GDL - GDL: Profit From Merger Arbitrage

2023-12-04 12:00:55 ET

Summary

• Closed-end fund IPOs are terrible.
• But they can lead to big discounts.
• Never pay full price but grab the sales.

Let me start with this caveat: Investing in closed-end funds ("CEFs") is mostly stupid. Few managers exhibit any investing skills. Their performance is often poor and fees are often high. One of their strong points is that they are great at building impermeable corporate defenses against shareholders asserting their rights. If closed-end fund investing is stupid, then investing in closed-end fund IPOs is the stupidest. These are simply wealth transfers from credulous retail investors, many of whom are yield-hungry seniors, to sleazy brokers willing to take advantage of them for a quick buck (or, more commonly, two per share).

The CEF IPO is an opportunity to lose 8% of your money quickly, then much of the rest slowly. They are useful for investors because they are the financial world's equivalent of a ski mask on a warm sunny day in that any broker caught with one has identified himself as a likely swindler.

While I am a longtime skeptic of boom era IPOs generally, my skepticism is greatest when it comes to initial public offerings of closed-end funds. With industrial IPOs, there is some pre-existing corporate asset being supplied. With CEFs, the IPO is driven by the demand. What CEFs get IPOed? Whatever the retail mass market wants. Whatever is most in favor, priced-in, or trendy is what gets invented and then sold to the trusting public.

At least industrial IPOs initially pop 16% or so on average on the first day and only later lose investors' money. But with CEF IPOs, there is not even that initial pop. Then, average CEFs are down about 8% within three months, 13% within five months, and 19% within a year. While there is a market inefficiency in the repeated ability to sell such CEFs to the public for a 5-10% premium to NAV, the market is subsequently efficient at wrenching that premium out of the price.

Over a billion dollars of value has been transferred from CEF investors to underwriters on day one. That is about 8% of the money that they invested. There is zero evidence of skill in the (typically expensive) management of the remaining 92% of their money. It is instructive that only about 4% of investors in new CEFs are institutional investors compared with 22% of investors following similar industrial IPOs. This has been a smashing success… for underwriters are brokers. These wealth transfers are useful tools for investors to identify brokers who are willing to do anything and say anything to take your money.

This may seem like a rather lengthy and heavy caveat to lay on you before introducing a long idea, but the problem is also the opportunity. Nobody sells shares for no good reason like an investor who bought them for no good reason. By the time they have sold off, the investors are probably in the market for a new broker while the broker is in the market for his next mark. Closed-end funds have many sins, but nothing that can't be cured by underpaying. These closed-end funds can be good opportunities to buy at deep discounts to NAV.

One such deeply discounted closed-end fund is a merger arbitrage fund managed by Mario Gabelli called the Gabelli Global Deal Fund ( GDL ). According to the fund's objective:

The Fund is a diversified, closed-end management investment company whose investment objective is to achieve absolute returns in various market conditions without excessive risk of capital. Absolute returns are defined as positive total returns, regardless of the direction of securities markets. To achieve its investment objective, the Fund, under normal market conditions, will invest primarily in securities of companies (both domestic and foreign) involved in publicly announced mergers, takeovers, tender offers and leveraged buyouts and, to a lesser extent, in corporate reorganizations involving stubs, spin-offs, and liquidations.

It currently trades at a 23% discount to NAV, greater than its 22% year to date, 19% 5-year, and its 17% 10-year averages. The portfolio is diversified, and position sizes are disciplined, with most in the 2-4% range. It is further diversified across sectors, with top exposures including 8% in industrials, 4% in technology, and 3% in health care. A diversified portfolio of these ideas sized the way Gabelli traditionally sizes such positions is apt to protect capital and outperform equities in a down or sideways equity market and outperform bonds in any credit market. So why bother picking and choosing individual merger arbitrage opportunities when you can simply buy a basket at a discount? If you don't have the time, energy, inclination, and research budget to hunt down asymmetric information, then just buy the discounted basket. If you want to put in the time and effort to be an advantage player, then consider buying GDL, then tweaking it with your personal views.

The fact that Mario keeps his positions relatively small is one place to seek an edge. For example, some of the good opportunities become great opportunities when panicky traders dump them because of temporary and resolvable problems. You could tweak GDL by sizing great opportunities far more assertively.

In my case, I tend to cap individual risks around 3% of the original invested capital, but that can give me a lot of discretion in situations with limited downsides, such as when there is a fundamental valuation close to a deal price. So I can occasionally double or triple an exposure relative to a standard GDL allocation to add upside in my day job and emphasize my Investing Group. Where might you significantly increase sizing on specific spreads? We gave three examples to our members (click the links to the service above or below) that I own and like at today's prices.

A value investing cliché repeated in countless slide decks is that we seek a dollar for fifty cents. I certainly do. However, there is much more talking about value investing than actual value investing, and much of that talk offers an insufficient explanation for why a market offers these $0.50 dollars. Secondly, it is not always clear how you're supposed to get your dollar even after you forked over your $0.50. For the first problem, I like my colleague Andrew Walker's idea:

Where should we look for investment opportunities? Where no one else is looking and where everyone else is panicking.

If your target is ignored or its investors have lost their minds, then it is conceivable that they are offering you a sale price. When you see the $0.50 price, you might be looking at an opportunity instead of simply looking at a data point. As far as getting your dollar back, arbitrage in particular and event-driven strategies in general offer a falsifiable process for getting paid. The right opportunity offers value without risking a value trap.

Would I quibble with the specific positions? Sure. But does GDL deserve this deep a discount? I don't think so. Does Gabelli Equity Trust ( GAB ) need an activist to come in and demand that they cut executive compensation? No comment. But if Mario Gabelli is available, he might want to take a look at it.

Caveat

The manager is someone I respect, but the expense ratio of over 3% is indefensibly obscene (if less so than any hedge fund). The distribution yield is over 6%, but not much above today's riskless yield available on savings accounts.

Conclusion

The market is good. It is good enough to trust in its general fairness and approximate efficiency. You can put all of your money in passive exposure to equities, debt, and cash with the confidence that - on average and over time - you will get what you pay for.

But it is also imperfect. For diligent bargain hunters, some durable inefficiencies include occasional share class spreads, cheap parent-subsidiary stubs, and broken CEF IPOs. It is possible to beat the market over the long term by judiciously selecting securities within such categories.

Is the market efficient? I find much of the academic literature that indicates significant efficiency to be persuasive, yet in my direct experience, I keep finding lucrative exceptions. What do you think, and what have you found? If you find it efficient, just put your money in federally insured savings accounts and a broad-based tax-efficient ETF such as Vanguard Total Stock Market Index Fund ETF Shares ( VTI ). If you find it even occasionally inefficient, then I hope you like the exploitable examples on our Investing Group!

Today, there are some great merger arbitrage opportunities. Tomorrow, they could get even richer if we see a big antitrust suit against one or more of the current deal crops. If you want to take a dip but don't want to bother, consider GDL as one way to get exposure at a significant discount.

TL; DR

I own GDL and a number of merger arb spreads; you might want to too.

For further details see: