Special Situations Investing by Arquitos Capital Partners

Steven Kiel’s Arquitos Capital Partners released its first quarter investor letter. There aren’t many details about stocks but Steven Kiel discussed his special situations investing strategy. Here is what he said:

Special situations are a big part of why you pay me to manage your money. I turn over a lot of rocks and apply different strategies to find opportunities in this category. To give us an advantage, I usually don’t hunt for these rocks in the same fields as other portfolio managers. Of the nine investments I’ve opened up in this category, my guess is you’ve probably only heard of two or three of them.

As I discussed in the last quarterly letter, the portfolio is broken up into three categories: Value-oriented long positions, special situations, and shorts (which includes hedges). The idea behind the special situations is that they can create positive gains in any market. Opportunities include corporate events such as mergers, spin-offs, break-ups, tender offers, wind-downs or other event-driven or arbitrage opportunities. I won’t discuss specific company names now (other than Tyco), as we’re building the positions, but I do want to give you an idea of what this category contains so you’ll have a better understanding of what I’m trying to accomplish with these holdings.

The aim is to have about ten positions with 5% of the portfolio in each. That’s not set in stone in any way, and reality will depend on details of the given opportunity and how many attractive options I find. In general, if the overall markets seem to be overvalued, I’ll look to increase our holdings in the special situations. When the markets appear significantly undervalued, we’ll probably own fewer of these.

Mergers. Three of these holdings are previously announced mergers. Two are fairly straight-forward with small but safe gains. These are being bought out by larger companies with cash and I don’t expect any serious hiccups. They should close over the next few months.

The third is a little more unique. It’s an all-stock offer from a small, stable regional bank. The buy-out terms include a variation of the amount of stock paid depending on the share price of the acquiring company when the merger is approved. Because of this variable, the spread is wider than usual for a merger with a comparable degree of risk. As it stands today, we expect to receive a gain of between 5% and 12% by the time the transaction closes in the third quarter. Annualized, the gain would be two to three times that percentage. The acquiring company is one that I’ve followed for years and whose stock price has been so stable that the chances that the variable share payout clause will be triggered is low. Needless to say, it’s an excellent investment in today’s environment.

Bidding Wars. We’re also invested in two companies that involve buy-outs. Recently, more than a few bidding wars have broken out over small cap companies resulting in significant gains for shareholders. I attribute this outbreak to a few things. Easy credit and low interest rates make this type of activity occur more often. Some of these involve private equity firms who are a bit desperate for the acquisition and willing to engage in a bidding battle. Some of these small cap companies are significantly undervalued, and the first or second buy-out offer is an attempt to acquire them at a price much lower than their true worth.

The first company we’ve begun to buy into has the characteristics outlined above. Its market cap is smaller than $200 million. A private equity firm that was formed only last year (but with experienced partners) made an unsolicited offer late last year. That offer values the company at a multiple of sales lower than any U.S. retail acquisition ever completed. The company has rejected the offer as too low but opened its books to the offeror. I expect the private equity firm to either raise its offer or for another bidder to enter. So far we’ve been able to buy shares at about a 10% discount to the original buy-out offer.

I have also acquired a few shares in another company going through a very similar situation. This company is tiny, with a market cap of less than $25 million, and my limit order has not yet been completely filled. It has received two buy-out offers and there is a fair chance a bidding war will occur. I’m attempting to buy more shares at the price of the second offer.

Break-ups. I briefly discussed Tyco in the last letter as an example of buying into a company that is breaking up and that I expect will be more fairly valued after the break-up. Tyco shares have climbed more than 20% since then as they’ve announced that one of the divisions they are spinning off will instead be acquired outright by another company. That particular division has been described as the least attractive standalone of the three divisions, so it is welcome news for us. We are also participating in another break-up opportunity that appears to be about 25% undervalued when judged against its current assets.

Event-driven. Another special situation strategy relies on company-specific events. We have initiated positions in two companies with these characteristics. Each of these has an event coming up in the near future that will allow the value of their shares to be fully reflected if all goes as expected. I look forward to updating you after the events occur. Each has an interesting story.