SILVERPEPPER
MERGER
ARBITRAGE
FUND
2Q 2015
Our Hedge Fund
Experts Speak
Their Mind:
kid in a
candy store
I’m a kid in a candy store. Every morning I turn on my screens, and the merger
announcements pour in. My eyes widen, my lips part, and I start to lick my chops as I
consider the sweet implications of the bountiful merger and acquisition activity for the
SilverPepper Merger Arbitrage Fund.
The first half of the year set a record. According to Dealogic, U.S. targeted acquisitions
surpassed $1 Trillion (with a “T”) for the first time in the first half of any calendar
year. Both the number of deals, and the magnitude of the deals were impressive.
There were, for example, 17 domestic acquisitions that were larger than $10 billion
each. Healthcare was the most active sector, accounting for more than $290 billion in
transaction value across 500+ deals, as health-care companies scramble in the wake
of ObamaCare to reshape their businesses to the changing environment. The largest
deal of the first half of the year was the $78 billion merger of Charter Communications
and Time Warner Cable. With borrowing rates low, and economic and top-line growth
hard to come by, it makes sense for companies to get married.
Opportunity
Abounds
Robust merger activity is helpful to the Fund for a number of
reasons. First, the more deals the merrier. We typically like to have
20 to 35 deals in the portfolio at any one time. Currently we have 23. We have
always been picky, or selective, about the deals in which we invest. We want high-
quality companies, being purchased by well-financed acquirers, who are making acquisitions that are strategic to their
businesses and that have modest anti-trust or other regulatory hurdles to overcome. With more deals, we can build a
very high quality portfolio of companies where we have a high confidence level that the deals will close, and close on
time. Second, the more deals there are, typically the wider merger spreads become across the board. This translates
into the possibility of increased returns for investors, with no discernible increase in risk (traditionally, risk—as defined
in modern portfolio theory—is defined as “volatility,” or the ups and downs of investing). However, in merger-arbitrage
investing we think about risk in different terms, particularly: “what’s the risk of a deal falling apart, and not closing as
scheduled?” The more of a quality basis we can build into the portfolio, the more we are able to reduce the risk a deal
will not close, or not close on time.
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Regulators
are out in full
force
And deals are getting delayed. Indeed, several announced
mergers are collapsing under fickle regulatory enforcers. As
cataloged in a recent Wall Street Journal Article, “U.S. Antitrust
Review of Mergers Gets Longer,” the length of regulatory
reviews by the likes of the Justice Department, Federal Trade
Commission, or the Federal Communications Commission has increased to nearly 14
months, up from about 10 months. Not only is regulatory scrutiny delaying the completion of deals, and hence
having a dampening impact on returns, but it is also causing mergers to fall apart. The Comcast and Time Warner deal, as
well as the Sysco and U.S. Foods acquisitions, are just a few that have been quelled by regulatory approval.
We weren’t immune to government hand-wringing.
The SilverPepper Merger Arbitrage Fund also felt
the impact of these delays. Currently, our largest position is in the AT&T acquisition of DirectTV. In late June, we started to
hear positive comments on the merger that suggested the FCC was going to vote 5-0 in favor of the merger. But because
of the cumbersome regulatory process, the vote hasn’t happened. Consequently, the deal closing has been delayed past
June 30th, and is now expected to close in July. As a result of the delay, we had to pay a $0.47 per share dividend on the
AT&T short hedge, which will reduce our spread by 89 cents, and hence our profit on the deal. The delay in a closing for a
merger is part and parcel of merger investing, but the effects cascade downstream, primarily in that it hinders our ability to
maximize the compounding of returns, by delaying our redeployment of the profits into another merger.
SilverPepper Merger Arbitrage Fund Monthly Returns (%)
JAN
FEB
MAR
APR
MAY
JUN
JUL
SPAIX
AUG
SEP
OCT
2013
2014
-0.10
0.10
0.10
- 1.48
1.40
0.69
2015
0.60
0.99
0.10
0.29
0.78
0.10
0.79
0.68
-0.77
-0.10
NOV
DEC
YEAR
0.10
1.00
1.10
1.37
-0.23
2.44
2.88
One-Year Return as of 6/30/2015
4.66
Total Annualized Return Since Inception (10/31/2013)
3.89
Total annual fund operating expenses 2.56% gross; after contractual fee waiver and/or expense reimbursement,
capped at 1.99%. The advisor has contractually agreed to waive its fees and/or pay for expenses to ensure
that total fund operating expenses do not exceed 1.99% for the Institutional share class. This agreement
is in effect until November 1, 2024, and it may be terminated or amended prior to the end of the term
with the approval of the Trust’s Board of Trustees. Investment will fluctuate so that an investor’s shares,
when redeemed, may be worth more or less than their original cost. Performance shown is as of date
indicated, and current performance may be lower or higher than the performance data quoted. To obtain
performance as of the most recent month end, please call 855-554-5540.
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Good things
come
in small
packages
However, with mergers coming out of the woodwork, we have also been able to purchase
a number of deals that are smaller acquisitions (the targets’ market capitalizations range
between $100 million to $500 million). We like these deals because they typically don’t
get a lot of regulatory review—the businesses are simpler—and because they are smaller
transactions, competition is less and the spreads are frequently wider. Currently, out of
23 merger investments in the Fund, we have eight deals where the acquisition target is
less than $500 million, and nine deals between $500 million and $5 billion.
One area where we have found some mergers that meet our quality expectations is in the local
bank community. For example, Community Bank Systems, a New York State community Bank acquired Oneida Financial Corp,
in a $145 million dollar cash and stock acquisition. Both banks cater to similar customers in Upstate New York and Northeastern
Pennsylvania, allowing for an expanding reach and cost consolidations. In addition, we held the Bank of Kentucky, a $363 million
transaction, which closed during the quarter. As a strong player in the Kentucky and Cincinnati markets, BB&T snapped up the
regional player. BB&T had a strong, strategic interest in the Bank as a quick way to gain a toehold in these new markets.
Opportunistic
Leverage
Because of the quality of deals and the robust environment,
we have been increasing our economic exposure, or leverage,
within the Fund opportunistically. At the end of the quarter, the Fund
was approximately 130% long, and 56% short, or had 186% gross exposure to merger
investments. Leverage can cut both ways, increasing both the size of gains and losses. We understand this, so we try to stack
the deck in our favor. First, deal quality is imperative. We estimate 96% of all announced mergers and acquisitions close. Hence,
by being picky on deal characteristics, we can improve even further the probability of a merger closing. Second, merger-arbitrage
volatility, historically, has been about 3%. That’s 1/5th the long-term volatility of the S&P 500 and much closer to intermediate
bonds. So, we can grow our exposure to merger investments, and likely maintain five to six percent volatility at current levels of
leverage. Nonetheless, deals do break, and when they do, it can be like a parachute ripping at 10,000 feet. I have about 90% of
my liquid-net worth invested in merger arbitrage, so I want to be thoughtful about how and when we use leverage.
Indeed, even deals with very high-quality characteristics can go awry. Most recently, many merger arbitrage shops took it on
the chin by investing in the merger announced between two sister companies, Williams Companies and its subsidiary, Williams
Partners, of which it already owns 40%. Purchasing the remaining amount of Williams Partners, which operates 33,000
miles of natural gas pipelines, follows on the successful and similar related-subsidiary transaction by Kinder Morgan, another
energy firm. However, and unexpectedly, industry-competitor, Energy Transfer Partners, threw a monkey wrench into the mix.
It announced a hostile bid on Williams Companies. This caused the spread, on what was a very high-quality deal, to widen
significantly. Lots of folks owned the deal because they thought it was a slam dunk, so they built up large positions in the deal
and suffered losses on day the hostile takeover was announced. Risks in merger arbitrage investing are real and, therefore,
investing in these transactions requires discipline and respect for the unknown.
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Let ‘em raise,
let ‘em raise
Rising interest rates should be a tailwind to the Fund’s returns.
Merger arbitrage is all about the spread, the difference between the contractual
purchase price of a firm to be paid at closing, and its price after the announcement.
The spread is made up of three components: opportunity cost, plus time risk, plus
deal risk. Rising rates impact the “opportunity cost” of the spread equation. If we invest in a big-event like a merger, we
want to be compensated for the risk we are taking. At a minimum, if a deal is going to close in six months, we demand
a rate of return, at a minimum, that is as great as the six month T-bill, often referred to as the “risk-free rate” or the
“opportunity cost” of money. If we didn’t earn at least that amount, why take the risk? Hence, if Janet Yellen at the Fed
blows the trumpet to announce the beginning of long-overdue rate increases, we will not suffer the fate of fixed-income
investors who will see the value of their bonds decline. Our spread, and potential profit, should move up, or increase, in
tandem with the risk-free rate of money.
Looking Up
The market environment is favorable. The tailwinds of robust
merger activity, and the prospect of rising rates are positives
for the SilverPepper Merger Arbitrage Fund. By being picky about the
deals we invest in, finding opportunities in smaller-capitalization mergers where spreads may be wider, and by using leverage
opportunistically, we believe we are in a sweet environment for creating attractive returns. Importantly, these returns and
these risks—which stem from the successful or unsuccessful completion of a merger—should zig when the market zags,
providing portfolio benefits for investors looking to diversify from their dependency on the generic stock and bond markets.
Thank you for entrusting us with your hard-earned assets.
Yours,
Steven Gerbel
Portfolio Manager
SilverPepper Merger Arbitrage Fund
Investors should carefully consider the Fund’s investment objectives, risks, charges and expenses. Please see the prospectus
for a complete discussion of the risks of investing in these Funds. To obtain a prospectus, please call 855-554-5540 or visit
silverpepperfunds.com. The prospectus is boring but should be read carefully before investing.
As of 6/30/15, long positions in DirectTV represented 15.8%, Onieda Financial Corp. 6.5% and short positions in AT&T 9.7%,
Community Bank Systems Inc. 4% of the SilverPepper Merger Arbitrage Fund’s total net assets. None of the other
names mentioned represent a position in the Fund. Portfolio holdings are subject to the change without notice and are
not intended as recommendations.
All investing involves risk including the possible loss of principal. There can be no assurance that either Fund will
achieve its investment objective. For the Merger Arbitrage Fund, the primary risk is event risk which revolves around
the successful or unsuccessful completion of an announced merger or acquisition. If a merger doesn’t close as
expected, the fund could lose money. Other risks include smaller companies risk, foreign investment risk, derivatives
risk and non-diversification risk. Please see the prospectus for a complete discussion of the risk of investing in these
Funds. To obtain a prospectus, please call 855-554-5540 or visit silverpepperfunds.com. The prospectus should be
read carefully before investing.
Distributed by IMST Distributors, LLC.
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