Portfolio manager Barbara McKenna explains how her fund uses a “merger arbitrage” strategy that seeks to capitalize on the difference between the market price of a company being purchased, and the price offered by the acquirer.

Kate Stalter: Today’s guest is Barbara McKenna, portfolio manager of the Touchstone Merger Arbitrage Fund (TMGAX).

Barbara, this is a pretty new fund, and you have a somewhat unusual methodology, in terms of the universe of stocks you’re investing in. So maybe, start out today telling us why the fund was formed and what its objective is.

Barbara McKenna: Well, we’ve actually been managing this strategy for the history of our firm, for which we just celebrated our 26th anniversary. But because of the uniqueness of the structure, where we’re both going long and short securities, it’s much easier to have it in a mutual fund structure than separate accounts, and this allows also the retail market place to participate.

So we have been working with Touchstone Investments out of Cincinnati previously on other funds, and rolled this fund out in the fall of last year. And it’s been very well received in the fund format.

Basically, the strategy of the fund is that we look to take advantage of the arbitrage opportunity for companies involved in publicly announced definitive deals. So just to take an example: Company A decides to buy Company B for $10 a share, and once that’s announced the stock price of Company B is going to reflect the likelihood of that deal, and when that deal will go through.

So it might be trading now at $9.50 and you say, “Well, gee, if they’re going to buy them at $10, why doesn’t it go to $10?” And part of that is just the time value of money that individuals would have to tie up in order to get that, and the other is that there’s always the risk the deal falls apart, and then the stock goes back to trading at wherever it was previously, maybe $8.

So our objective is to build a portfolio of these definitive deals, and over time approximately 97% of definitively announced deals do close. And our objective is to avoid that 3% that don’t, because you will tend to lose more on those deals. And the way that you succeed in this strategy is by understanding what the timing is for different industries, how quickly the deals will close, what’s the likelihood that they’re going to hit regulatory hurdles, or other types of financing risks, and things of that nature.

And we kind of group this strategy into two different types of deals. One, are the strategic deals. So, say for example, GE (GE) decides they want to buy Company X because they want a product or a group patents.

Oftentimes that target company is small and it doesn’t really matter what their quarterly earnings are going to be. They’re being bought for a very specific reason. Those deals will have a very high rate of closure.

The other types of deals are financially driven—private equity, leveraged buyouts, etc. They are much more sensitive to the acquisition meeting financial hurdles. They also may have a higher risk of financing. As a result of that, we limit our exposure to that financially-driven type of acquisition to only 10% of the portfolio, and we also limit each individual deal that’s financial driven to only 1%.

Though the bulk of the strategy is focused on these strategic acquisitions, and it’s also our focus, something else that makes us a little unique is that we’re focused on small- to mid-cap acquisitions. So just for example: In 2011 we were involved in 161 new deals. Of those, 78 had market caps less than $500 million.

So the thing that makes us unique is because of our size, we can really participate in those types of deals. Those deals do have not only a better closure rate, but a higher return.

And you might say, “Huh, that doesn’t make sense. If they have a better closure rate shouldn’t they have a lower return, because there’s less risk?” Instead, what happens is that the larger market participants in this strategy, they don’t bother looking at them because they couldn’t buy enough.

Physically they wouldn’t be able to buy a full position for their fund. They’d have to own half of the company. So what happens is, when you take the really large merger players out, it means that they trade much more attractively, so you get a better deal and you get a better return.

Kate Stalter: I can think of a lot of follow-up questions to you, but we only have a short time today. One thing that did occur to me: When you hear of an acquisition announcement in the news, frequently you’ll see the stock gap up higher, perhaps even to a price that’s above the announced acquisition price. How do you handle a situation like that?

Barbara McKenna: Well, there are times that we’re buying deals higher than the announced price, and that’s because the company is in play, and the market—we would think that other buyers are coming in and they’re going to get a bump.

There are many times that the stock price goes at or over the announced price, and we don’t participate. That’s because we don’t believe, and we don’t always buy the first day. Sometimes we buy two or three days before the deal’s going to close, so an average deal might be anywhere from 30 to 120 days, with an average probably 60 to 70 days. So, we’re not always on day one.

But once a deal is announced, we’ll do the work, and then whether we participate or we don’t participate, we’re monitoring it constantly, so that at a future point in time if it was only the valuation that caused us not to participate, we would look at that opportunity. If there’s another reason why we didn’t participate—regulatory, or others—we would wait for those to be clear.

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The other thing I would like to mention about this strategy is that many people find it attractive because it isn’t highly correlated to either the equity or the overall bond market. So for individuals who are looking, or organizations, for diversification and strategy, this has a very low correlation to the S&P 500, at about 0.3%.

It actually has a zero correlation to the bond market. It does have a little bit higher correlation to short-term interest rates. As I mentioned earlier, that sort of time value of money, which is often based on short-term interest rates. As short-term interest rates rise, typically the yields we’re able to get on deals also rises.

So this is kind of like a very, very, very, short floating-rate note that resets every 60 to 90 days. You don’t have that risk of the bond market you have diversification from the equity market, but as interest rates rise your opportunity rises as well.

Kate Stalter: I’m just curious again about the exit strategy here. Do you end up holding shares in the acquiring firm after the deal closes, or do you exit the position? How does that work?

Barbara McKenna: Typically, what happens is once the deal’s closed, the offset, the old stock—we don’t get delivered the new stock. We just get delivered cash. You can choose, but once the deal closes, your shares would be transferred in, and instead of getting issued new shares, we just get cash.

Kate Stalter: I also noticed that you tend to be more US-focused than international. Say a little bit about that.

Barbara McKenna: Yeah, we do invest in international deals. Primarily we’ve been involved in deals in Canada, a few in Israel, and a couple in Europe. But Europe has a very difficult regulatory environment, and if we are involved in an international deal, we will immediately hedge the currency forward, so we’re not taking currency risks.

That’s locked in at the beginning, and so we’re just looking at the deals. And over time, I would say anywhere from about 93% to 100% are US-based, and that’s just because of the volume, the regulatory, the funding, and so on.

Kate Stalter: Last question for you today, Barbara. How would you suggest or envision that investors incorporate your fund into an overall equity and fixed-income portfolio?

Barbara McKenna: Well, I’m not really an advisor for individuals or others. But what we typically see is that, especially in this environment, but often in many environments, investors are looking for a pool that isn’t correlated and is a more stable type of asset class. And sometimes they might utilize cash as a means to do that. Even though they don’t necessarily need the liquidity of cash, they’re looking more for the stability of cash.

This is a nice way to get a little bit better yield or return target. Right now, we’re targeting returns in the 4% to 6% range, so a little bit better return than cash, but still very stable. In the history of the fund, we’ve had three negative years, and the worse year was minus-3%.

So, I think for investors who are looking at diversification and an asset class, that’s a little bit more stable.

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