Julian Klymochko – Arbitrage Trades Don’t Always Turn Out to Be Risk-free

BIO: Julian Klymochko is the CEO and Chief Investment Officer of Accelerate, a leading provider of alternative investment solutions.

STORY: Julian got into an M&A trade where the acquirer had to stage a shareholders’ vote. This led to a hostile acquisition where the target company was bought by another acquirer that was not part of the deal. Julian made a significant loss in this trade.

LEARNING: Never put on an M&A trade that has the buy side vote. Arbitrage doesn’t always mean a riskless trade.

“The best way to learn is to practice by doing. So, try it out yourself, and don’t risk more than you can lose.”

Julian Klymochko

Guest profile

Julian Klymochko is the CEO and Chief Investment Officer of Accelerate, a leading provider of alternative investment solutions. Accelerate helps investment advisors, institutions, and individual investors diversify their investment portfolios, manage risk, and improve their portfolio’s risk-adjusted returns. Prior to founding Accelerate in 2018, he was the Chief Investment Officer of Ross Smith Asset Management. He started his career as an Analyst at BMO Capital Markets. Currently, Julian is a Director of the CFA Society Calgary.

He has been featured in some of the world’s top financial and business media, including Bloomberg, CNBC, The Wall Street Journal, BNN, Business Insider, and The Globe and Mail.

Worst investment ever

Julian started out in the mid-2000s as a young investment banking analyst working 100 hours weekly. He was handling mergers and acquisitions (M&A) and advising. During that period, Julian worked on some exciting deals. He got excellent insights into the inner workings of M&A, equity offerings, and capital markets. It was a great place to start a career.

From that, Julian went to a startup hedge fund. He cut his teeth doing closed-end fund arbitrage, which was a fantastic trade, specifically during the great financial crisis of 2008. He could generate nearly risk-free returns that, at one point, were yielding 50% to 100% annualized returns because there was very low liquidity in the market, and people were desperate to sell. So arbitrage spreads were extensive. After that, Julian got into different arbitrage strategies; volatility arbitrage, convertible arbitrage, and one of his and Warren Buffett’s favorites, risk arbitrage.

In 2012, Julian launched a standalone risk arbitrage strategy. He started with a $5 million investment from a handful of wealthy investors to conduct this risk arbitrage investment strategy. Risk arbitrage aims to generate high returns consistently—ideally, double-digit annualized returns and no down years.

For the first four months, Julian put a lot of pressure on himself and was sick to his stomach every morning. But he still had a terrific first year with low volatility. Julian produced a double-digit return with low volatility and minimal drawdown. So investors were happy. The fund continued with that excellent trend for the first three years and grew significantly.

2015 was an interesting environment in the M&A business. It was open season for pharmaceutical mergers. There was this popular trend called tax inversion. Tax inversion was where pharmaceutical companies would take over a foreign company to re-domicile offshore to lower their tax bill significantly. That trend buoyed M&A activity as domestic US pharmaceutical companies rapidly sought to conduct tax inversions by acquiring non-domestic competitors.

At the time, a company called Valeant Pharmaceuticals was rapidly consolidating the pharmaceutical space. Their business model was dramatically different than their competitors—the old-school pharma companies. The company hired a former McKinsey consultant, Michael Pearson, to run Valeant. The company had already conducted a tax inversion and was now Canadian-based and not part of the S&P 500. It was part of the Canadian benchmark, the TSX. With that, their attitude toward growth was utterly different. Michael Pearson’s thesis was such that R&D is wasteful. The company grew through acquisitions. They would do hostile takeovers and gobble everyone up. This strategy was working. Their stock was doing exceptionally well.

Everyone was praising the accolades of Michael Pearson and his business model. It became a highly respected strategy on Main Street and Wall Street. Analysts were going gaga over it, and investors loved it, creating copycats.

Tax inversions were still all the rage, and Julian was active on these within the fund’s portfolio. Julian had this one particular M&A trade that looked quite attractive. The company, QLT, was a failed biotech company with just a bunch of cash. They were trading at roughly cash value, with few prospects aside from the money they had on the balance sheet and perhaps some tax losses. But one redeeming factor was that they were Canadian, not American, making it a prime candidate for an inversion. That inversion came through a definitive merger agreement with a US company called Auxilium. Auxilium was looking to run this new pharma playbook, re-domicile offshore by a tax inversion merger, then conduct M&A growth like Valeant.

The requirements to consummate this merger were a successful shareholder vote by QLT shareholders. Additionally, since Auxilium was issuing approximately 25% of its outstanding shares in this merger, its acquirers’ shareholders would have to approve the deal. So they struck a deal with a 5% spread that would close in three months. A 5% spread over three months would be about 20% annualized, a handsome return.

This trade was 4% of Julian’s fund’s portfolio, both long and short. Over time, Julian felt that a lot of consolidation was happening. He was worried that someone could make a play for Auxilium and acquire the stock in which his fund had a significant short position, which could lead to a considerable loss. So Julian decided to buy call options on Auxilium, utilizing some of that spread available to protect his fund in that awful potential scenario.

A few months after putting on this trade, the worst-case scenario Julian had imagined happened. A pharmaceutical company run by Michael Pearson’s protege came and made a hostile takeover bid for Auxilium, the target acquirer in this M&A deal. Julian’s fund suffered a massive loss from this deal.

Lessons learned

Never put on a merger arbitrage trade in which the acquirer has to stage a shareholder vote because it makes you vulnerable to a hostile takeover.

Andrew’s takeaways

Be careful when dealing with arbitrage. It doesn’t always mean riskless arbitrage.

Julian’s recommendations

Julian recommends Twitter as an excellent resource for information. You can follow him @JulianKlymochko. Julian also posts a lot of research and insights on his website that can help you, especially if you’re starting out. You can also check out other investment websites, such as Value Investors Club, where you’ll find professional research.

Julian also has a couple of favorite investment books that he recommends:

Parting words

“Teach a man to fish, feed him for a day. Teach a man to arbitrage, feed him for life.”

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