Q: Could you give us some background information on the history of the fund?

The history of the fund would have to start with my own history. I grew up in a small town in Michigan and I always wanted to trade. I went to DePaul University simply because it was three blocks from the Chicago Board of Trade. I started out in my third year in the Treasury bond futures pit, jumping up and down, yelling and screaming in brightly colored coats, and I worked my way up to having a seat at the board.

In that period I realized that everything was going to be electronic one day. I got out of futures trading quickly and started working for a limited partnership. That was in the early 90s, before they were even called hedge funds. I worked for several guys that came from Bear Stearns, which, at the time, had the best merger arbitrage trading desk on the Street. There I crafted my skills and learnt the business. I worked for them for five years and reached the partner level. Then I realized that it was mostly family money in that fund, so I left in November 1997.

In January 1998, I started Chicago Capital Management with $550,000. The fund was a broker dealer, so we could get the leverage. We were a market maker on the Chicago Stock Exchange providing bids and offers, and numerous securities that were involved in mergers, and we did pretty well. 

As things progressed, the world changed. Spreads narrowed, interest rates when down. Trading became much more electronic in nature. Compliance became more important, and we grew from several guys in a closet to a company with legitimate offices, professional services, a big-name auditor, tax accountants, third-party administrator, and all the bells and whistles that you need to be considered an institutional fund manager. 

Q: What is your investment philosophy?

The goal of the fund is to provide high single-digit or low double-digit returns consistently and in every environment. Our goal is consistent capital growth, compounding year after year with low volatility. 

I was brought up and taught that the first rule of investing is to never lose money. The second rule of investing is to never violate rule one. The third rule is to try to make money now. If you have $1 and lose 50%, even if you make 50% in the next year, you are still down. It is incredibly important to provide consistent returns year after year and to outperform my peers.

My goal has never been asset gathering. After being in the business for 18 years, I have only $170 million of assets under management and the SilverPepper Merger Arbitrage Fund has only $12 million. Many fund managers try to raise as much capital as possible and then collect a fee. I would have probably made a lot more money for myself if I would have pursued that venue, but I always took pride in earning money for my clients, not in the fees that I was able to charge them. 

I believe that’s more of a Chicago thought process that comes out of the pits. In the old days, the standard deal was to take the expenses out of the account and then to split the profits 50/50 between the investor and the trader. I have always lived by the rule that you have to earn the money that you make, not just raise money, let it sit in an account, and collect a fee. 

Q: What is your investment strategy?

We are merger arbitrage specialists and our strategy is similar to that of an insurance company. Basically, we ensure people against the risk of a merger falling apart. 

If the merger goes through, we earn the difference between the price when the merger is consummated and the price when we purchased the stock. That difference is called the spread and that’s our profit on each individual trade. Obviously, if the merger falls apart, the target stock will decline significantly and we will suffer a loss. 

It is very similar to how an insurance company works when it insures homes in Florida. If there is no hurricane, it keeps the premiums and makes money. If a hurricane destroys homes, the company will have very large payouts to make.

To clarify, the fund doesn’t speculate on whether a company will be acquired and doesn’t try to capture that 20% to 30% jump. The fund invests after the merger has been announced and the stock has already jumped 20%. We target the increase over the next three to six months; the increase between the announcement and the date when the deal is closed. 

That is a big differentiator from other strategies because the stock, assuming the merger goes through, is going to march up to that final deal price. Any fluctuations on the market over the course of those months are not going to affect the merger transaction. Statistically, about 96% of the announced mergers do actually close. 

The strategy results in very low volatility and low correlation to the equity market. It allows our investors to sleep at night. We consistently make money, pretty much month after month, without the volatility. After all, it is about boring consistent compounding of returns. It does not get anyone really excited but compared to other investments after five years it provides a very favorable stream of income. Merger arbitrage is a niche strategy and a less volatile investment style with a history of providing great returns over time. 

Q: How would you describe your research and investment process?

We only invest in announced mergers and we limit our universe to the U.S. and Canada. When a merger is announced, there is usually a press release. We evaluate the terms of the merger and make sure we understand the deal, the regulatory risks, the possibility for an antitrust problem, and the time needed for approval. 

For example, deals involving public utility companies are reviewed by commissions and that can take a great deal of time. That’s a factor we consider. We also review the 8-K file that contains all the terms, conditions, and specifics of the merger as drawn up by the attorneys and signed by each company. All of that information is considered. 

We may call the companies to understand any unresolved issues, and we would call the analysts on Wall Street to get their opinions. We always try to find out if there are any skeletons in the closet. For instance, for a drug company, we would try to understand if there are any potential lawsuits or patent infringement trials on the horizon.

Then we move towards building our position. We usually take about 50% of a full position the first day. Then we add to that position over the life of the deal as the companies achieve certain milestones or get regulatory approval. When the timing becomes more certain, and if the rate of return is still attractive, we will continue to add to our position.

Q: What characteristics of the merger deals do you consider before investing?

Some deals may be announced as tender offers. Companies like Oracle, with lots of cash, tend to purchase companies for cash and to structure the merger as a tender offer. By rule, the tender offer has to be made public and launched within five business days of the announcement, and then the tender is outstanding for 20 business days. Assuming that all the regulatory approvals come in as expected, they will do a second-step merger and close it. But from our perspective, we invest during that first step, which can continue for 25 to 30 business days. 

Then, there are companies that merge and exchange stock. After the deal is announced, they may need to get antitrust approval. The proxy has to be approved with the conditions of the merger and all future projects of the combined company and each separate company, as well as recommendations of the boards, advisors, and lawyers. Then the shareholders receive that document and it needs to be outstanding for approximately a month before a shareholder meeting. The shareholders approve it and then the stock transaction will close. The process usually takes about four to five months.

Another aspect refers to companies like Baker Hughes and Halliburton, where a significant overlap in multiple markets makes the deal very complex. The U.S. government may examine the deal for a very long time without granting regulatory approval. Usually, the companies would go ahead and have their shareholder meeting while still waiting for the regulatory approval from the Department of Justice or the Federal Trade Commission. The process may continue to the point when either the regulators file a lawsuit against the companies to block the merger or the companies abandon the merger. 

Q: Could you give us an example of a specific investment?

One of our more successful recent trades was a local textbook manufacturer which was trying to purchase another company for years. There wasn’t a cultural fit, so the deal never occurred. Then, all of a sudden, the target company signed a deal with someone else. It was trying to sell itself to a white knight, even at a lower price, because it didn’t want to work for the big company. At that moment, I had the opportunity to invest in that trade for a positive rate of return with the chance for significant upside if the big company came back in play. It was the best of all worlds. In the worst case scenario, I would still make some money in a solid deal and in a basic industry. In the best case scenario, a bidding war of egos would erupt. That is a good situation, but such situations do not happen very often. 

Q: What is your portfolio construction process?

The benchmark that we use internally is HFRI ED-Merger Arbitrage Index. We aim to be as diversified as possible, although sometimes that’s difficult if deal flow dries up. We limit the maximum position size to 20% of our portfolio. Typically, our larger positions are close to 10% of the fund’s value. We do use leverage which allows us to be invested in about 30 mergers at any time. 

Typically, half of our positions are cash deals and the other half are stock deals. In a stock deal, there is a long and a short side, while a cash deal has just a long side to it. So our portfolio is about two-thirds long and about one-third short. 

We are typically leveraged about two times. If we have $1 in cash, we are usually long $1.40 worth of securities and short $.60 worth of securities. We manage several client portfolios and each has its own restrictions. 

Q: How do you define and manage risk?

Traditional risk parameters such as standard deviation are not very applicable to us. If a deal is great today and falls apart tomorrow, the standard deviation will go to pieces. The stock will be down significantly and we will lose a lot of money. I take pride in the fact that in 18 years there has been only one occasion when we lost more than 5% of a portfolio’s value on a single merger. 

Our risk assessment is focused mainly on the potential loss in value of a stock in the event an announced merger falls apart. We try to equate that value to 5% of the fund’s NAV and that’s our maximum position size. We don’t violate that five-percent rule under any circumstances because we are trying to build a long-term franchise. We don’t aim to be a one-hit wonder or retire tomorrow or next year. We want to retire in 20 to 30 years after doing money management successfully for 40 or 50 years. That is our strategy and we are very cognizant of the long-term success. 

Let’s take the example of two equal companies merging, with the target being acquired at a 100% premium. If the target trades at $10 at the time of the announcement, the purchase price would be $20. After the announcement, assume that the target would increase to $19. If the deal falls apart, the target would fall back to $10, its pre-announcement price. The risk in that transaction is easier to gauge. 

However, it is a completely different story if, for example, a biotech company, which just received test results that nobody knew about, and which has the latest and greatest technology to cure cancer, is being taken over at a 100% premium to its latest stock price. You have to factor in that this merger would fall apart only if the drug is not working or a test trial down the road failed. If a $10 stock was taken over at $20 and the deal falls apart, this stock could do down to $1. 

So, in some transactions the risk is very high and you need to exercise extreme caution and diligence. The size of the position has to correspond to the merits of the deal, to what the market is telling you, and what really could happen. 

You also have to take into account the unforeseen. A few years ago, we invested in a lens-making technology company that was being taken over. This specific company had made the lens for the Hubble telescope, considered to be a national security prize possession, for 10 years prior to the takeover and had the technology for 20 years. When the deal was announced, however, you could get better lens technology off the shelf with Kmart binoculars because the science and the industry had progressed so much in that decade. Yet, the government blocked that merger initially. It was completely illogical and, ultimately, the decision was revised, but crazy illogical things happen with government approvals. 

You have to be prepared for the illogical randomness that may occur and to always be cognizant of the worst case scenarios when trying to determine downside risks and prices.