The Interview – Steven Gerbel, Chicago Capital Management: “The next few years will be a very good time to be invested in merger arbitrage”
Steven Gerbel, founder and president of merger arbitrage specialist Chicago Capital Management, expects a historic number of mergers within the US banking industry over the coming years as a result of the crisis highlighting the strengths and weaknesses of institutions, and believes this will present the sector with some of the largest merger arbitrage spreads and profit margins ever seen.
GFM: What is the background to your company?
SG: Chicago Capital Management LP started trading on January 2, 1998 and currently has USD36m in assets under management. The primary focus of the fund has always been merger arbitrage, but it also invests in convertible arbitrage situations from time to time, depending upon market opportunities.
GFM: Who are your key service providers?
SG: Our clearing firm is Goldman Sachs, our law firm is Katten Muchin Rosenman Cornish, and our auditor is Ryan & Juraska.
GFM: Have there been any recent changes to the management team?
SG: In January this year Chicago Capital Management hired David Purkey, previously a managing partner with Horus Partners, a Chicago-based hedge fund manager specialising in convertible bond arbitrage. David has been instrumental in helping to build out our convertible bond trading desk.
GFM: What is the profile of your current and targeted client base?
SG: Since 1998 we have concentrated on providing an alternative investment opportunity for high net worth individuals that is not correlated with traditional asset markets, offers low volatility and generates average net returns to investors exceeding 15 per cent.
Chicago Capital Management has averaged net returns of 15 per cent or more since launch, and day-one investors have realised cumulative returns of more than 450 per cent. As the fund continues to grow, we strongly believe that the current market environment is extremely conducive to our investment strategy, and for the first time in a number of years, we have begun to market the fund actively.
As a result of this decision, the fund has for the first time undertaken a marketing effort to reach family offices, smaller funds of funds and endowment funds. Currently the fund’s investors almost exclusively comprise high net worth individuals.
GFM: What is your investment process?
SG: Our primary investment focus is merger arbitrage; the fund only invests in publicly announced merger transactions. After a merger is announced our analysts quickly analyse the merger and assign a probability to the likelihood that the transaction will be completed under the announced terms.
During this initial analysis, analysts look at the balance sheets of each company, any lawsuits that the companies might be involved in, the probability that the companies will be able to obtain the financing necessary to complete the deal, the likelihood that the companies will be able to obtain a favourable anti-trust ruling and any other regulatory ruling issues that might affect completion the merger. After that initial work is done, a determination is made whether or not to take an initial position.
If we do take an initial position, we continue our research to strengthen our original convictions further and carefully monitor each position as the merger progresses. After each significant milestone is reached, we assess the remaining risks and reward and either add to or reduce our position.
However, more often than not, as the risks of the transaction being completed are reduced by events such as positive earnings announcements, regulatory approval and the announcement of progress toward the completion of the merger, we tend to add to our position with the intention of holding it until the merger is consummated.
GFM: How do you generate ideas for your funds?
SG: The majority of our investment ideas stem from merger announcements via press releases, newspaper articles and wire service stories.
GFM: What is your approach to managing risk?
SG: We look at each merger transaction after we take an initial position and attempt to determine how much money we would lose if the merger were to fall apart, by taking into consideration the premium paid to the target company as well as analysts’ opinions of what would happen if the merger were to fall apart.
We seek to take into account not only the impact on the target’s share price should the merger fail but what would happen to our short position in the case of a share swap merger. In most cases a merger arbitrage investor loses not only when the target’s share price declines but on short stock hedges if the acquirer’s price recovers. The arbitrageur is forced to cover the short positions at an additional loss to that suffered on the long position.
GFM: How has your recent performance compared with your expectations and track record? Do you expect your performance to change going forward?
SG: Last year the fund was up 11.92 per cent net of fees, right in line with my expectations. A merger arbitrage fund should at least be able to generate double-digit returns during tough times and returns of 40 per cent or more net of fees in the good years, as Chicago Capital Management was able to do in 1998, 1999 and 2000.
The next few years will be a very good time to have your money invested in a merger arbitrage fund. There will be a tremendous amount of consolidation happening within the banking and technology sectors.
GFM: What opportunities are you looking at right now?
SG: Over the next few years I expect a historic number of mergers within the banking industry. Currently there are more than 8,000 banks in the US, compared with just eight in Canada. With all of the turmoil in the banking industry last year, it is easy to distinguish between the strong and weak banks.
It is also clear that more regulation within the banking industry is around the corner, and its additional cost will take a further toll on small banks that are already struggling. Once the new regulations are in place and it becomes crystal clear to many smaller banks that they will not be able to survive with their current business models, they will seek to be acquired by bigger institutions.
The regulators will welcome these transactions with open arms. Their role is to insure the stability of the banking system, and what better way is there to ensure the stability and long-term viability of the system then to encourage larger, stronger banks to acquire smaller, weaker ones.
The other benefit for regulators is that consolidation will leave a significantly smaller number of banks to regulate – no-one could disagree that it is easier to regulate 2,000 banks than 8,000. This will allow banking regulators to get a better handle on the industry in general, and hopefully lead to a better understanding of how to prevent a repeat of what happened to the industry in late 2008 and early 2009.
GFM: How will these developments affect your own portfolio?
SG: If a large number of banking mergers are announced in 2010, we will have a tremendous range of merger arbitrage transactions to choose from. When this happens, I expect that the remaining 60 per cent of my competition that is still in business will be perfectly positioned for some of the largest merger arbitrage spreads and profit margins ever seen, but I do not believe anyone is better positioned to profit from this phenomenon than we are.
GFM: Are investors’ expectations shifting between capital preservation and growth?
SG: We have always made capital preservation as priority number one, and I strongly believe that it was this emphasis that enabled us to return 11.92 per cent to our investors last year. However, we have begun to alter our selection criteria for merger arbitrage positions slightly to help our portfolio generate a slightly higher return should the market continue to advance over the next 12 months.
GFM: What differentiates you from other managers in your sector?
SG: Unlike other portfolio managers in our field, we truly hedge all our transactions. This becomes very clear when you compare our 2008 results with those of other merger arbitrage funds.
GFM: How do you view the environment for fundraising?
SG: The environment for raising funds in 2009 was significantly better than that we were forced to operate in during 2008, and I believe it will continue to improve. We were able to increase the size of our fund by 10 per cent last month and as I spend more time marketing the fund, it is possible that the rate growth could accelerate.
GFM: Are you planning any mergers or acquisitions?
SG: If I could find a small struggling fund manager to purchase at the right price I would certainly consider making an acquisition.
GFM: Do you have any plans for other product launches in the near future?
SG: We plan to launch the Chicago Capital Management Offshore Fund on January 1. I am also contemplating launching a convertible arbitrage fund later in 2010, depending on the opportunities.
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