Ep684: Julian Klymochko – Arbitrage Trades Don’t Always Turn Out to Be Risk-free

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Quick take

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.”

Julian Klymochko


Read full transcript

Andrew Stotz 00:02
Hello fellow risk takers and welcome to my worst investment ever stories of loss to keep you winning. In our community. We know that to win an investing you must take risk but to win big, you've got to reduce it. Ladies and gentlemen, I'm on a mission to help 1 million people reduce risk in their lives to join me go to my worst investment ever.com and sign up for my free weekly become a better investor newsletter where I share how to reduce risk and create grow and protect your wealth. Fellow risk takers this is your worst podcast hosts Andrew Stotz from a stance Academy, and I'm here with featured guests, Julian Klymochko. Julian, are you ready to join the mission?

Julian Klymochko 00:47
Yes, Andrew, thanks for having me on the show. And I'm excited to talk about my worst investment. And if

Andrew Stotz 00:53
it's something that you've thought about, I think pretty deeply so I'm looking forward to hearing about it. But before we get into it, let me introduce you to the audience. Julian 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 return. Prior to founding and 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 and now my worst investment ever podcast Julian, take a minute and share with us the unique value that you are bringing to this wonderful world.

Julian Klymochko 01:55
Sure, sounds great. Andrew, I don't know if it's that unique with almost 10 billion people on the planet, but I do my best to bring value to people and put a bit of a different spin on it. So in the context of this podcast, what I tried to do differently been in the hedge fund business a long, long time, managed various investment strategies largely around arbitrage risk arbitrage closed in fund arbitrage, convertible arbitrage and additional strategies, such as punctured equity, distressed debt, long lead value, investing Alpha short, and so a wide experience in various hedge fund strategies. And with that, it's always been an industry that is quite secretive, not a lot of transparency, and not a lot of innovation. Some people are trying to run a hedge fund similar to the Buffett partnership that he ran mid 1950s to the late 1960s. We're talking about 70 years ago, doing the exact same thing. So what I tried to bring to the table is a mix of innovation and transparency, doing things that are much more invested from on the hedge fund side, which includes radical transparency. I know that's a word or a term that Ray Dalio uses, but actually don't know what Bridgewater does at all. But our view of radical transparency is, is showing exactly how our strategies work, whether it's multi strategy, long, short equity, absolute return, risk arbitrage, whatnot, we explain exactly how it works precisely what we're doing, and have done some innovative things to make these types of strategies, more accessible, more liquid. More transparent, obviously, significantly lower cost. So there's a lot of innovation to be had in the Alternative Investment Management segment, because it's been a space that's been around for several decades, and has largely stayed the same. So we're trying to change the game.

Andrew Stotz 04:22
When you talk about the transparency versus not wanting to reveal what you're doing. Why are you so comfortable with transparency when let's say others say, Oh, well, you're just going to reveal what you're doing and you're gonna lose the effectiveness of what you're doing. Let us understand a little bit more of your thinking there.

Julian Klymochko 04:43
So it's similar to a lot of things in life that, you know, you look at someone like Tiger Woods, or LeBron James, or, you know, anyone performing to the highest level. It's not hard to figure out how they do it. But what So incredibly difficult is to do it as well, or mimic that, right? So you can try to copy our strategies, but it requires a significant amount of experience, and just hard work. And with the committed fees we charge, it's like, just worth it to let us do it for you. Right? So there's the notion of it not being worth your time to replicate, because it's far easier to just let it let us do it for you. And there's plenty of analogies, right? Like, you're not going to start a basketball team and be on it, when you can find much better players. Younger, faster, they practice more, they put in the time they put in the effort, and tell him about, you know, 80 plus hours per week, for decades, and in many, many years, building up that talent and experience and know how and database and, and all those all that skills and knowledge required that? Once people find out, they're like, actually, I'll pass on that. That's way too difficult. I'll just let you do it.

Andrew Stotz 06:14
Exactly. Yeah. I mean, I do some seminars and stuff. And I basically tell them in this seminar, I'm going to tell you everything you need to go do what, what I can also sell you

Julian Klymochko 06:26
exactly, it's like, you know, you got to need some sort of legal representation. Sure, you can, you know, study to become a lawyer on your own, or you can just hire a professional to do it. Right. So like many things in life, it's easier if you just, even if you know how to do it would rather just get a professional who's focused on that, to do it for me, right? Yeah. And

Andrew Stotz 06:51
the other thing that's interesting is when you you know, study businesses and try to understand strategy and the things that they did when I was younger, I thought that strategy was a pretty complex thing, and then you realize, no, actually, great strategy is really simple, and, you know, consistently executed, and then you realize that all the attempts by people to try to kind of conceal their strategy and stuff. The reality is, is that, you know, it's the execution of that strategy on a consistent basis that really makes that strategy work. So I, I feel a lot like you do a lot like less worried about and all the other thing, too, that I said to my business partner many years ago when he said, What if somebody steals our Excel model that we've created, and I said, within one year, we're going to be miles ahead of where they're sitting on that model that they got through theft, basically, in that case, and they're not going to be able to develop it, but we are going to be a mile ahead. And that needs to be our commitment to continuous improvement. One of the other questions I have before we get into the big, the big question is, you know, you talk a lot about diversify, manage risks, risk adjusted return. And I'm just curious for the, for the for the listener out there. I mean, there's some pretty standard ways to reduce risk. And then there's like some really complex ways that can sometimes be difficult for a fund that's investing, let's say globally, where it's harder to hedge certain positions are more expensive. If I think about diversification, I first think about, okay, first diversify within, you know, your equity portfolio, don't be too overexposed in one place or another. The second is diversification across asset classes, where you add in maybe some bonds, and you add in some gold, and occasionally, some people may add in a commodities or something like that. And I'm just curious. And then, of course, there's some trading things like stop losses and things like that. But are there other other types of risk management that you see that people could take advantage of? Or are those really the core things that cover 80 90% of it?

Julian Klymochko 09:03
You got to some of it, but I can talk about how I approach risk management. I always like to use the phrase risk management before it's too late. You're here about a stock market crash and then people are like, Oh, buy put options, and they're just doing the equivalent of buying a home insurance after the house fire burned down the house, which is terrible idea. So risk management before it's too late. refers to being prepared for anything that can happen in the global economy, markets, etc. And with that, a second phrase that I really like is they say that diversification is the only free lunch in investing. If you talk to a lot of people, they just go with traditional asset classes, stocks, bonds, cash And that worked for quite a while, like they had the benefit of a steady decline in interest rates from the early 1980s to the early 2020s. And so when the 10 year yield goes from 15% to 50 basis points, providing a massive tailwind to bonds, and more specifically, with that a good tailwind to the 6040 stock and bond traditional portfolio, people thought that was sufficient diversification and get got lulled into a false perception that bonds diversified stock portfolio. So I was speaking with a potential client 18 months ago when the 10 year yield was at 1%. And I asked them, Why do you own treasury bonds yielding 100 basis points, when, you know, inflation is higher than that. And there's really not a lot of upside potential here. You said, Oh, it's simple. I own those bonds to protect our equity portfolio, when that trades down because stocks or when bonds protect equity portfolios, because they'll rally in a recession. And boy, they could not have been more wrong, and 2020 to really showcase what actual diversification is, you know, stocks were down about 20%, and bonds were down about 20%. And what people forgot, is that in inflationary environments, stocks and bonds become positively correlated, ie move in the same direction. I like to joke that in 2022, the QQ ETF and NASDAQ, and the TLT, ETF, long term treasury bonds are the same asset, they're near nearly 100% correlated. It was all one big duration bet. And with that, 2022 proved that, you know, the 6040 portfolio is not balanced, nor is it diversified. So with that, I always think like a stock portfolio, whether you own 510, or 500, that's one asset, you own one asset, they're all highly correlated, for the most part, and you want to be diversified, globally, not just a few 500, or focused in one country, and then bonds to big duration that you can diversify the fixed income side of things. But one really interesting stat. And the framework that I approached diversification is that if you go from one asset stocks to two assets, you have a big step down and risk, I'm talking about uncorrelated assets. But really the sweet spot is if you can include six uncorrelated asset classes. So imagine, as you add uncorrelated asset classes to a portfolio, you have this steady decline in volatility, until, you know that additional benefit of adding more asset classes doesn't really move the dial that much. And that sweet spot is generally around six uncorrelated assets. And with that, imagine going through 2022 and owning strategies that were actually up double digits. Sounds like a great idea, right. And that's the true essence of diversification such that you have strategies with either zero correlation or perhaps negative correlation to your traditional asset classes. And those are your diverse buyers. And the goal being, you know, you can have a portfolio doing this, or you can have a portfolio doing that, which one would you prefer?

Andrew Stotz 13:49
And to follow that up the asset class, a lot of times people slice up the equity market into many different slices. And then they refer to those slices as different asset classes, which I think is really a misnomer. You know, as you said, equity is pretty much an asset class of itself, we can met play around within that asset class to build more diversification. But overall, it is one asset class. And if I think about bonds, that's, I would say is the second asset class. Some people would say, okay, maybe gold or precious metals is the third asset class. Some people would say commodities, but you could also argue that commodities include some of those precious metals, but let's strip out the precious metals and say, okay, commodities, Soft Commodities, you know, hard commodities, excluding precious metal. Okay, now, we're maybe out of fourth asset class would have would you call that an asset class?

Julian Klymochko 14:48
Oh, certainly precious metals. Yes. Okay. Yeah. And then yeah, there's some additional ones. You have everything besides traditional asset classes stock bonds in cash. So we refer to everything besides those as alternative asset classes. And within that there's a myriad of various uncorrelated alternative investment strategies.

Andrew Stotz 15:13
So like raw land, would that be an example of a different asset class and or there has been vehicles that can give access to that

Julian Klymochko 15:21
real estate, farmland infrastructure. So there's, I classify alternatives into two segments. There's illiquid and liquid alternatives. So on the illiquid side, you have real estate, infrastructure, farmland, music, royalties, venture capital, private credit, leveraged buyouts, then on the liquid alternative side, there's cryptocurrencies, precious metals, hedge fund strategies and within hedge funds, long short equity, multi strategy managed futures, arbitrage, market neutral CTA strategies, tail risk, hedging strategies, risk parody, distressed debt event, all these different strategies within hedge funds, and then commodities, also a liquid alternative. And, yeah, there's just a lot, a lot beyond just stocks and bonds, and they've never been more accessible to the everyday investor, you can find the vast majority of these alternative asset classes now in easy to use low cost ETFs. Right.

Andrew Stotz 16:39
And I guess that, ladies and gentlemen, there you go, that's one of the big values that Julian brings to the clients is helping to understand. I'm fascinated by of course, risk because, well, this is a risk reduction podcast, ultimately. And so it's a great discussion to understand about that. So I appreciate that discussion. Now, it's time to share your worst investment ever. And since no one goes into their worst investment thinking it will be tell us a bit about the circumstances leading up to that up to it and then tell us your story.

Julian Klymochko 17:12
Sure, that sounds great. So I'll start off just given my career background. So started out in mid 2000s, as a young investment banking analyst, you know, working 90 100 hours per week in work on m&a transactions, mergers and acquisitions advising. And as an investment banking analyst, you're the one doing the grunt work, doing the Excel modeling, accretion dilution merger models and putting together PowerPoint deck. So you become a real ninja in Excel and PowerPoint, and worked on some really interesting deals and got very good insights into the inner workings of mergers and acquisitions, equity offerings and the capital markets. So great place to start a career and from that went to a startup hedge fund at the time cut my teeth doing closed end fund arbitrage, which was an awesome trade, specifically during the great financial crisis. or eight or nine you can generate, you know, nearly risk free trades that at one point are yielding over 50% annualized 50 to 100% annualized returns, just because there was very, very low liquidity in the market and people were desperate to sell. So arbitrage spreads were incredibly wide. And after that got into different arbitrage strategies, volatility arbitrage convertible arbitrage, and in one of my favorites, and Warren Buffett's favorite, which is risk arbitrage. And so Buffett has been conducting arbitrage investments, I think ever since the 1950s. If you read back on some of his Buffett partnership letters, or even Berkshire Hathaway's annual reports, specifically their 1988 letter to shareholders, the details, quite a few of their arbitrage investments. And that's contrary to popular belief, where he says buy good company at a fair price. Buffett and Berkshire Hathaway made their best returns conducting arbitrage. So it's been a great investment strategy for many, many decades. And with that, in 2012, I launched a standalone risk arbitrage strategy started out with a $5 million investment from a handful of wealthy investors just to conduct this risk arbitrage investment strategy. Now the goal of risk arbitrage is to generate consistent high consistent returns. So high Sharpe ratio, high risk adjusted return on a consistent basis, ideally double digit annualized returns and no down years which is a tough feat. But if it's done properly, it can produce what I believe is one of the best absolute and risk adjusted investment return profiles. So 2012 of our first year, the funny the funny thing is, you know, I was pretty young when we started it, I would wake up at 4am Every day in the office by 5am, working 80 hours per week, weekends, evenings, holidays, for the first four months, I was, you know, a lot of pressure on myself was sick to my stomach every single morning, but still managed to have a really good first year, low volatility. Just a handful a down month, maybe that the worst was down 1% But produce double digit return with low vol, very little drawdown. So investors were happy, and kind of continued that for the first several years in the fund grew significantly, investors were happy. And with that, after about three years, a really good track record. This takes us to 2015. Now 2015 was an interesting environment. In the m&a business, it was all season four or sorry, open season for pharmaceutical mergers. At the time, a huge trend was something called a tax inversion. Now what a tax inversion was, and it was very popular with pharmaceutical companies would be they would take over a foreign company to read domicile offshore in order to lower their tax bill. It's a pharmaceutical company, you can do that become a non US Corporation, and therefore pay significantly lower tax rate. So we saw companies like activist do this and quite a few others. And that really buoyed m&a activity. As domestic US pharmaceutical companies. were rapidly looking to conduct tax and versions by acquiring non domestic competitors. And that was the environment and also, if you remember, a company called valiant pharmaceuticals, var x, they were rapidly consolidating the pharmaceutical space, their business model is dramatically different than their competitors are or sort of the old school pharma companies. You have. The Pfizer's and the mercs. And the GSK is and such that were heavily reliant on research and development, to fund their growth or to produce their growth. So they invested heavily on r&d. So along came a former McKinsey consultant, Michael Pearson, who got hired by an activist hedge fund to run valiant and valiant had conducted already a tax inversion, or re domiciled, they're Canadian based, so not part of the s&p 500. They're part of the Canadian benchmark, the TSX. And with that, their attitude towards growth was completely different. Michael Pearson's attitude, his thoughts were his thesis was such that r&d is wasteful. They grow through acquisition. And they were doing just an absolutely. And that's a blitz of m&a acquisitions, incredibly active, they would do hostile takeovers, and they're just gobbling it up ever. And it was working, their stock was on fire. It was doing exceptionally well. If you remember, Bill Ackman at the time, he was just praising the accolades of Michael Pearson, and valiance business model. So it was a highly respected strategy, both on Main Street and Wall Street. Analysts were going gaga over it, investors loved it in the stock was doing nothing but going up. So it's like if you didn't own Valiant, you're doing something wrong. And that started to reflect on others. And you saw copycats, saying, Wow, this is this consolidation. It's really working for Valiant. They're growing like crazy. They become, I believe, the largest company on the Canadian exchange by market cap. So the number one, the TSX a very, very quickly and some copycats started to spring up. And it wasn't surprising to see that their shares were also performing very well, this rapid consolidation strategy, no r&d, so it was very much financial engineering. Now at that time, as I indicated tax inversions were all the rage, and we are active on these within the portfolio. And in order for a tax inversion to work, the acquirer on the target had to have certain characteristics in terms of relative size, and the type of transaction to make it work. So what the acquirer was trying to accomplish with a certain size of target was to issue shares do a deal via by all share, and with that read domicile into a foreign jurisdiction. So generally, they would look for a target around 25% Take them over and carry on as a foreign entity subject to much lower tax rates. And with that, one, m&a trade that we put on that look quite attractive was you had a Canadian company called QL. T, if you're on T was a failed biotech company that just had a bunch of cash. So they're trading at roughly cash value, not a lot of prospects, aside from the cash that they had on the balance sheet, and perhaps some tax losses. But one redeeming factor was that they're Canadian, not American, and so a prime candidate for an inversion. So that inversion came way by a definitive merger agreement with a US company called Auxilium that was looking to run this new farm a playbook read domicile offshore by a tax inversion merger, then conduct m&a growth that had really been proven over the last few years and was super super hot in the market at that time. So the deal that was struck was a US entity called Auxilium, Auxilium therapeutics was looking to run that same playbook so struck a friendly deal with QL T to do an all share merger that would result in this tax inversion and Auxilium would take over QL T and re domicile to Canada. And to do that, in an all share deal of that size. The requirements to consummate this merger was not only did you require a successful shareholder vote at the target, so QL T shareholders and in Canada, if it's a plan of arrangement, that 66 and two thirds. Additionally, since Auxilium was issuing approximately 25% of their shares outstanding, in this merger, their shareholders ie the acquirers shareholders would have to approve the deal as well. So they struck the deal and it's going along and you know, there's a spread. And so if you go long, the target short, the acquirer, according to the share exchange ratio, it'll be out here say like, you know, it's a 5% spread, that would close in three months, right 5% spread over three months would be about 20% annualized, right, which is, which is a very attractive return, that you can earn, theoretically, irrespective of what the market does market goes up market goes down. As long as the deal closes, you generate that very attractive rate of return. One trick to that deal is you have the short position, right, a short position and environment of rapid pharmaceutical company mergers and acquisitions, friendly, hostile. And the key risk on this specific deal in a tax inversion in general is where they have to do an all share deal because in an all cash deal, the acquired shareholders don't need to vote on it. However, in an inversion where they're issuing about 25% or more of their shares, the acquires shareholders to vote so that that produces a big risk. So we put on this trade and is fairly decent size of our portfolio 4% both on the long and the short, approximately. And over time, I got the Inkling it's like, no, it's a lot of consolidation happening. I'm worried that you know, the key risk here is someone could make a play for Auxilium the acquire the stock in which we have a large short position and that can be very painful. So what we're doing is we're buying call options on Auxilium utilizing some of that spread available to kind of protect it in that awful potential scenario, now, after after a few months or prior to getting into that, I should I should talk about one more company and this company is called Endo, endo pharmaceuticals end p. At the time endo was run by a gentleman by the name of Raju de Silva. Now, Rajiv was basically Michael Pearson's protege, also ex McKinsey consultant also worked for Michael Pearson, at conducting valiance new strategy, immersion rapid rollout of the industry know r&d, extremely aggressive with deals. And so endo was out there. So called mini valiant trying to copycat run the same strategy. And with that, a few months after putting on this trade, disaster struck, endo came and made a hostile takeover bid for Auxilium the target the acquirer in this m&a deal, in which we had a short position to hedge our QL T long, we had that merger arbitrage and trade on molecule T short Auxilium and then Endo, this third party interloper came in and did or the acquirer now the like the key risk. And my biggest mistake that I learned from is that when the acquire has a shareholder vote on a deal that puts the acquirer in play in by in play, I mean, no subject to a potential hostile takeover. Because endo offered a 30% plus premium or Auxilium shares. Now if you're a shareholder of Auxilium would you vote for this takeover of Q LTI. Or would you vote for, you know, being taken over by endo 30% Higher. It's not a difficult decision to be made. And so Auxilium was put into play instantly. A QL T. It was clear as day that that deal was dead. I still remember the conference call. After hours. This bid was revealed after hours. And endo CEO Rajeev DE SILVA said, you know it's contingent upon the guilty deal being terminated. And I already knew that was the case because there's no way the Auxilium shareholders would vote for the QL T deal when they have this big premium by selling to Endo, whose stock was going crazy. So, the effect on us is Auxilium short we got our face ripped off that rallied like crazy. Remember, we did a hedge some of it with call options but it clearly wasn't enough. Not only that, but you're getting punished on both sides of the trade because the Target Q lt is dropping double digits right. So it's this double whammy face ripped off on the short as it surges and get crushed on your long as it plunges. So it was kind of like you know, shit sandwich if you want to talk about it, where the loss on that trade was significantly higher than expected. Granted, the QL tea deal failed. Auxilium ended up signing up with endo and a hostile term friendly deal. Bad deal closed and over time. It actually proved to be a horrifically bad acquisition for endo as everyone including myself expected. If you look at endo stock if you try to look it up, it no longer exists. It went bankrupt went to zero. Within a year of closing the Auxilium deal they already had a massive massive write down the CEO got fired and the stock plunged valiant As many know their stock plunged they are CEO got fired they had all this fraud going on. They had to split the company now they're trying to they're still trying to rebuild but I think that stocks down about it's didn't go to zero but it's pretty close down 90 95% But was definitely my worst trade ever. A detail than in a blog post I called the first time I lost $1 million. The lesson that I learned as an arbitrage er is you never put on merger arbitrage trade in which the acquirer has to stage a shareholder vote because 100% of the time I'd like to put on that merger arbitrage trade, you need to be short, the acquirer because there's a shared consideration. And with that, the existence of a shareholder vote on the buy side on the acquire side puts that acquire in play, it puts your short position in play, and makes it vulnerable to a hostile takeover. And then you get your face ripped off from the short, and you lose on the long. So it's a double whammy of losses, that in my opinion, it's just not worth taking that risk. I got burned on it almost 10 years ago, and have not been and will not ever put on that trade again, unless, of course, the acquirer has a controlling shareholder that would block it. But, you know, that's my words of wisdom for anyone looking at merger arbitrage, never put on an m&a trade that has the buy side both.

Andrew Stotz 35:51
And just to be clear if it hadn't had gone to the shareholder vote, and it would have just been the management team allocating cash resources that they had to acquire, then basically, they didn't have to pull together shareholders to even think about this. And as a result, you didn't have an option, you didn't have the opportunity of a you called an interloper, but as a third party coming in, just it's just not, there's just not an opportunity for them to seduce the shareholders way.

Julian Klymochko 36:29
Exactly. There's no leverage there. However, when there's leverage, and a shareholder vote, that's going to be voted down, the Board of Directors of the would be acquire and the one out subject to a hostile bid. They know the jig is up, their shareholders aren't going to vote for an acquisition that they're gonna make when they can sell to an interloper at a large premium, like no shareholder is going to vote.

Andrew Stotz 36:58
And why wouldn't Why wouldn't it be? Let's just imagine this same situation, and that the company, the acquirer is sitting on, you know, a reasonable amount of cash. And a third party comes in and says, I'll better allocate that cash. It's a stupid deal that they're doing. I'll, you know, come in and try to try to make a bid for the company. I mean, they're always free to do that. But that would just be too difficult if there wasn't this leverage point on the shareholder vote.

Julian Klymochko 37:30
Yes, so specifically with a US entity. In the US, there's a mechanism called the poison pill, which effect effectively protects companies from hostile takeovers. However, the existence of the shareholder vote on an m&a deal makes them extremely vulnerable, and basically, eliminates a poison pill, or the effect of potential ones. So it puts them in play and makes them vulnerable. And in Canada, poison pills don't don't really work, either. They get seats traded and fully puts a company in play. But yeah, it is that mechanism, or the shareholder vote at the acquirer side that creates that leverage such that a hostile, would be hostile acquirer can step in and present something to shareholders that significantly more attractive because for a hostile takeover, to be effective, it needs to be at a significant premium to be an effective price. I'm talking about 30% or higher. So, and one one more thing, like from a board of directors standpoint, they're looking at issuing shares in this initial deal. However, if someone comes in and says, Okay, you're willing to issue shares, ie sell them at, say, $10. If we come along and ish, and are willing to buy them at 3040 50%, premium, you know, 1314 $15, how can you say no to that? When you say yes to issuing them at 10? Right. So the jig is up from the board of directors, and they really have no choice.

Andrew Stotz 39:09
Well, I think you've explained it very, very well. And it's pretty clear. So I think my big takeaway is that anything can happen. And you've got to just you know, the idea of arbitrage, you know, used to mean when I was young, what we would call a riskless profit, but nowadays, I would say arbitrage is just a term of taking some opposing positions that may or may not be in restless and other cases, it may be that there is some residual risk, whether you're, let's say more long or more short. So I just say be careful when for the listeners out there when you hear the words arbitrage, it doesn't mean riskless arbitrage. It can mean that at times, but generally it doesn't. Um, so let me ask you, what's the resource you'd recommend for our listeners? Let's read the story. But that's, that's, that's a good one.

Julian Klymochko 40:12
So there's a lot online, I encourage listeners to be on Twitter, I find that to be a great resource, you can follow me at Julian Camacho. On Twitter, we post a lot of research and insights on our website, accelerate shares.com. I did write about this story a number of years back. And for investors, I think one resource especially starting out that I found quite helpful. There's investment websites, one being, you know, value investors club. I was a member of that for many, many years. So it's, you know, if you can get your hands on professional research, I think that helps a lot and read as much as you can. There's a lot of good investment books out there. So some of the books that I would recommend my personal favorite. It's kind of got a funny title. It's called you can be a stock market genius by Joel Greenblatt. And it's a classic was also one that I don't advise to buying, because it's incredibly expensive because it's quite rare. But it's called margin of safety. You can find a PDF version online it's by Seth Klarman and other well regarded investor and in addition to that, you know, the stuff by Graham intelligent investor that that's always a good one to look at. Peter Lynch, he's written some good books. So there's, there's a ton of great books out there that you can glean a lot of good knowledge and blog posts, people posting online, investor forums, Twitter, so much for resources. And most of all, once you read about it, the best way to learn is to practice by doing so try it out yourself and don't risk more than you can lose.

Andrew Stotz 42:12
listeners. There you have it another story of loss to keep you winning. Remember, I'm on a mission to help 1 million people reduce risk in their lives. If you've not yet joined that mission, just go to my worst investment ever.com And join up for the free weekly become a better investor newsletter to reduce risk in your life. As we conclude, Julian, I want to thank you for joining our mission and on behalf of a Stotz Academy, I hereby award you alumni status for turning your worst investment ever into your best teaching moment. Do you have any parting words for the audience?

Julian Klymochko 42:47
Yes, Andrew, thank you for having me on your show. And I will start with my favorite quote from Warren Buffett. He says Teach a man to fish. Feed him for a day Teach a man to arbitrage freedom for life.

Andrew Stotz 43:08
And that's a wrap on another great story to help us Greg grow and protect our well fellow risk takers. Let's celebrate that today. We added one more person to our mission to help 1 million people reduce risk in their lives. This is your worst podcast host Andrew Stotz saying. I'll see you on the upside.


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About the show & host, Andrew Stotz

Welcome to My Worst Investment Ever podcast hosted by Your Worst Podcast Host, Andrew Stotz, where you will hear stories of loss to keep you winning. In our community, we know that to win in investing you must take the risk, but to win big, you’ve got to reduce it.

Your Worst Podcast Host, Andrew Stotz, Ph.D., CFA, is also the CEO of A. Stotz Investment Research and A. Stotz Academy, which helps people create, grow, measure, and protect their wealth.

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