Hedge fund arbitrage strategies 101
Hedge fund arbitrage opportunities become available when there are price discrepancies in the market. Hedge fund managers (like us) can exploit these pricing discrepancies by using a combination of going long (buying) on one of the assets and taking short positions against the other (selling).
There are loads of arbitrage strategies, but this mail will only examine event-driven arbitrage ones, which aim to exploit the price discrepancies that arise before or after corporate events such as mergers and acquisitions, corporate restructurings and rights issues.
The magic of unbundling
Arbitrage opportunities often arise when investment holding companies decide to unbundle some of their assets or undergo corporate restructuring. An investment holding company is usually set up for a specific reason. When the original rationale for the holding company changes, the founders may decide to disinvest in the hope of unlocking the value they believe is trapped in the current holding structure.
Investment holding companies often trade at discounts to their net asset value (the sum of all the holding company’s assets and liabilities). For a variety of reasons, the holding company’s share price can misrepresent the underlying value of its listed and unlisted assets.
A discount emerges when investors don’t have confidence in either the management team or the assets held by the holding company. (A holding company can also trade at a premium if the investors believe in management’s ability to add value.) To get rid of a discount that has developed over time, management needs to show they are improving their deal-making ability by taking decisions that will add value to the company. They can also unbundle assets to get rid of the discount.
For hedge funds, these discounts, and the decisions taken to reduce them, can offer very attractive arbitrage opportunities.
But how attractive is Remgro?
Remgro, which recently announced its intention to unbundle, has tended to trade at a discount to NAV of between 14% and 18%. This discount widened to 28% during October and November 2019 and is currently hovering around the 25% mark. Rand Merchant Holdings, the other holding company involved in the corporate restructuring, typically trades at a narrower discount range of between 5% and 10% (it’s got a much simpler holding structure). That discount has now widened to around 12%.
There are a few reasons for these discounts:
The negative sentiment foreigners have towards South Africa has seen them sell Remgro which, given the diversified nature of its assets, is seen as a proxy for SA’s economy.
There is still some uncertainty surrounding the unbundling.
Investors are not accurately pricing how much value could potentially be unlocked during the unbundling process.
Enough theory, how does it work in practice?
To work out the extent of an arbitrage opportunity, the hedge fund manager needs to calculate whether discounts are likely to narrow or disappear when investors reward management for unlocking value by creating a better corporate structure. In the case of the Remgro unbundling, if the discount to NAV narrows back to a fairer level of 18% from an implied 36% (which would exist post the unbundling of RMH and FSR) investors would stand to make a significant profit from the arbitrage trade.
If a hedge fund manager is confident that value is likely to be unlocked during the corporate restructuring, then the manager would usually implement a market-neutral investment strategy. This doesn’t expose investors to day-to-day moves in the general equity market but is rather structured to take advantage of the relative moves between the shares of the companies involved in the restructuring.
Don’t try this at home
To make the most out of a hedge fund arbitrage opportunity, the investment team needs to have a deep understanding of all the moving parts in the transaction and the ability to correctly calculate the intrinsic value of the assets that are going to be affected by the corporate restructuring. This requires loads of experience and very sophisticated investment skills…it goes without saying that investors must make sure that they go with a firm that ticks all these boxes.
AIP has been taking advantage of this kind of opportunity for 3 years. If you’re keen on profiting from Remgro’s unbundling, please do give us a ring to find out how it might work for you and your clients.