Gabelli Merger Plus+ (GMP) has published its annual results for the year ended 30 June 2023, during which it provided NAV and share price total returns of 10.54% and 1.33% respectively (in US dollar terms). It compares itself primarily against the US 3-month treasury bill index, which returned 3.80% although given the radically different risk profiles, we struggle to see how this is a particularly relevant benchmark.
Manager’s comments on the portfolio
“Marked by stubborn inflation, conflict in Europe, and the Federal Reserve’s war on inflation, 2022 was a difficult year for risk assets, marked. Higher interest rates and the prospect of a recession spared neither stocks nor bonds, as the S&P 500 and investment grade bonds were down 18% and 13%, respectively. As we have noted in the past, our merger arbitrage portfolios generate returns from taking idiosyncratic deal risk and not market risk, and thus were able to earn a positive return for our clients, despite the volatile markets. Uncertainty in the boardroom, elevated borrowing costs, and a bid-ask divide- that often persists until market participants can digest a sharp decline in asset values- all contributed to a 30% decline in M&A volumes (ex-SPACs) in 2022. However, despite the sharp decline from record 2021 levels, volumes only declined mid-single digits from more normalized 2018 and 2019 levels. The fourth quarter did enjoy an uptick in announced M&A with a healthy $800 billion in deal activity. We expect M&A to remain fairly robust on a historical basis. In terms of merger arbitrage spreads, they remain wide and attractive compared to recent history. There are three main reasons for this: (1) market volatility; (2) perceived regulatory risk; and (3) interest rates. Deals close in all market environments, and volatility provides us with an opportunity, as it is often indiscriminate. Mispriced risk allows us to add to our highest conviction positions at lower prices-the benefits of which will be apparent as these transactions progress towards closing. Regarding regulatory risk, the aggressive policy reform rhetoric we have written about in the past has translated in some cases into aggressive action. Some deals were able to close in spite of regulatory action (Change Healthcare) and some were able to find alternative, less problematic suitors (Aerojet Rocketdyne). We feel as though this regulatory regime has created unique investment opportunities and an attractive risk/reward. Lastly, the merger arbitrage strategy is a beneficiary of rising rates, as the risk free rate is one of the components of a deal spread. As rates rise, nominal spreads should widen, all things being equal. With the 3 month U.S. Treasury bill yielding well over 5%, this should continue to create a more compelling spread environment going forward. We continue to find attractive investment opportunities in newly announced and pipeline deals. We remain focused on investing in highly strategic, well-financed deals with an added focus on near-term catalysts, and are upbeat about our prospects to generate absolute returns.
“U.S. capital markets rebounded significantly in the first half of 2023 despite headwinds. The S&P 500 finished the first half up 16.8% against the backdrop of a debt ceiling drama, a U.S. banking crisis, geopolitical uncertainty, and a Fed that has so far been unwavering in its commitment to fight inflation.
“M&A volumes did not prove as resilient, as economic uncertainty and combative regulators contributed to a 37% year- over-year decline in the first half. Despite this sharp decrease in dollar volumes, the number of transactions was only down 9% compared to last year. Deals are still getting done-albeit, smaller in size. The second quarter did begin to show some green shoots, as volumes totaled $750 billion, a 33% sequential improvement. We expect this momentum to continue as the year progresses.
“The aggressive policy stance of regulators has persisted in 2023, but companies are adapting and showing a willingness to fight back when case law supports their cause. Regulators’ efforts to bring cases with more novel theories of harm thus far have not translated into much success in court. While this has created volatility in certain arbitrage spreads, it has provided unique investment opportunities with an attractive risk/reward.
“A company’s PMV is not constant, and changes as a function of many variables. Our analysis emphasizes balance sheets, cash flows, and the long term defendable position of a corporation. We achieve returns through investing in businesses utilising our proprietary Private Market Value (“PMV”) with a Catalyst™ methodology. We PMV is the value that we believe an informed buyer would be willing to pay to acquire an entire company in a private transaction. Our team arrives at a PMV valuation by a rigorous assessment of fundamentals from publicly available information. Further, PMV’s are enhanced through the analysis of announced corporate mergers and acquisition activity. Mergers offer tangible insights into the long term capital allocation decisions of global corporations. We highlight several investments across sectors which have offered insights to the corporate allocation process below.
Notable contributors to performance include:
Defense Infrastructure
“The strategic rational around US defense spending as a long term investment continues, notably in the race to develop hypersonic weapons capabilities as seen in Aerojet Rocketdyne Holdings, Inc. (AJRD-NYSE) agreement to be acquired by L3Harris Technologies, Inc. (LHX- NYSE). Aerojet Rocketdyne Holdings, Inc. (AJRDNYSE), which designs and manufactures specialised power and propulsion systems for space and defense applications, agreed to be acquired by L3Harris Technologies for $58 cash per share, or about $5 billion. In December 2020, Aerojet agreed to be acquired by Lockheed Martin for $51 cash per share, but that deal was terminated in February 2022 after the U.S. Fair Trade Commission sued to block the transaction, claiming that Lockheed would be able to raise the prices the U.S. government pays for rocket engines, and potentially deliver a lower quality product Portfolio Manager’s review continued Half-Yearly Financial Report (Unaudited) for the six months ended 31 December 2022 11 to Lockheed’s rival defense contractors that utilise Aerojet’s propulsion systems. We believe the acquisition by L3Harris provides fewer antitrust risks than the Lockheed transaction did. L3Harris primarily produces electronics and communications systems, so there is no horizontal overlap with Aerojet’s business and no benefit from bundling the two companies’ products. An important distinction from the Lockheed deal is that there is also no vertical integration, as Aerojet does not supply L3Harris with any products used in L3’s programs, and Aerojet will become a new business unit for L3 as a merchant supplier of engines to prime contractors. We believe shares of Aerojet Rocketdyne were inexpensive after the deal with Lockheed Martin was called off and certain shareholders were forced to sell their position. At the time, shares traded at less than 10x EBITDA, a significant discount to its historical valuation, and Tony Bancroft, Gabelli’s defense analyst, thought other buyers for Aerojet would emerge and that shares were worth more than $60 in a takeover. We expect the L3Harris deal to close in mid-2023.
Food Distribution
“The attributes of consumer food distribution benefits through scale synergies and as such our investment in Albertsons Companies, Inc. (ACI- NYSE) entered a new stage as they agreed to be acquired by The Kroger Co. (KR-NYSE). Albertsons operates food and drug retail stores in the U.S. under banners such as Albertsons, Safeway, Vons, Tom Thumb, ACME and more. Under terms of the agreement Albertsons’ shareholders will receive $34.10 cash per share (inclusive of a special dividend and potential spin-off), valuing the transaction at approximately $25 billion.
Biotech Pharma
“Undervalued and fairly unique and well positioned business in our portfolio continued to attract suitors and as such Dechra Pharmaceuticals plc (DPH LN-London) agreed to be acquired by EQT and Abu Dhabi Investment Authority. Dechra is a global veterinary pharmaceuticals and products business. Under terms of the agreement, Dechra shareholders will receive £38.75 cash per share, valuing the transaction at approximately £4.8 billion.
Gaming and Entertainment
“Fundamentals for the online gaming industry continued to accelerate as Activision Blizzard Inc. (ATVI- NASDAQ) agreed to be acquired by Microsoft Corp. (MSFT-NASDAQ). Activision Blizzard develops and publishes interactive entertainment content and services. Under the terms of the agreement Activision shareholders will receive $95.00 cash per share, valuing the transaction at approximately $74 billion.
Financial Services
“Access to the US financial investor is increasingly becoming a valuable asset and as such Focus Financial Partners, Inc. (FOCS-NASDAQ) received an offer to be acquired by Clayton, Dubilier & Rice, LLC. Focus provides wealth management, investment advice, financial and tax planning, consulting, tax return preparation, and family office services to ultra-high and high net worth individuals, families, and business entities. Under terms of the offer, Focus shareholders will receive $53.00 cash per share, valuing the transaction at approximately $7 billion.
Biotech Pharma
“The rationale for buy vs. build where developer costs are always increasing led to Horizon Therapeutics plc (HZNP- NASDAQ) agreeing to be acquired by Amgen, Inc. (AMGN-NASDAQ). Horizon is a biotechnology company that focuses on the discovery, development, and commercialization of medicines for rare, autoimmune, and severe inflammatory diseases. Under terms of the agreement, Horizon shareholders will receive $116.50 cash per share, valuing the transaction at approximately $28 billion.
Energy Infrastructure
“US energy PNM Resources, Inc. (PNM- NYSE) agreed to be acquired by Avangrid, Inc. (AGR-NYSE). PNM Resources engages in the energy and energy-related businesses in the U.S. Under terms of the agreement, PNM shareholders will receive $50.30 cash per share, valuing the transaction at approximately $8 billion.
Infrastructure and Engineering
“Our analysis and understanding of PMV multiples benefit when our portfolio holdings are subject to bidding wars. CIRCOR International, Inc. (CIR-NYSE), which designs, manufactures, and distributes flow and motion control products globally, was the subject of a bidding war. Under terms of the original agreement, dated June 5, 2023, CIRCOR shareholders would have received $49.00 cash per share, for approximately $1.4 billion. Later, on June 27, 2023, CIRCOR agreed to be acquired by KKR under improved terms of $51.00 cash per share, after CIRCOR received an unsolicited bid of $52.65 cash per share from an unnamed third party. Subsequently, on June 28, 2023, Arcline Investment Management LP was revealed as the unnamed third party with an all-cash proposal to buy CIRCOR for $57.00 cash per share. In response, on June 29, 2023, CIRCOR entered into an agreement to be acquired by KKR for $56.00 cash per share, valuing the transaction at approximately $1.6 billion. CIRCOR accepted KKR’s lower price due to more certain financing and a better antitrust profile.”