Zweig Fund (ZF) – Merger Arbitrage – 7% upside

Current Price – $11.16

Expected Buyout – $11.85

Upside – 7%

Expiration Date – 31st of March, 2017

 

This is a relatively straightforward situation and I will keep the write-up light as I am travelling today (happy to expand more in the comments section later).

Zweig Fund (ZF) and Virtus Total Return Fund (DCA) will be merged by the end of March. Both closed end funds are administered by the same asset manager and shareholders have already agreed to the merger.

The arbitrage situation arises from different discounts to NAV for each fund. DCA trades at 5.3% discount whereas ZF at 12.5% discount (see here for discounts). Merger will be carried out based on NAV. So the trade here is to buy ZF (which is cheaper relative to NAV) and then short equal amount of DCA (on dollar NAV basis). Both funds will also make distributions before the merger. The discount on the merged fund is likely to be somewhere in the middle, my guess is around 8%. An unhedged position of ZF is also a potential trade here, but then one is exposed to deviations in NAV and only to portion of the spread gap.

Bulldog was involved with DCA and forced a the fund to launch tender offer for 40% of the stock. Tender expired yesterday, so today is the first day when post-tender shares of DCA will be traded.

15 COMMENTS

  1. Makarid

    So if for example we want to buy ZF for $1000, we will buy ($1000/market price of ZF) number of ZF shares and hedge it with ($1000/market price of DCA) number of DCA shares.
    Is that right?

    Thanks a lot!

    1. dt

      For full hedge long and short positions should be equalized based on NAV rather than market price. So for $1000 NAV of DCA short there should be an equivalent $1000 NAV of ZF long.

  2. Joe Ern

    Does this AM sudden 4+% drop in DCA indicate that the arb is now gone now that the discounts to NAV are now more in line?

    1. dt

      Yes the opportunity is less attractive now with the DCA price drop. Updated discounts to NAV will be posted tomorrow morning. There are still couple weeks left till the actual merger, so better entry opportunities might appear.

    1. dt

      Indeed. That’s the combination of DCA being small cap as well as arbitrageurs hedging the position.

      1. FM

        From my little understanding about funds merger, there’s always an exchange ratio to determine how many shares of surviving fund will be received by shareholders of the acquired fund. Normally they use acquired fund’s nav divide by acquiring fund’s nav for the exchange ratio, then multiply this ratio by the number of shares held by the shareholder. I’m not sure whether this is applicable to this case, if yes, then the exchange ratio for the two funds will be 0.385 based on their navs today. So if I’m have 1000 shares of DCA, I can get 385 shares of ZF after the merger. So DCA is priced at $4.43 now, meaning I’m holding $4430 worth of DCA, then divide it by 385 shares, I’ll get a price $11.5 for ZF. Is this the right way to calculate the potential buyout price?

        And also, I saw on the sec filling that there’s a tender offer program going on in ZF, saying the fund will tender 5% of the shares if the 12 weeks discount is larger than 8%. Is this where your 8% discount come from?

        Thank you.

        1. dt

          FM, there will be no buyout, just instead of DCA shares shareholders will receive ZF shares after the 31st of March. I agree with your exchange ratio calculations, but your thinking on buy-out price over-complicates the story. My 7% upside comes simply from difference in discounts to NAV between both funds. One was trading at 12.5% discount and the other at 5.3% discount. Upon merger that discount will converge. So if one shorts the expensive one and gets long in the cheap one, then the spread of 7% closes, which is what I have indicated as an upside for this trade.
          After the move yesterday, the spread has already narrowed to 2%.

  3. FM

    “Merger will be carried out based on NAV.” Which date’s NAV is it referring to here? Any document specifically stating that? Is there any chance the merger will fail according to past similar examples? Thank you.

    1. dt

      My understanding is that exchange ratio will be based on NAV as of 31st of March. I see very low risk of this deal being cancelled – shareholders already approved it and both funds are managed by the same company.

  4. over2u

    Today results of tender offer of DCA is announced with 62% proration. So, I guess DCA is under pressure from those who bought shares to participate in tender offer

  5. dt

    As the spread narrowed to less than 2% (difference between discounts to NAV) and DCA borrow costs increased considerably, I have closed out the trade resulting in 4% return (i.e. spread narrowed by 4% from my entry prices which were less favorable than the ones indicated in the write-up) in less than a week.

    1. Makarid

      You open the trade before the tender offer expired.So what happens with the tender offer while you are shorting the stock?I don’t know the mechanism about that.Do you own something to the guy that you short his shares?
      I am sorry if my question is stupid,i don’t know about this corporate event on the short side.
      Thanks a lot!

      1. dt

        Makarid, I opened the short side of the trade after expiration of the tender – upon market open on the 16th of March (so at the time of posting I did not have a short position).
        But generally, if you open short position before tender expiration, you are risking that the stock you borrowed will submitted/accepted for the tender and in that case you will need to pay out tender price for the accepted shares.
        There is also a chance that the shares you borrow, will not be submitted for the tender, in that case nothing changes with the short position after tender expiration. I had it happened both ways, so it is a matter of luck and likelihood depends a bit on the expected proration. Hope this explains it.

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