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Required return on special situations


Lupo Lupus
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Do you have a framework for what return you require (hurdle rate) to invest in a special situation?

 

Suppose you require 10% on ordinary stocks, what return do you want on a specific special situation?

 

My thinking is that I vary this with the market dependence of the investment. For example, a liquidation where most of assets are already in cash will show little correlation with the market. I may hence compare it to the risk free return (eg government bonds). Contrast this with a liquidation where the company still has to sell a lot of real estate. The payout may then be really low if the market goes south in the meantime and liquidation happens at fire-sale prices. I may hence require the hurdle on stocks, or even higher (think of NYRT -- a leveraged real estate liquidation susceptible to fire-sales).

 

But how to apply this to other situations, like merger arbitrage? In principle the pay-off there might be unrelated to the market -- but maybe not fully as the merger might be called off if the market tanks.

 

Any thoughts on this? Any ressources to read up on this?

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This is a bit of an old man response.  I used to do a lot more liquidations.  There are a few issues.  I think if you can buy "cash boxes" in 2017, by all means do it.  But "cash boxes" tend to not exist in the euphoria of 2017.  The issue is that special situations requires a lot of turn over.  As an old man, I prefer to find 10 really good ideas that I can sit on for a very long period of time, i.e. BRK.  More turnover also expose you to more mistakes. 

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If you have the inclination, you might want to run some Monte Carlo simulations and decide for yourself what strategy you feel most comfortable with.  It’s hard to get more specific than that, partly because many of the key variables involved (like your risk tolerance and such) are ultimately subjective. 

 

Like BG2008 said, high portfolio turnover is a drawback to keep in mind here.  It not only increases the likelihood of making mistakes (because you’re constantly jumping into new situations), but it also tends to have negative tax consequences (though this depends on your personal circumstances).  Ideally you would want your calculations to reflect these issues.

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I was buying cash box liquidations 5-6 years ago with 20+IRR underwritten and I usually end up in the teens.  Be mindful of small liquidations, the fees eat up everything.  A lot of people figure out over time that the fees and the accounting adjustments is a pain in the ass, especially if you run a fund. 

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I don't think there's a clear-cut solution. Judge every special situation on its own merits. Some things I try to keep in mind:

 

- IRR is not as useful when working with short time frames

- what is the absolute spread?

- cash deals usually less risky than stock deals

- cross-border deals more risky and prone to delays

- liquidations tend to take longer than expected

- liquidations: how accurate are the values on the balance sheet? What effect would a small increase in liquidation costs have? Are there any relevant filings on Pacer?

- I find regulatory hurdles very hard to handicap

- what are possible reasons the spread seems juicy (i.e. uncertainty? something fishy? is the stock very illiquid?)

- in case of acquisitions: is it a big deal for the buyer or a very small deal? Is there a termination fee? Reverse termination fee?

- in case of acquisitions: is there a go-shop period? Were there other bidders?

- in case of offers: is there a minimum acceptance threshold? Is the offer conditional on anything else?

- what is downside protection in case something goes wrong?

- what are the incentives of involved players and what are they doing? (i.e. do they own shares? Are they voting / tendering / selling)

- does the corporate action make sense for everybody involved?

- position sizing: how comfortable am I adding if this goes down another 10%?

- how do you estimate the chances you are missing something (usually they are higher .. ) ?

- is it a liquid idea or not? has it received lots of attention (aka NYRT) or is it off the beaten track?

- what sector? I.e. I tend to avoid cannabis blockchain lithium companies.

 

etc. etc.

 

Sometimes a situation basically guarantees no loss of principal with some upside optionality: in that case 5% annualized can be great. On the other hand, if a highly leveraged Chinese company is trying to buy a nuclear power company in the US at a huge premium I'd be hesitant even if the market seems to offer 50% annualized. There's no formula for that. Read the documents, keep an open mind and think for yourself.

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I don't think there's a clear-cut solution. Judge every special situation on its own merits. Some things I try to keep in mind:

 

- IRR is not as useful when working with short time frames

- what is the absolute spread?

- cash deals usually less risky than stock deals

- cross-border deals more risky and prone to delays

- liquidations tend to take longer than expected

- liquidations: how accurate are the values on the balance sheet? What effect would a small increase in liquidation costs have? Are there any relevant filings on Pacer?

- I find regulatory hurdles very hard to handicap

- what are possible reasons the spread seems juicy (i.e. uncertainty? something fishy? is the stock very illiquid?)

- in case of acquisitions: is it a big deal for the buyer or a very small deal? Is there a termination fee? Reverse termination fee?

- in case of acquisitions: is there a go-shop period? Were there other bidders?

- in case of offers: is there a minimum acceptance threshold? Is the offer conditional on anything else?

- what is downside protection in case something goes wrong?

- what are the incentives of involved players and what are they doing? (i.e. do they own shares? Are they voting / tendering / selling)

- does the corporate action make sense for everybody involved?

- position sizing: how comfortable am I adding if this goes down another 10%?

- how do you estimate the chances you are missing something (usually they are higher .. ) ?

- is it a liquid idea or not? has it received lots of attention (aka NYRT) or is it off the beaten track?

- what sector? I.e. I tend to avoid cannabis blockchain lithium companies.

 

etc. etc.

 

Sometimes a situation basically guarantees no loss of principal with some upside optionality: in that case 5% annualized can be great. On the other hand, if a highly leveraged Chinese company is trying to buy a nuclear power company in the US at a huge premium I'd be hesitant even if the market seems to offer 50% annualized. There's no formula for that. Read the documents, keep an open mind and think for yourself.

 

writser is the special situation capo di tutti i capi.  8)

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I have printed out writsers post. Great stuff, thanks!

 

Quick question, as one thing doesn't square with my experience. Why would you say cash is less risky than stock? Obviously some of your other factors come into play here (eg size) but it seems to me that having to come up with actual cash increases risk.

 

A buyer can pretty much always print more of its shares to fulfill a deal, and if I hedge them out I don't care what happens in the meantime. I suppose a big decrease in stock price changes the chances of shareholders approving?

 

Actually, as I think about it, this just happened on one special situation I did, where Precision Drilling lost a bid to Ensign because Ensign offered cash and Precision's bid (which was a topping bid) dropped materially in value due to the oil market rout. I bought slightly below the cash value hoping for a raise from one, which didn't happen.

 

On a straight acquisition though I wonder if share deals are more or less likely to close. My guess would be slightly more likely because financing doesn't fall through, but would be curious to hear thoughts on the matter.

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A cash deal that doesn't have financing ready might be more risky, but for a deal that is financed with for example cash on hand or existing credit facilities the cash deal offers a certain return while in the stock deal you have to hedge the acquirer to lock in the current spread. But hedging might not be possible because insufficient shares are available, it could cost quite a bit in borrow fees, and it might eat up a huge amount of your margin space if the target and/or acquirer can't be bought on margin. Additionally, there are scenario's possible where both your long and short hedge will move in opposite directions (could be deal breaking for example). So everything considered, usually a cash deal is preferable above a stock deal :)

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I have printed out writsers post. Great stuff, thanks!

 

Kind words, thanks. By no means do I think the list is complete. Just some stuff that came to the top of my head. I think there was a decent checklist in the latest book from Mario Gabelli (link - the rest of the book wasn't that interesting imho).  Also the old-school book from Maurece Schiller was very decent if you are interested in this sort of stuff (link). I thought it also featured some checklist-y thing. Not sure.

 

Special situations are a bit of an escalated hobby for me. I think the space is interesting, diverse and I like that it is a bit more quantitative, market-neutral and short-term oriented than investing in, for example, Berkshire. Also, I have a lot of spare time and I think this is a space where you can make money by spending a lot of time monitoring every new deal and every deal spread. I.e. I can convert spare time into money (one might call this: work). If you like special situations just follow a lot of them, read all the filings, discuss them with others, (lose some money), you'll get a feel for what can go wrong and what potential pitfalls are.

 

A cash deal that doesn't have financing ready might be more risky, but for a deal that is financed with for example cash on hand or existing credit facilities the cash deal offers a certain return while in the stock deal you have to hedge the acquirer to lock in the current spread. But hedging might not be possible because insufficient shares are available, it could cost quite a bit in borrow fees, and it might eat up a huge amount of your margin space if the target and/or acquirer can't be bought on margin. Additionally, there are scenario's possible where both your long and short hedge will move in opposite directions (could be deal breaking for example). So everything considered, usually a cash deal is preferable above a stock deal :)

 

Well said. On top of that, if one of the legs of the trade is (or both are) illiquid then hedging is super annoying because you'll get a fill in one leg and you end up chasing the market in the other leg Every Single Time. Setting up and unrolling a hedge is often expensive and time consuming. You can't leave limit orders in the market in one leg without monitoring them, you have to watch out not to get a fill just before the close, etc. With a cash deal you can be much more opportunistic and/or flexible.

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