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On July 25, 2018, Qualcomm’s (“QCOM”) tender offer for NXP Semiconductor (“NXPI”) shares officially expired. The merger agreement was initially struck on October 27, 2016. In the ensuing months, Qualcomm bumped its bid as the semiconductor industry rallied and activists agitated for a richer offer. In early 2018, the companies appeared to be headed toward a successful marriage, having received regulatory approval from all required agencies except for one: China’s Ministry of Commerce (“MOFCOM”). Then, on April 19, 2018, MOFCOM requested additional time to review the deal. In response, Qualcomm withdrew and refiled its application, and extended the offering period.
At the time, we firmly believed the transaction would ultimately be blessed by Chinese authorities. Now, three months later, as the trade war between the US and China intensifies, Qualcomm has announced its intent to abandon its pursuit of NXPI, and instead conduct a $30 billion stock-buyback program.
As we look back on this investment and examine what we could or should have done differently, we do see areas where – especially knowing what we know now – we may have taken a different tack. At the same time, we also see instances where we likely would have stayed the same course.
Why did MOFCOM ask for an extension?
The delay at MOFCOM occurred, hardly coincidentally, shortly after the Trump administration imposed $50 billion in tariffs on a litany of Chinese goods, kicking off a tariff tit-for-tat between the two nations. In addition to the ongoing trade dispute, the US Department of Commerce established a ban on sales to ZTE Corp, a major player in China’s telecommunications and technology industries, in response to the company violating US sanctions on doing business with Iran and North Korea. The ban could have a crippling effect on ZTE’s business (in part because QCOM’s very own chips – chips on which ZTE relies for several segments of its business – would be subject to such a ban).
On April 19, MOFCOM representative Gao Feng stated the reason for the delay was that the potential negative impact of consolidating NXPI and QCOM made it difficult to approve the deal under its current structure, though we believe this was purely political posturing. As mentioned above, anti-trust regulators across the globe had already signed off on the transaction. More likely, this was yet another volley in the gamesmanship between the US and China, rather than legitimate concern.
Why did we remain confident the deal would complete?
As we have written in prior notes, MOFCOM has a long history of extracting concessions that would be favorable to China in exchange for approving mergers, rather than blocking deals outright. The value of such concessions should not be understated. China has used its power to spur growth in nascent domestic industries that it is incentivized to support, such as telecommunications and technology (including semiconductors). Whether it is a peek under the hood at the actual design of intellectual property, or perpetual licenses to important technologies at favorable rates, the advantages can be significant. As such, it is in China’s best interest to continue to approve mergers when local players can benefit from concessions. In fact, implicit in Feng’s public statements on April 19 was a request for further concessions from Qualcomm in exchange for regulatory approval.
QCOM, for its part, was highly incentivized to complete its acquisition of NXPI and agree to concessions. The strategic rationale behind the deal was strong. NXPI’s specialized semiconductors for automotive, security, and internet-of-things devices could have provided a clear path for future growth, especially considering QCOM’s established position in wireless networking and the impending rollout of 5G wireless technologies. Beyond that, the companies had agreed to a not-insignificant $2 billion break fee.
As for the Trump administration, though it may be unpredictable, the President is nothing if not willing to play ball in a negotiation process. In May, following initial discussions with China, President Trump began vocalizing his support for lifting the Commerce Department’s ban on doing business with ZTE. While the ban was subsequently removed from the National Defense Authorization Act (“NADA,” an annually-updated defense policy and spending bill), and approval from Congress is still pending, this at least marked a potential resolution to what was likely a key stumbling block for China.
Lastly, we believed any level of anti-trust risk in the deal was easily surmountable. Regulatory approval was required in nine separate jurisdictions spanning the globe, eight of which had already signed off on the deal. This gave us confidence that MOFCOM would fully conduct its process – even, yes, extracting as many pounds of flesh as it required. True, when the trade dispute began, the agency initially hit the pause button on US-related approvals while continuing to approve deals involving other jurisdictions. Contrary to some expectations, though, MOFCOM was not entirely closed for business. It wasn’t long before MOFCOM again began blessing US-based activity. Not only that, the list of approved deals included other transactions in the semiconductor space (such as Microchip Technology’s acquisition of Microsemi Corp) and even a deal involving Qualcomm itself – which, amidst the NXPI delay, received approval for a joint venture with China’s state-owned Datang Telecom Technology Co to design smartphone chipsets.
What did we get wrong?
Throughout the transaction, as we do with every position in the portfolio, we continually assessed NXPI/QCOM from a risk/reward perspective. We ask ourselves, “Based on potential upside, probability of closing, and our downside estimate, does this position make sense?” The answer for this deal was consistently, “Yes.” Had we handicapped certain factors differently, we may have arrived at a different conclusion.
First, we misjudged the political risk inherent in the situation. While we trusted in MOFCOM’s process, and we believed China and the US would conduct trade negotiations in good faith, the rhetoric has persisted longer than we expected – and clearly longer than NXPI and QCOM were willing to wait. Would MOFCOM have approved the transaction if Congress had passed the NADA bill, effectively lifting the ban on ZTE, before the July 25 walk-away date? It’s hard to say, but regardless, we remained in the position through the volatility that ensued in Q2 – and perhaps longer than we should have.
We also clearly underestimated the downside in NXPI, which led us to build an overweight position in the security. We had a high level of conviction in both the strategic rationale supporting the deal and the lack of meaningful anti-trust risk, and we allocated our capital in line with that conviction. In hindsight, this sizing resulted in a position that exceeded our drawdown expectations. While our risk management process did lead us to reduce our exposure and increase our hedges over the course of Q2 as more information became available and our risk/reward expectations evolved, we would have been better served if we had accounted for the market’s negative reaction to potential bad news and trimmed our position sooner.
We still believe NXPI is an attractive acquisition target, particularly at current trading levels, but the timeline for any potential new bidders has reset, and speculative arbitrage is not a strategy we employ in our portfolio of definitive, publicly-announced M&A.
What does this mean for the portfolio?
Our process, as always, begins with gauging the potential to make money in a deal versus the potential to lose money in a deal, while remaining cognizant of the continuously-evolving risk landscape. Beyond our standard risk/reward analysis, we now have additional questions that must be asked in evaluating any given transaction. First, while determining exposure to regulatory approvals has always been part of our process, particular attention must be given to any transaction subject to MOFCOM or CFIUS (Committee on Foreign Investment in the United States) review. Importantly, in the current environment, our analysis must not stop there. We must dig deeper and attempt to anticipate what could happen if the current trade negotiations between the US and China devolve into a full-on trade war. Furthermore, any fallout could spread to other areas such as Mexico, Canada, and Europe. The impact on investor sentiment could be significant, and in anticipating such a scenario, one must consider a portfolio in its entirety rather than any particular deal in isolation. As of June 30, outside of the NXPI/QCOM transaction, the portfolio had less than 15% exposure to broader trade-war concerns or cross-border transactions requiring MOFCOM or CFIUS approval.
We have added these scopes to our risk management process and continue to reevaluate our risk tolerances as the landscape shifts around us. While we are living in a world of heightened political risk and uncertainty, we remain constructive on M&A. As we have stated for several months now, the conditions for the merger arbitrage strategy are approaching ideal. The three primary driving factors of merger arbitrage returns remain deal volume, interest rates, and volatility. For the past few years, deal volume has been healthy. The passage of tax reform in the US in late 2017 unlocked additional sources of capital (in the form of repatriated cash held overseas) for acquirers, which has spurred further activity that had been on hold. As a result, deal volume for the first six months of the year reached record levels in 2018, continuing to provide a broad opportunity set of potential investment for arbitrageurs. Economic growth, low unemployment, and high consumer confidence in the US continue to lead the Federal Reserve to raise interest rates. Rates have been raised twice already in 2018 (four times in the past 12 months), and further hikes before year-end seem likely. This should provide additional support for wider merger arbitrage spreads. Lastly, after a record-low year for volatility in 2017, market volatility returned in earnest in early 2018. It has shown no sign of disappearing soon, which should help provide attractive entry points for investment. All told, we are highly optimistic regarding the prospects for merger arbitrage, and we look forward to navigating the ever-changing risk landscape as we attempt to deliver to our clients the risk-adjusted returns they deserve.
As of 6/30/18, Arbitrage Fund held 5.9% of the portfolio in NXP Semiconductors NV and 0.0% in Qualcomm Inc, and Arbitrage Event-Driven Fund held 5.8% of the portfolio in NXP Semiconductors NV and 0.0% in Qualcomm Inc. Holdings are subject to change. Current and future holdings are subject to risk.
Material represents the manager’s opinion and should not be regarded as investment advice or a recommendation of any security or strategy.
RISKS: The Funds use investment techniques with risks that are different from the risks ordinarily associated with equity investments. Such techniques and strategies include merger arbitrage risks (in that the proposed reorganizations in which the Fund invests may be renegotiated or terminated, in which case the Fund may realize losses), high portfolio turnover risks (which may increase the Fund’s brokerage costs, which would reduce performance), options risks, borrowing risks, short sale risks (the Fund will suffer a loss if it sells a security short and the value of the security rises rather than falls), and foreign investment risks (the securities of foreign issuers may be less liquid and more volatile than securities of comparable U.S. issuers), which may increase volatility and may increase costs and lower performance. Arbitrage Event-Driven also invests in bonds, which decrease in value as interest rates increase, and also includes credit risks, interest rate risks, interest rate swap risks, credit default swap risks, and convertible security risks. Foreign investing also involves special risks such as currency fluctuations and political uncertainty. Past performance is not a guarantee of future results.