Anatomy of a Trade and Managing External Risks: Safeway Edition

I’ll let my former eBFF, @given2tweet,  give you the details of this trade from last week:

I was pretty fascinated with SWY last week. This deal has now closed and there is nothing to do but if you want to read about what the deal/trade was you can do so here:

http://alphavulture.com/tag/swy/

Here’s the crux:  The  day is Tuesday. SWY was trading at $35.15. The odds of the deal closing were 99.99999% as they just received FTC clearance and put out a PR saying the deal will close in the next 5 business days. People estimated the deal would close Friday morning making Thursday the last trading day of SWY stock. Upon closing of the deal, an investor would get $34.88 in cash and two CVRs (contingent value rights). One of these CVRs was to be worth 7 cents payable in about a year. The other is the crux of the investment: A 49% stake in a Mexican supermarket chain that is estimated to be worth between 50 cents and $1.50, payable anytime in the next 3 years with 3 years being the max.

Here’s the problem most people had with the idea: You need to buy a ridiculous amount of SWY stock to make the CVR a meaningful position. Let’s do an example:

I have a $1,000,000 portfolio. I buy 10,000 shares of SWY, costing me $350,150. This would be a 35% position in my portfolio which is obviously huge for anyone unless it’s SRPT (hehe).

Upon closing, you would be left with 10,000 shares each of 2 CVRs. Your cost would be $35.15-$34.88 = 27 cents. 10,000 shares x 27 cents = $2700.

On a $1 Million portfolio, your entire position would be $2700 or less than 1/3 of 1% of your assets. If you’re lucky, that $2700 should grow to $10,000 sometime in the next 3 years and is almost certain to not lose money. But you had to put up 35% of your entire portfolio to create that teeny tiny position!

For people w/ margin, money is cheap. Very very cheap. Interactive Brokers will lend you money at under 2%. If you borrowed 100% of your entire account value for a week to finance this transaction it would cost you:

$1,000,000 X 2% = $20,000 annual interest/52 weeks = $384 in interest making your total cost of the CVR $2700 + $384 = $3100. Still, who wouldn’t want any investment that is most likely going to triple in well under 3 years and has little risk associated with it?

My biggest issue was Interactive Brokers. They let me leverage SWY at more than 5-1, which is great. But what would happen once the deal closed and I had to wait 2-3 days for the cash to hit my account? My fear was they would make SWY “non marginable” for those 2-3 days and I would have an instant margin call on the rest of my portfolio which is filled with illiquid non marginable stuff, mostly ABCD and SRPT (haha). After spending a day talking to them and emailing them and having some friends do it too, I got comfortable they would not liquidate my portfolio.

I made SWY 40% of my portfolio, on margin. On Thursday night I decided I was going to take it to 75% or even 100% as if IB was going to screw me and liquidate my portfolio, I’d be pretty much completely screwed even if it’s just a 40% position so why not go for gold. Unfortunately, it never traded on Friday and I wasn’t able to get the trade off.

Why did this opportunity exist? Well, virtually every fund in the world can’t make a position bigger than 10 or 15% let alone 40 or 50%, for starters. If you made SWY a 10% position the value of the CVR (at cost) would be so small (less than 1/10 of 1% of assets) that most funds wouldn’t even bother. Further, the CVR is non-tradeable and many funds can’t or don’t want to own an asset like that because they have no idea how to mark it for their investors at year end.  Index funds likely sold their position on Monday when Safeway was removed from the S&P 500.

In short, it’s a headache to make a very little amount of money.

SWY was a 9B market cap! That’s a shitload of stock that needs to be absorbed by people who are either willing to take on a CVR that’s a teeny tiny part of their portfolios or for people who are willing to risk 40-100% of their capital for a week. And thus, the opportunity existed.

I told a few people about it and half passed and the other half made it huge (30-200% of their portfolios). There is no real good reason to pass, even if you only made SWY 10% of your portfolio. It’s free money w/ a small accounting headache at tax time.

Say you have a $250,000 account and bought 1000 shares of SWY. When all is said and done, you will have $250~ tied up that will be worth about $1000 in 1-3 years. That’s $750 you did nothing to get. That’s a lot of dinners! But most just wouldn’t waste their time…which is clicking “buy 1000 shares of SWY” in their online account and doing nothing after.

I wish we had 10 of these a year but this situation was super unique and will probably not be repeated often if ever. You need:

Very large, liquid company
Non-core assets that the acquirer doesn’t want
Unable to sell those non-core assets quickly resulting in a CVR
CVR non-tradeable
CVR worth less than 1% of the entire deal making it too costly/hard to acquire a meaningful position

Kid Dynamite here: This reminds me of what I wrote about many years ago with respect to the Norilsk Nickel tender offer, where I talked about the concept of RRR: Random Russian Risk.  Now, Interactive Brokers screwing up their margin calculations isn’t quite in the Random Russian Risk category, but it’s in that category of “external” risks unrelated to the underlying asset.   I did this $SWY trade that Matt discussed above, but I wasn’t nearly as big as I wanted to be (although my $SWY position was in fact greater than the entire equity value of my Interactive Brokers account, my IB account only contains a portion of my trading assets), despite having had some online conversations with Interactive Brokers’ customer service where they insisted that they were aware of the situation and how the margin should/would be affected.    Ultimately, I would have felt fine putting on a maximum position if I’d had no other equity positions – only cash in my account – so that by the time IB changed the margin requirement, there would have been nothing to liquidate anyway: my assets would have been in $SWY which was about to be paid out in cash.

I do have other positions, however, and I didn’t want to have to stress the possibility of IB coming up with senseless margin requirements (I say “senseless” because by the time their systems default to the higher margin requirements, the trade is done!) which would leave me in a pickle.  I had this happen to me with last year’s $PFE$ZTS spinoff trade, where  I’d hedged all sides of the trade, but still had a margin issue when IB’s systems changed the tendered $PFE position to a 100% margin requirement.

My point in this post is twofold:  1) to allow @given2tweet to illustrate the mechanics of a relatively unique trade and the importance of thinking about position sizing with respect to portfolio size and 2) to illustrate how one needs to be mindful of external risks that may seem unrelated to the direct trade in question:  in this case: the broker’s ability to correctly calculate the margin on the position both before the trade is complete and after the event happens (but before the cash is paid out).

-KD

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