Special Situations in the ArbitrOption Portfolio
ArbitrOption’s portfolio has two kinds of investments: merger arbitrage positions and special situations. In general, merger arbitrage comprises 80% or more of the portfolio and special situations are 20% or less.
A special situation occurs when a publicly-traded company has a pending event that is expected to increase or decrease shareholder value. To be included in ArbitrOption’s portfolio we need to be able to estimate the time frame for the event and the terminal value if the event occurs as expected.
Examples of special situations include an activist investor pushing management to explore strategic alternatives, the initiation of a substantial share buyback program or Dutch tender, an announcement of a special dividend, or an upcoming regulatory event. An area where ArbitrOption has had particular success with recent special situation investments is biotechnology firms in the midst of a regulatory event before the US Food and Drug Administration.
We evaluate special situations for inclusion in the portfolio by applying a 7-step process:
- Basis for idea: Where did the idea originate? Sources include corporate press releases, articles in Barron’s or other financial press, Securities and Exchange Commission filings, or court documents that are identified, in part, through search filters that have been refined over the past decade.
- Expected event and corresponding completion date: What is the event, and when is it expected to occur? Note that we prefer a time range instead of a specific date because a range will better represent the degree of uncertainty. We rely on analogous situations that we’ve seen before in order to forecast expected time frames for currently pending events.
- Expected value: What will the company be worth at the event’s completion? Again, a range is preferable to a specific figure, and we attempt to use conservative estimates of future value to compensate for uncertainty.
- Risks to investment thesis: What could go wrong with the company? We seek to identify the known risks and prepare for the unknown risks. An example of a known risk is the potential for commercial underperformance that overpowers the positive potential of the pending event. Another example, particularly relevant for biotechnology companies, is the release of positive data by a competitor. An unknown risk is something unprecedented that can only be observed with the benefit of hindsight.
- Systemic risks to investment: What could go wrong with the system in which the company operates? Examples could be the harmful impact of an increase in interest rates, negative impact of a change in the industry’s regulatory regime, or any development that prompts a market selloff.
- Suggested target exposure: How much of the portfolio should be risked on this investment? ArbitrOption’s portfolio management rules set a maximum of 5% risk exposure to special situation opportunities. Most of the special situations have a risk exposure between 1 and 2%.
- Suggested trade, including expiration, strikes, and maximum price: How do we set it up? The ideal way to use exchange-listed options to profit from this special situation, if we are correct about its potential.
A recent special situation in the portfolio was our investment in Alnylam Pharmaceuticals (NASDAQ: ALNY). On November 16, 2017, Alnylam announced it would submit a New Drug Application (NDA) to the FDA for “patisiran”, a drug that treats hereditary ATTR (hATTR) amyloidosis. On December 12, 2017, ArbitrOption initiated a position in the January 2018 $105 / $110 option spreads at a risk of $440 to make $60, or 13.6% risk on return. Our investment thesis was that the pending FDA decision would be sufficient to support the stock above $110.
The position was exited profitably when the options expired on January 19th, 2018. On an annualized basis, the investment return was approximately 130%.
ArbitrOption has developed a framework for identifying, researching, and investing in pending events that are either a merger arbitrage opportunity or, as described above, a special situation. Special situations help to diversify the portfolio and improve the portfolio’s risk-adjusted returns. Please get in touch at Contact@ArbitrOption.com if you would like more information about ArbitrOption.