from 35% to 21%, but also reduced the tax deductibility of interest, which may shift the financing mix towards equity for some deals. The tax repatriation holiday could add as much as USD 3 trillion to the USD 1.7 trillion of cash sitting on the balance sheets of S&P 500 companies, which means more dry powder for deals.

“Tax law is an impetus for more M&A deals in all situations. It had not been possible to liquidate a US company without incurring tax at the corporate level; hence spinoffs were a more tax efficient way to effect a sale. Now that corporate tax rates have come down, an outright asset sale is more attractive than it had been previously. New accounting changes allowing for the write-up and re-depreciation of assets effectively diminish the net cost of making an acquisition from a conglomerate, so companies can divest more quickly. This more fluid situation in M&A, corporate divestment and spin-offs, creates a robust opportunity set for special situations based on partial rather than pure M&A and has application to private equity as well as strategic buyers including for targets emerging from bankruptcy. We are probably only in the early stages of this segment of transactions because companies are only just starting to get comfortable with the accounting rule change that came into law slightly more than a year ago,” predicts Schoenfeld.

Credit 

Mergers apart, PSAM’s Deputy CIO and co-Head of Credit, Peter Faulkner, who has been with the firm since 2002 and has invested in distressed and special situations since 1983, is broadly sanguine on credit, pointing out that defaults are low and QE is not in fact being completely tapered. At the same time, PSAM’s five-strong credit team led by Faulkner and Phil Brown are cautious given that disruption is creating losers, covenants are weak, and the new liquidity landscape – marrying potentially fickle ETF and mutual fund investors with depleted dealer inventories – has not yet been tested in a full-blown crisis.

Therefore, PSAM prefers to focus on process-driven credit situations, where the firm can help to shape outcomes through in and out of court restructurings, including events such as liability management exercises. “Though defaults are low, there are intermittent and selective opportunities in distressed, where CCC rated debt has not recovered as much as BB rated paper. Certain industries and companies, including in power and retail, have run into specific troubles, but it is hard to find the classic distressed trade of ‘good companies with bad balance sheets’. We are wary of energy sector names as we do not have much conviction on the direction of commodity prices. We are identifying very name-specific opportunities in software, telecoms and steel companies with stressed capital structures, mainly in the US. European distressed is closer to a private equity style of investment,” Faulkner says.

European credit spreads have been severely compressed, though PSAM could revisit the area if a dislocation made valuations attractive. PSAM strategies have allocated as much as 70-80% of their credit sleeve to European distressed credit in the wake of the European sovereign crisis. 

Analytical process 

“Our business is people dependent and we need to be more than the sum of our parts,” says Greenwald. The investment process for all strategies is structured and documented. “We’re keen to always have the portfolio managers put pencil to paper and work through their investment ideas in a structured way, above a predesigned investment threshold. Investment teams draft an in-depth memo setting out their investment thesis, which is reviewed by peers during twice-weekly investment committee meetings where all of the forces of the firm are brought to bear. There are guidelines on reducing positions that drawdown beyond pre-set levels, unless the position is re-underwritten at the committee. Our morning meetings review existing and newly available opportunities as well as relevant macro influences,” says Schoenfeld. To complement in-house expertise, PSAM uses external lawyers and other experts to advise on issues such as corporate disclosure, corporate governance, tax, regulatory and competition law.

Risk management

Recently the firm introduced more separation between portfolio and risk management. A senior risk manager with 10+ years of experience, Oleg Rakov, has been hired as the CRO and now reports directly to the management committee. “We have implemented a risk framework that allows the firm to evaluate and analyse the effectiveness of the processes we employ across the three strategies – it’s clearly an iterative process but has been an important step in our development,” says Greenwald. The firm’s dialogue with CdR Capital (a London-based asset manager in which PSAM has an ownership stake) has been helpful on the risk side in terms of looking at risk factors, flows, and how share prices react to earnings releases, which can be an extreme reaction of a sharp drop after a small miss.

PSAM is generally seeking to isolate idiosyncratic corporate events, control portfolio volatility and hedge out other risk factors. “If a stock has high beta, this could be hedged out with a basket of similar securities. Options on indices can sometimes be a cheaper way to hedge, depending on the pricing of implied volatility. The indices used could be generic ones, sector-specific baskets or customised baskets. Currency is hedged as a matter of course, and there are also hedges on equity and credit,” says Schoenfeld.

Assets, vehicles and ESG

Greenwald joined PSAM in 2002 after a few years at Reuters and has led a business development drive that grew assets from c.USD 400 million to a peak level of c.USD 4 bn. With assets around USD 2.2 billion in May 2019, there is capacity in all strategies.

PSAM offers managed accounts; commingled Cayman or Delaware funds, and was one of the first US managers to launch a UCITS back in September 2010. “We’ve stayed in the game and thrived because we were able to constantly evolve,” says Greenwald. As of early June, PSAM has transitioned the UCITS fund from the Morgan Stanley FundLogic platform to a new platform recently purchased by Generali, called Lumyna (originally Merrill Lynch Investment Solutions) and has been renamed the PSAM Global Event UCITS Fund. A strong multi-year partnership with Morgan Stanley’s FundLogic UCITS platform helped PSAM to raise assets of c.USD 700 million for its UCITS fund. The Lumyna fund went live in early June 2019 and we expect a wave of inflows from pent-up demand,” says Greenwald.

The PSAM Global Event UCITS Fund carves out the more liquid subset of PSAM’s flagship strategy and is intended to deliver a slightly varied return profile with less volatility than the flagship, which will typically pick up some degree of illiquidity premia from trades that would not fit into the UCITS fund. The UCITS fund caps credit at 20% and avoids bank loans (because of the UCITS guidelines). Even so, the flagship strategy – which has delivered a Sharpe ratio over one since inception in 1998 – operates towards the liquid end of the event and distressed investing spectrum, generally seeking event catalysts within one year. 

PSAM’s evolving ESG approach is being integrated into the investment process. “Each investment memorandum has an ESG matrix, coordinated and maintained by the CRO. There is no dedicated ESG team, but ESG is part of the overall process and has been for many years. PSAM recently became a signatory to the UNPRI. The ‘E’ and ‘S’ are considered in most investments that do not seem like obvious ESG candidates, which can include coal-powered utilities transitioning to renewable energy generation,” says Greenwald.

Staffing, women in finance and succession

“In the late 1990s, PSAM were amongst the earliest hedge fund managers we know of that hired women in investment and trading roles,” says Greenwald.  

In the New York office, Reggi Reich Gerber, a Founding Partner of PSAM, worked with Peter Schoenfeld for 40 years before retiring in 2018. In the London office, Ilse Weidlich, who was Head of European Trading, left the firm in 2017, after 19 years. C-suite women currently at the firm include Greenwald, who featured in the 2017 edition of The Hedge Fund Journal’s 50 Leading Women in Hedge Funds report published in association with EY, and CFO Annie Lerner. Previous editions of the report – which has been published since 2009 – might well have featured Gerber and Weidlich, who appear to have had a low media profile. 

PSAM has recently selectively interviewed female investment professionals in a search for somebody with the right skillset and experience. “We’re quite focused on finding women to place in positions where they will have an impact,” says Greenwald. 

PSAM’s succession planning has recently been finalised after sounding out stakeholders including investors, distributors and investment consultants; growing assets are testimony to their collective vote of confidence in the plan. “Peter Schoenfeld has the energy of a man in his thirties, his passion for deal dynamics is unparalleled,” says Greenwald, who, for the record, is Schoenfeld’s daughter. Even so, it seemed prudent and good practice to put in place a succession plan, which also has the effect of creating a more demarcated firm governance structure. With no external shareholders, this succession plan and firm re-organisation was simpler than it might have been at some other firms.

Greenwald has assumed the role of Co-Managing Member with Peter Schoenfeld. The firm has had a management committee in place for the last nine years where Dhan Pai, Managing Partner, President & COO, Peter Faulkner, Greenwald and Schoenfeld all play an active role. “The four of us together have successfully been managing the firm through  multiple market cycles. ,” says Dhan Pai. The committee is responsible for the strategic direction of the firm and has developed extensive plans for the business over the years to come. As CIO, Schoenfeld retains ultimate veto, but 17-year PSAM veteran Peter Faulkner is now in a newly created role of Deputy CIO for the whole firm. He has spent more of his career specialising in credit but is now turning his attention also to equities, harking back to his earlier career in value equity management.

Adds Greenwald, “We’ve managed to continue to perform and adapt in a world where returns are harder to come by and fee structures have been challenged but as asset price dispersion and market volatility pick up, we will re-enter a world where our traditional skill sets become more valuable. PSAM has been successful because of our comprehensive planning, focus on risk management and ability to attract the best talent. With the management team in place, and the depth of the team we currently have, PSAM expects to continue to build on the franchise cultivated over the past two decades”.