Q:  What is the investment philosophy of the fund? A: Our philosophy is to achieve capital appreciation by engaging in merger-and-acquisition arbitrage. This approach up to now has been primarily used by wealthy families and institutions in the hedge-fund world. As the rules and regulations have changed over the years, it has become possible for public funds to engage in these alternative strategies. The strategy is designed to generate consistent positive returns, independent of the moves of the general equity and fixed income markets. One of the main goals of the fund is preservation of capital. In terms of strategy and investment approach, profits are made from the successful completion of corporate reorganizations, either mergers, acquisitions, takeovers, spin-outs, or liquidations. Following the announcement of such a transaction, the shares of the target company are purchased at a discount to what we expect to receive when the transaction closes, referred to as the spread. Q:  How do you implement your investment philosophy? A: Depending on the type of transaction that is announced, our fund will follow a number of different strategies, designed to profit from that transaction. We are talking about publicly announced transactions involving publicly traded securities. Our decision to invest in a particular transaction is dictated by the size of the spread relative to the price of the target – the percentage return potential, compared to the risk associated with a successful close. Risks to the deal closing may include approval from shareholders or approval from various regulatory agencies. Another hurdle to a successful closing could be dictated by the buyer in the merger agreement; the target company must achieve certain financial targets. All these hurdles are laid out in some detail in the agreements, whether it is a merger agreement or a financing agreement, that are made public through SEC filings, regulatory filings, communications with the company and analysts. We examine the hurdles to a successful close of a transaction and the return potential associated with that transaction. In an all cash deal, there is no need to short the shares of the acquirer. In a stock for stock deal, the shares of the acquirer’s stock would be sold short. Depending on the terms of the deal, the shares are sold short in the same ratio as the deal terms. There are some deals that are pegged in value, based on the average closing price of the acquirer over a short period of time, prior to the deal close. Therefore, in some cases the shares of the acquirer would not be sold short until that pricing period begins which could be two, three, or four months down the road. If the acquirer is willing to give a certain value based on a fixed pricing period, then we move into the marketplace and begin to short when that pricing period begins. Deals of this more complicated variety require more complex hedging methodologies to be employed. Put and call options are utilized, if necessary. Q: When does the fund invest in a deal? A: We look to lock in a rate of return, the difference between where you can buy the target company’s shares today and what you will receive when the deal closes, which can be stock or cash. With stock deals, we look to sell those shares we will receive at deal close in advance through a short sale in order to lock that consideration in today. So, if we lock that consideration in today at a premium to what the target trades at today, then we have locked in the spread. To give an example, Procter & Gamble’s purchase of Gillette is a stock-for-stock deal. Procter & Gamble is offering 0.975 shares of their stock for every share of Gillette. If Gillette trades at a level less than 0.975 times the price of Proctor & Gamble’s shares, then the deal has a positive spread and may be considered for inclusion in the portfolio. Q:  Could you describe your research process? A: A thorough analysis is performed for each particular publicly announced transaction. We look at what the combined entity looks like relative to its peers once the merger is completed. On a valuation basis, we are looking at where the target’s shares trade relative to its peers. We are looking at fundamentals around all the situations that we have in our portfolio. Ultimately, we are fundamental analysts and view this business as fundamental investors buying these companies. Our return objective is a successful close of the deal in which they are engaged. The majority of the deals we are looking at are acquisitions and takeovers. Therefore, we are looking at the acquirer as well. An in-depth analysis of the shares of the acquirer, in terms of valuation, is done in order to understand the strategic rationale behind the deal. The stronger the rationale behind the deal, the more likely it is that the transaction will close, the more likely that the shareholders will support the transaction and the more likely that the market will embrace it as a value-enhancing transaction. We speak to antitrust counsel around some of the more complex deals to try and understand what it is that is driving the merger in terms of the interest that brought these two parties together, and to determine how the antitrust regulators at the Federal Trade Commission or Department of Justice will view the deal. Q:  How do you construct the portfolio? A:We look to construct the portfolio across a diverse array of deals. Any one deal would probably not exceed 5% of assets. However, our investment will also be limited by a worst case downside scenario. If the deal were to be canceled based on some unexpected news, we analyze where we expect the shares will trade. We construct a position in any particular deal such that the loss that we would incur if the deal breaks would not exceed 1% of the portfolio assets. We have never had that 1% rule exceeded. That downside dictates position size. We also look to mitigate any downside exposure we think that might exist through the purchase of put options. We spend a lot of money on such insurance in the portfolio. Industries that are in turmoil are avoided. For example, we tend to avoid airlines. Typically we do not look at the restaurant business or food-service businesses which have volatility around them. We look to avoid low value or volatile industries, which, through some change in either business sentiment, or the economy, can experience significant deterioration of fundamentals. Q:  Do you also have sector limits? A: Yes, typically we limit any sector to 20% of the portfolio. We also diversify within that industry exposure. For instance, in healthcare, we have an HMO deal, a skilled nursing facility deal, a medical technology deal, and a deal involving companies that build software around medical imaging. Q:  What other risk controls do you use? A : From a risk standpoint, we want to understand what it is that we own. What is the upside if the deal goes through versus what is the downside if the deal breaks? This is the “risk/reward’ ratio. What level of downside are we looking at? What is our potential loss? These questions are all part of our initial analysis and continuous research process. In addition, we are looking to eliminate the risk associated with the broader equity markets. We are looking at locking in spreads, not betting on stock prices or indices. We are looking at generating an absolute rate of return, regardless of what the markets do. The spreads may expand or contract, depending on what occurs in the marketplace. If the deal is to be delayed for regulatory review, the perceived risk increases, and the spread will widen. Likewise, the spreads will narrow on a day-to-day basis as deals move forward. That is typically the factor that adds volatility around returns in this strategy. The other issue that adds volatility around returns is if the deal does not close or appears less likely to close. Shareholders may voice their concerns, or regulators may extend their review, and therefore the spread can be volatile based on any number of issues. Given the research we do on a day-to-day basis, we are always monitoring and tracking deals, and that news will dictate the volatility related to spreads. Q:  Can you give us an example of how you apply your investment strategy to a certain pick? A: A recent investment was the recently completed acquisition of Creo, Inc. by Eastman Kodak. In an all cash transaction, Eastman Kodak was paying $16.50 a share for Creo, a smaller competitor in the data imaging segment. There was no risk associated with the value of Eastman Kodak shares with this deal because we were getting cash as opposed to stock. The primary risk associated with this deal was whether the authorities would allow the deal to go forward because of Eastman Kodak’s growing presence within the digital imaging sector. Another possible problem at Creo could have been an earnings problem. These potential issues haunted the deal and caused the spread to widen. The shares of Creo traded at a discount to that $16.50 – a discount we expected to narrow as the deal closed. When the deal closed, we collected the spread as our profit. Q:  Perhaps you will also comment on how the perception of government approval affects the volatility and risk spreads? A: In the case of Eastman Kodak buying Creo, there was a chance for the antitrust regulator to launch an investigation into the competitive aspects of the deal. However, with Eastman Kodak being a new player with a small market share in the product areas where Creo plays, we believed that the Department of Justice would most likely approve the deal without conditions. But what happens when the regulatory authorities are not familiar with a new technology or new products? The regulator may extend the review into the product lines or the products where the overlap is taking place. This is what the Department of Justice decided to do in the case of Eastman Kodak and Creo. The digital photographic transfer sector is a very small part of the business where Eastman Kodak and Creo overlap, but it is an important space that Creo and Eastman Kodak compete in against other companies in that particular sector. The Justice Department focused on how digital imaging would replace film as the dominant imaging process. Upon the announcement that the Justice Department was going to extend their review, the spread widened to reflect the longer time it would take to close the deal. Typically, that investigation would last about three or four months. So, we originally thought this deal would close early April, had they not gotten the additional review, but it eventually closed in mid-June. As spreads widen on news of an extended review, we may increase the position. When the risk/reward scenario is unfavorable, we may exit. As the deal gets closer to closing we may see better places to invest some of our dollars, reduce our positions or exposure to that particular deal, and allocate those resources to other deals that we think have better returns associated with them on a risk-adjusted basis.