About one year ago, Bulldog Investors agitated for changes at Virtus Total Return Fund (DCA) that has culminated in the recently closed self-tender offer and the approved pending merger into Zweig Fund (NYSE:ZF). Although the self-tender offer for 40% of DCA's shares expiring on March 15, 2017 appeared to be an opportunity to capture an easy 5% with the shares being purchased at 99% of NAV, and the shares trading about a 6% discount leading into the tender offer expiration date, this was not the case. Tendering DCA shareholders awoke to trading on March 16, 2017, to discover that since over 64% of all outstanding shares were tendered into the offer, only 62% of the shares they tendered were accepted to be purchased at 99% of NAV. This left tendering shareholders with 38% of their shares returned and exposed to market risk. Since DCA opened on March 16, 2017 down 5% from the close on March 15, 2017 on any significant volume, tendering shareholders barely profited from this transaction. Their gain on their tendered shares was largely offset by their losses on the tendered shares returned.
The drop on March 16, 2017 of DCA should have been expected. Since DCA was trading at a 6% discount to NAV while ZF was at a 12% discount to NAV heading into the tender offer, the values in relation to NAV for both securities would need to equalize after the tender offer, otherwise an arbitrage opportunity would present itself. Here is the reason. With a merger of DCA into ZF approved prior to the expiration of the tender offer, DCA, with the tender offer out of the way and ignoring upcoming dividends, essentially became ZF. Why? Because the pending merger states that DCA shareholders as of the close of March 31, 2017 will get ZF shares on April 3, 2017, representing their proportion of NAV to the total DCA and ZF combined NAV as of the merger effective date.
Source: DCA Special Meeting Proxy Statement
And this is almost exactly what happened. As of March 16th's close, the discount to NAV of both closed-end funds nearly equalized at 11.75% for ZF and 9.96% for DCA.
Equivalence and Opportunity
- DCA's NAV as of March 16, 2017 close is $4.92.
- ZF's NAV as of March 16, 2017 close is $12.77.
- Combined NAV as of March 16, 2017 close is $17.69.
- $4.92/$17.69 = 27.8% DCA ownership of merged closed-end fund.
- $12.77/$17.69 = 72.2% ZF ownership of merged closed-end fund.
- ZF Merged Ownership Percentage/DCA Merged Ownership Percentage = Share Equivalence
- 72.2%/27.8% = 2.59 shares of DCA equal 1 share of ZF
- 27.8%/72.2% = 1 share of DCA is equal to .385 shares of ZF
- DCA market price as of March 16, 2017 close is $4.43.
- ZF market price as of March 16, 2017 close is $11.27.
- Combined market value as of March 16, 2017 close is $15.7.
- $4.43/$15.7 = DCA being bought as if it had 28.2% post-merger ownership. Traders overpaying.
- $11.27/$15.7 = ZF being bought as if it had 71.7% post-merger ownership. Traders underpaying.
- Sell (Short) DCA and Buy (Long) ZF in equivalent post-merger ownership amounts (Hedge). As of close of March 16, this would mean you sell 2.59 shares of DCA for every 1 share of ZF you buy.
- Maintain the NAV proportions up to the merger close date (Dynamically Hedge).
- At the close of the merger, collect the discount to NAV difference between ZF (larger discount, cheaper equivalent) and DCA (smaller discount, more expensive equivalent) as your profit.
- DCA dividend of $.10 to shareholder holding this stock through the close of March 21, 2017.
- ZF dividend of $.361 to shareholder holding this stock through the close of March 21, 2017.
You will need to pay the DCA dividend since you will be short and will receive the ZF dividend you are long. Since the ZF dividend you would be paid for each ZF share you are long would be $.361, while the DCA dividend you will pay for the equivalent 2.59 shares you are short is $.259, this will work to your advantage in this merger arbitrage trade.
You will need to locate and insure you can maintain the short DCA stock position. Interestingly, I was not able to find DCA shares even returned by Interactive Brokers short stock availability tool, much less available.
Source: Interactive Broker Short Stock Availability Tool
Shares are difficult or not available to short when they are held by shareholders in certificate form in a cash account and when they are very actively traded. I am not sure what is creating the challenge in finding shortable DCA shares in this situation. However, if you are able to locate DCA for shorting, and can be confident that you can maintain this short through the merger close date of March 31, 2017, the closed-end fund discount difference can be captured as arbitrage profit. It is likely that NYSE market makers, who are exempt from the short locate rules, and other large institutional brokerages have no problem finding the DCA shares that are required to be shorted to make this arbitrage work. In fact, this is likely what drove the discount to NAV between DCA and ZF close to parity after the expiration of the tender offer.
The risks to this arbitrage investment is maintaining the short position in DCA through the combination of DCA into ZF on April 3, 2017. There is the additional risk in maintaining a long position in ZF and a short position in DCA in proportion to their NAV ratio as it changes through time up to the closing. In other words, the ability to dynamically hedge this trade.
This is an interesting special situation for those with the ability to locate DCA to short. DCA's market capitalization is only $135 million, which may limit the opportunity and explain the difficulty in finding available shares to short. It will be interesting to see in the comments section whether anybody can locate the shares and has confidence that they could maintain the DCA short through dynamic hedging through the close of the merger. I believe myself and others would benefit from the knowledge this information would provide for future opportunities, and perhaps even this one if timely enough.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Do your own research, make your own investment decisions, and own those choices.