Hunting Endangered Species: Investing in the Market for Corporate Control Fall 2012 Strategy Paper

EYQUEM FUND LP STRATEGY Fall 2012

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EYQUEM INVESTMENT MANAGEMENT

Toby Carlisle +1 646 535 8629

[email protected]

Hunting Endangered Species Investing in the Market for Corporate Control

Executive Summary

The market for corporate control acts to catalyze the stock prices of underperforming and undervalued corporations. An opportunity exists to front run participants in the market for corporate control—strategic acquirers, private equity firms, and activist hedge funds—and capture the control premium paid for acquired corporations. Eyquem Fund LP systematically targets stocks at the largest discount from their full change-‐of-‐control value with the highest probability of undergoing a near-‐term catalytic change-‐of-‐control event. This document analyzes in detail the factors driving returns in the market for corporate control and the immense size of the opportunity.


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1. Exploiting Opportunities in the Market for Corporate Control

The market for corporate control is the market for external management control of publicly traded companies. Targeted companies are typically underperforming, with depressed valuations as a result of corporate governance failure. Participants in the market—strategic buyers, private equity firms, or activist hedge funds—act to catalyze the stock prices of such underperforming and undervalued corporations, either by takeover, leveraged buyout, or proxy fight. Bidders seek to substitute existing management with new, external governance, either by taking over the corporation in its entirety, or by controlling the composition of the board of directors.

In Henry G. Manne’s classic 1965 paper Mergers and the Market for Corporate Control1, Manne described the market as follows:

The lower the stock price, relative to what it could be with more efficient management, the more attractive the take-over becomes to those who believe that they can manage the company more efficiently. And the potential return from the successful takeover and revitalization of a poorly run company can be enormous.

Studies suggest that acquirers tend to overpay for corporate control.2 Indeed, the conventional wisdom in the market is that the only way to successfully complete a takeover is to overpay. The premium paid for control is often so great that it eliminates the acquirer’s opportunity for even a par return—a phenomenon known as the “winner’s curse.” Rather it is the target shareholders at the time of the bid who enjoy the largest gain, earning approximately 43 percent over the prices at which target firms’ shares traded immediately prior to the takeover.3

Many public companies in the $250 million to $22 billion market capitalization range are now trading at a significant discount to their value in a change-‐of-‐control event. This is likely due to recent absence of activist

1 Manne, H.G. “Mergers and the Market for Corporate Control,” Journal of Political Economy, Vol. 73, No. 2 (Apr., 1965), pp. 110-‐120. 2 Han, Ki C.; Suk, David Y.; Sung, Hyun Mo. “The evidence of bidders' overpayment in takeovers: the valuation ratios approach,” The Financial Review, May 1, 1998. 3 Data are for the period 1980 to 2005, as recorded in the Handbook of Corporate Finance: Empirical Corporate Finance, Vol. 2, Chapter 15, pp. 291-‐430. Eckbo, ed., Elsvier/North Holland Handbook Series, 2008.


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hedge funds and the lull in merger and acquisition (“M&A”) activity, which has been sluggish in the first half of 2012, with 17,562 deals at a value of approximately $1.1 trillion.4 This is a temporary period of cyclical weakness likely to reverse soon. Past periods of persistent undervaluation have been followed by a steep increase in M&A activity. Typical companies in the investment universe have the customary defensive mechanisms in place. Absent the attention of activist hedge funds, some very attractive targets are unlikely to be acquired other than on a friendly basis. Coercing these companies into a change of control will mean a full proxy fight or tender offer, which is an activist hedge fund’s bread-‐and-‐butter.

The other participants in the market now have unprecedented levels of firepower. American corporations hold $2.2 trillion in cash on their balance sheets—more than at any time in the last half-‐century,5 and private equity firms hold record levels of capital for buyouts at approximately $3 trillion.6 Activist hedge funds, quiet after a period of success in the early 2000s, are likely to re-‐emerge as the stars move back into alignment for activist investing. The economic climate, shareholder sentiment and opportunities available have the potential to create a new golden age of M&A activity, like the hostile takeovers and leveraged buyout wave in the 1980s and the private equity boom in the early 2000s.

A clear opportunity exists for patient investors to systematically capture the control premium by identifying likely targets before a bidder announces a transaction or files a Schedule 13D notice. Such a strategy has a number of attractive qualities:

• Abnormal Returns: it has consistently beaten the market, the investment universe, and a comparable passive value index

• Asymmetric Risk:Reward Profile: target stocks have limited downside, and the potential for an asymmetrically elevated upside

• Embedded Catalysts: target stocks have high-‐probability, latent catalysts

• Scalable: the investment universe is large, and liquid

4 Primack, D. “M&A Cliff: Deal activity falls 21% in 2012,” CNN Money Term Sheet, July 2, 2012 (http://finance.fortune.cnn.com/2012/07/02/ma-‐cliff-‐deal-‐activity-‐falls-‐21-‐in-‐2012/) 5 Pinkowitz, L., Stulz, R.M., Williamson, R. “Multinationals and the High Cash Holdings Puzzle,” NBER Working Paper No. 18120, Issued in June 2012 6 Financial Times June 30, 2012, “Private equity assets hit record $3tn” (http://www.ft.com/intl/cms/s/0/9e9e2ae8-‐da65-‐11e1-‐a413-‐00144feab49a.html#axzz25trEdDES)


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2. Bagging Rare Game

2.1 Change-‐of-‐Control Value: Capturing the Control Premium

The magnitude of investment returns in the market for corporate control is dictated by the size of each stock’s discount from its change-‐of-‐control value, which comprises the stock’s intrinsic value plus a premium for control—the “control premium”. The control premium is the differential between the intrinsic value of a company and its final acquisition price. Exhibit 2.1 below demonstrates the change-‐of-‐control value opportunity, and the control premium.

Exhibit 2.1: Change-‐of-‐Control Value and the Control Premium

The return available to investors in the market for corporate control is the differential between the marginal publicly traded market price prior to the bid, and the final acquisition price, which includes the company’s intrinsic value and the control premium.

2.2 Change-‐of-‐Control Event: The Catalyst

A catalyst is a corporate action that causes the market price of a stock to rise to its value. It can take the form of a takeover, management buyout, return of capital, special dividend, stock buyback, sale of key asset, or similar value-‐enhancing act. Management may undertake these acts, but typically without producing a control premium. The control premium appears when the

MARKET

PRICE

CHANGE-‐OF-‐

CONTROL VALUE


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company changes control in a takeover or proxy fight imposed on the company by an activist hedge fund, private equity firm, or strategic buyer.

While the size of the discount from value is the ultimate determinant of return, the investor reaps the return as the stock price rises to the value. The faster the price rises, the more rapidly the investor benefits. The market can spontaneously remove the discount, but the evidence suggests that reliably identifying such companies a priori is difficult, and it is unlikely to generate a control premium. Catalysts bring immediate whole or partial closure between market price and value. In the absence of a catalyst, value can erode, or the gap between price and value can widen. The attraction of catalysts is that they reduce the impact of market forces on investment profits. By precipitating the realization of underlying value, catalysts reduce risk, and augment the margin of safety achieved by investing at a discount from value.

Bids from private equity firms or strategic buyers are important catalysts. Researchers find the magnitude of such a catalyst is on average around 43 percent over the prices at which target companies’ shares traded immediately prior to the takeover. The filing of a Schedule 13D notice by an activist hedge fund is another catalytic event. Recent confrontational activist campaigns generated “significantly positive market reaction for the target firm around the 13D filing date” and “significantly positive returns over the subsequent year.” The immediate abnormal return7 upon filing is in the range of 7 percent.8 Target companies then earned 10.2 percent average abnormal stock returns during the period after the 13D, and an additional 11.4 percent abnormal return in the following year. 9 We seek to invest prior to the filing of the 13D, or the bid, and so capture the full abnormal return.

Companies with the conditions in place for a catalytic change-‐of-‐control event offer asymmetric returns, with limited downside and elevated upside. By targeting companies with an embedded near-‐term catalyst prior to the emergence if the catalyst, we can capture the full control premium, expect a more rapid resolution of holdings, and reduce risk.

7 The “abnormal return” is the difference between a stock’s actual return and the stock’s expected return. 8 Klein, April and Zur, Emanuel, “Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors (September 2006).” AAA 2007 Financial Accounting & Reporting Section (FARS) Meeting Available at SSRN: http://ssrn.com/abstract=913362 or http://dx.doi.org/10.2139/ssrn.913362 9 Brav, Alon P., Jiang, Wei, Thomas, Randall S. and Partnoy, Frank, “Hedge Fund Activism, Corporate Governance, and Firm Performance (May 2008).” Journal of Finance, Vol. 63, p. 1729, 2008; Available at SSRN: http://ssrn.com/abstract=948907


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3. Deep Waters for Sport Fishing

3.1 Defining the Investment Universe

The investment universe comprises those companies most likely to attract attention from strategic buyers, private equity firms or activist hedge funds. Market capitalizations must be large enough on the low side to provide liquidity to activist hedge funds, and hostile acquirers—in most cases it must take less than a few weeks to accumulate 5 percent without moving the market—and small enough for private equity firms to take private. In practice this means the investment universe includes companies with a market capitalization between $250 million and $22 billion, representing approximately 33 percent of all public companies by number—a very large universe of potential acquisition candidates.

Exhibit 3.1 shows the distribution of investment opportunities by market capitalization in Fall 2012.

Exhibit 3.1: Distribution of Opportunities by Market Capitalization

Source: CRSP/Compustat

• Range: $250 million to $22 billion • Mean: $3.2 billion • Median: $1.4 billion


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Exhibit 3.1 demonstrates the scalability of the investment opportunity. The median market capitalization is $1.4 billion, meaning more than half the opportunities are between $1 billion and $22 billion.

Exhibit 3.2 shows the distribution of investment opportunities by enterprise multiple (enterprise value10/EBITDA) in Fall 2012.

Exhibit 3.2: Distribution of Opportunities by Enterprise Multiple


• Range: 0.2x to 5.3x • Mean: 3.7x • Median: 4.0x

3.2 Generalist Industry Outlook

The investment universe includes all industries, excluding the following high-‐risk GICS industries:

• Airlines • Commercial Banks, Thrifts and Mortgage Finance, Consumer Finance,

Diversified Financial Services, Insurance • Gas, Electric, and Water Utilities • REITs, and real estate developers

10 “Enterprise Value” includes equity market capitalization, net debt, preferred shares, minority interests, and after-‐tax under-‐funded pension liabilities, and asbestos liabilities (if any).


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4. Tracking Big Game

The primary driver of investment performance in the market for corporate control is undervaluation. The secondary driver is the probability of a change-‐of-‐control event, dictated by a company’s vulnerability to a change-‐of-‐control event, and possession of characteristics likely to attract attention from strategic buyers, private equity firms or activist hedge funds.

4.1 Investment Criteria

The investment criteria for target selection are as follows:

1. Market Price Discount to Change-of-Control Value: Uses acquirers’ valuation metrics to identify undervalued public company targets, and then rank on the discount to total change-‐of-‐control value (intrinsic value plus hidden control premium). The change-‐of-‐control value ignores a firm’s current bottom-‐line profitability and business quality, and examines the company’s potential under an effectual management team.

2. Probability of Change-of-Control Event: Identifies features likely to attract strategic buyers, private equity firms or activist hedge funds, including:

• Lower payout ratio: Often accompanied by other latent examples of inefficient employment of capital.

• Enhanced takeover defenses: Removal of which enhances value. • Higher CEO pay: Enhances effectiveness of public campaign. • Higher institutional ownership and trading liquidity. • Lower insider ownership: Enhanced potential for successful

hostile takeover bid or proxy contest. • Concentrated insider ownership: Enhanced potential for MBO. • “Lazy” balance sheet, legacy business: Creates an unstable

relationship between balance sheet strength and business strength, which attracts activists seeking special dividends, return of capital, sale of a major asset or outright sale.

• Weaker balance sheet, underappreciated business strength: Private equity firm acquirers are indifferent to a company’s capital structure because they will substitute their own mix of debt and equity after acquisition.


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4.2 Systematic Investment Process

Eyquem Fund LP employs a rigorous quantitative process to identify target stocks. The investment process comprises the following four steps:

1. Eliminate stocks at high risk of earnings manipulation, fraud or financial distress to create investment universe

2. Rank stocks in investment universe for market price discount to value in a change-‐of-‐control event

3. Select deepest value stocks with highest statistical chance of undergoing a catalytic change-‐of-‐control event

4. Rebalance as catalysts are achieved or better opportunities emerge

4.3 Portfolio Management

The portfolio is constructed to accommodate the behavior of the target stocks. The median holding period is approximately 20 months, calculated from the Schedule 13D filing date to the date when the fund no longer reports a stake in a target.11 If a position does undergo a change-‐of-‐control event, the price movement may be rapid. The portfolio is constructed to maximize the probability of capturing such a move. To this end, the portfolio contains a maximum of 50 positions, each sized at inception at ~2 percent of the portfolio value. The portfolio is managed for long-‐term capital gains.

4.4 Case Study: NBTY, Inc. (NYSE:NTY)

The July 14, 2010 bid by the Carlyle Group for NBTY, Inc. (formerly NYSE:NTY) provides a near-‐perfect example of the quantitative investment process. NBTY is the largest nutritional supplements manufacturer in the US by sales. NBTY’s net income was unstable, declining from $153 million to $146 million between 2008 and 2009, but revenue growth had been consistent for 15 years.12

On May 17, 2010, NBTY was identified as being substantially undervalued and with a high probability of undergoing a change-‐of-‐control event. At $35, NBTY’s $2.1 billion market capitalization a represented a trailing enterprise multiple of 5.3x, and P/E of 9.3x. NBTY had ~$400 million debt and ~$100 million in cash. NBTY was also assessed as having the third highest probability of a change-‐of-‐control event in the universe of deeply discounted

11 Brav et al. 12 http://www.wikinvest.com/stock/NBTY_(NTY)


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stocks—behind first-‐ranked Kensey Nash Corporation (formerly NASDAQ:KNSY), which was taken private May 2012 for a 64 percent gain over 24 months, and second-‐ranked Dish Network Corporation (NASDAQ:DISH), which is still public, but up 44 percent over the period.

On July 14, 2010 the Carlyle Group bid $55 per share in cash, representing a market capitalization of $3.8 billion ($4.1 billion enterprise value), trailing enterprise multiple of 8.3, and P/E of 14.6. The bid represented a 57 percent premium over the trading price in approximately two months.

Figure 4.4: NBTY, Inc. (NYSE:NTY) Quantitative Buy Signal and Bid Chart

Source: CRSP/Compustat/WikiInvest.com

Table 4.4: NBTY, Inc. (NYSE:NTY) Quantitative Buy Signal and Bid Detail

Buy Signal Change-‐of-‐Control Event

Date May 17, 2010 Announced July 14, 2010 Closed December 2010

Price $35 (Market) $55 (Bid)

Enterprise Multiple 5.3x 8.3x

Price-‐to-‐Earnings Ratio 9.3x 14.6x

Buy Signal Expectations

Change-‐of-‐Control Value (Est.): $53 (8x EM, 14x P/E) Minimum Upside: ~50% Change-‐of-‐Control Event Probability Ranking: 3

57%

May 17, 2010 Buy Signal $35

July 14, 2010 Bid Price $55


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5. Change-‐of-‐Control Value Investment Performance Analysis

5.1. Eliminating Stocks with Elevated Probability of Financial Distress, Earnings Manipulation, and Fraud Reduces Risk

We eliminate from our investable universe companies at high risk of financial distress (including bankruptcy), earnings manipulation, and fraud. These companies have the potential to cause a permanent loss of capital because they have no intrinsic value to stockholders, and can provide no margin of safety at any price. Table 5.1 shows the impact of eliminating these stocks from our opportunity set by comparing our “scrubbed” investment universe to the full index of stocks (which includes the high risk stocks):

Table 5.1: Comparison of Investment Universe to Full Index (1964 to 2011)

“Scrubbed”

Investment Universe Full Index

CAGR 11.04% 10.80%

Standard Deviation 15.31% 15.49%

Sharpe Ratio 0.42 0.40

Sortino Ratio (MAR=5%) 0.62 0.59


Table 5.1 demonstrates that our “scrubbed” investment universe slightly outperformed the full index, but, importantly, did so at reduced risk. By eliminating the small number of companies at high risk of financial distress, earnings manipulation, or fraud (approximately 5 percent of the full index at formation of each annual portfolio), we expect to see reduced risk over the full index.

5.2. Concentrating on Stocks Trading at the Largest Discount-‐to-‐Change-‐of-‐Control Value Substantially Improves Returns

We rank each stock in the investment universe in 5.1 above according to the size of its market price discount to its change-‐of-‐control value (intrinsic value plus control premium). Table 5.2 below shows the performance for the period 1964 to 2011 of the value decile (the cheapest 10 percent) of stocks ranked in this way against the investment universe described in 5.1 above:


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Table 5.2: Performance of Change-‐of-‐Control Value Decile and Investment Universe (1964 to 2011)

Change-‐of-‐Control

Value Decile Investment Universe

CAGR 15.95% 11.04%

Standard Deviation 17.28% 15.31%

Sharpe Ratio 0.64 0.42

Sortino Ratio (MAR=5%) 0.96 0.62


Table 5.2 demonstrates that the stocks most discounted from their change-‐of-‐control value significantly outperformed the investment universe on both absolute and risk-‐adjusted measures. By concentrating on the decile of stocks at the lowest market price-‐to-‐change-‐of-‐control value (approximately 285 stocks), we expect to see substantially improved performance over the index.

5.3. Selecting Stocks with Higher Probability of Undergoing a Change-‐of-‐Control Event Beats the Passive Value Decile

We can compare the performance of undervalued stocks with high and low probabilities of changing control. Table 5.3 informally compares a hand-‐collected dataset from 1999 to 2012 of two portfolios formed by dividing the value decile into two half-‐decile portfolios (approx. 143 stocks in each) with higher and lower probabilities of undergoing a change-‐of-‐control event.

Table 5.3: Returns to Higher and Lower Probability Change-‐of-‐Control Event Value Portfolios (1999 to 2012)

Higher Probability Change-‐of-‐Control

Lower Probability Change-‐of-‐Control

Value Decile

CAGR 16.58% 14.97% 15.57%

Standard Deviation 17.96% 16.22% 16.87%

Sharpe Ratio 0.67 0.61 0.63

Sortino Ratio (MAR=5%) 1.01 0.91 0.95

Source: CRSP/Compustat/Riskmetrics


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Table 5.3 demonstrates that stocks in the value decile with a higher probability of undergoing a change-‐of-‐control event substantially outperformed those with a lower probability. Figure 5.3 below shows a performance chart of the higher and lower probability change-‐of-‐control portfolios over the more recent period 1999 to 2012.

Figure 5.3. Chart of Value Decile Divided Into Higher and Lower Probability Change-‐of-‐Control Event Half Deciles (1999 to 2012)

Source: CRSP/Compustat/Riskmetrics

Figure 5.3 demonstrates that separating stocks in the value decile into higher and lower probabilities of changing control better identified the winners and the losers. While a more formal study over a longer period is required, over the periods examined, the higher probability change-‐of-‐control portfolio had a persistent advantage over both the full value decile and the lower probability change-‐of-‐control portfolio.

By selecting the stocks with the highest probability of changing control from the tranche of stocks at the greatest discount from the change-‐of-‐control value, we can expect markedly improved performance over the raw value decile. Eyquem Fund LP seeks to hold the 50 best opportunities, combining the largest discount from the full change-‐of-‐control value and the highest probability of a near-‐term catalytic change-‐of-‐control event.


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6. Taking Tiger by the Tail

6.1. Portfolio Manager

Tobias Carlisle is experienced in activist investment, stock valuation, public company corporate governance and M&A law. He is the co-‐author of Quantitative Value: Advanced Factor-Based Methods For Stock Selection, a Wiley Finance title due 2012, and the well regarded website, greenbackd.com, which covers deep value, contrarian, and activist value investments.

Prior to founding Eyquem Investment Management LLC, the Eyquem Fund LP, and its precursor Eyquem Global Value Fund, Tobias was an analyst at an activist hedge fund, general counsel of a company listed on the Australian Stock Exchange, and a corporate advisory/M&A lawyer. As a lawyer he has advised on transactions in a variety of industries in the United States, the United Kingdom, China, Australia, Singapore, New Zealand, Bermuda, Papua New Guinea, and Guam, ranging in value from $50 million to $2.5 billion. He is a 2001 graduate of the University of Queensland in Australia with degrees in law and business (management).

6.2. Contact

For more information about the Eyquem Fund LP or the strategy, please contact:

Tobias (Toby) Carlisle Managing Member Eyquem Investment Management LLC IARD/CRD Number: 157310 Direct telephone: +1 646 535 8629 Email: [email protected]


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IMPORTANT DISCLAIMER: The information in this document is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell, any securities and has been obtained from, or is based upon, sources believed to be reliable but is not guaranteed as to accuracy or completeness. Eyquem Investment Management LLC is under no obligation to disclose or take account of this document when advising or dealing with or on behalf of customers. The views of Eyquem Investment Management LLC reflected in this document may change without notice. In addition, Eyquem Investment Management LLC may issue other reports that are inconsistent with, and reach different conclusions from, the information presented in this report and is under no obligation to ensure that such other reports are brought to the attention of any recipient of this report. To the maximum extent possible at law, Eyquem Investment Management LLC does not accept any liability whatsoever arising from the use of the material or information contained in this document. This research document is not intended for use by or targeted to retail customers. Should a retail customer obtain a copy of this report he/she should not base his/her investment decisions solely on the basis of this document and must seek independent financial advice.

The financial instrument discussed in this report may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed in this document. The value of securities and financial instruments is subject to currency exchange rate fluctuation that may have a positive or negative effect on the price of such securities or financial instruments, and investors in securities such as ADRs effectively assume this risk. Eyquem Investment Management LLC does not provide any tax advice. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Investments in general, and derivatives in particular, involve numerous risks, including, among others, market, counterparty default and liquidity risk. Trading in options involves additional risks and is not suitable for all investors. An option may become worthless by its expiration date, as it is a depreciating asset. Option ownership could result in significant loss or gain, especially for options of unhedged positions.

Hunting Endangered Species: Investing in the Market for Corporate Control Fall 2012 Strategy Paper

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