Guest Interview, David Paolella at The Special Situations Report

Edition 29

Good morning,

After having Conor Maguire on to discuss special situations a few months ago, I thought it would be great to revisit the subject with another investor, David Paolella. After an eight-year stint at Guggenheim Partners, serving as Vice President, David is now the author of the Special Situations Report.

I am fortunate that the work I conduct facilitates my ability to meet new investors and creators on a weekly basis. Much like in the case of previous guests, I first met David after reaching out to him, having a few Zoom calls, and getting to know him (yay, internet). It was quickly apparent that this was someone with rich expertise, whom I could learn from, but also a thoughtful guy too. Today’s discussion will centre largely around special situations investing, M&A, and David’s investment process.

If you enjoy this conversation, I would highly recommend subscribing to The Special Situation Report, where David shares his work (for free). It has now become part of my own weekly reading, allowing me to digest what’s going on in the world of M&A.

David Paolella at Special Situations Report

Conor: Welcome David, I appreciate you taking the time to chat. Back in February, I had Conor Maguire answer some questions, a fellow special sits investor, so I thought this would be a great follow-up, as well as a further opportunity to highlight another investor doing great work in that niche.

Prior to writing The Special Situations Report, you spent over 8 years at Guggenheim Partners, where you served as Vice President. I thought this would be a great place to start. Perhaps you could provide readers with a succinct backstory of how you found yourself in the field, and maybe a little bit about what you did at Guggenheim?

David: Thanks for having me, Conor.

As you mentioned, I publish The Special Situation Report. Every Sunday, subscribers receive a free email recapping the latest news in event-driven and shareholder activism. Periodically I publish long-form reports highlighting actionable investment ideas.

I graduated from university with a bachelor's degree in business and accounting. I have work experience on both the sell-side and buy-side. Most recently, I served as Vice President at a global financial services firm, Guggenheim Partners. In this role, I advised companies on mergers and acquisitions, capital raising, and other strategic transactions.

Conor: At Guggenheim you were involved in a considerable amount of high-profile M&A transactions, such as Adidas’ $425M divestiture of TaylorMade and other golf brands, Life Time Fitness’ $4.1B sale to Leonard Green and TPG Capital, and Ascena’s $2B acquisition of ANN, to name a few.

As a two-pronged question; were you always interested in special situations, or did your time at Guggenheim spark something in you? Then secondly, how do you feel that experience has shaped the style of investor that you are today?

David: My time at Guggenheim provided me with a unique perspective. I developed an expertise in valuation and a fundamental understanding of the mechanics and considerations around mergers, activism defence, and other strategic matters. And I had the opportunity to interact with many public company management teams and board rooms and got a first-hand look at the tactics they use to drive business success and shareholder returns.

That experience honed my expertise and built upon an existing interest in special situations.

Conor: Whilst we are on the topic of your investing style, it would be great to understand how you frame your approach. Is it purely special situations?

On that note, based on my relatively shallow understanding of special sits, it would appear that a few of the most critical components to success in that space are: finding a suitable valuation, protecting downside, having some form of near-term catalyst, and then the idea of having a level of asymmetry that is favourable to you, the investor. In what order of importance would you rank those components?

David: I would describe my investing approach as ‘value with a catalyst.’  

One way I implement this approach is by investing in takeover targets undergoing consolidation. These companies are typically selling below their intrinsic value, so you can profit in any market, particularly in sideways or down markets, during which takeover premiums provide asymmetric upside optionality.

I’d say your list is accurate. But it’s challenging to rank those components in order of importance because they need to be considered in the context of each individual company and situation.

I try to find “no brainers” – investment ideas that present such an attractive opportunity, they don’t require a creative approach to construct a profitable thesis. I think it is better to be roughly right than precisely wrong. I keep an open mind and adjust my theses to account for new facts or circumstances.

Conor: The Special Situations Report is the newsletter that you dropped in January of this year, and I have been enjoying the weekly roundups you send out, as well as the more nuanced subject matter you share in between.

What is the goal for The Special Situation Report over the long-term, what are your plans in terms of content variety, and why was 2022 the year you decided to take a stab at this?

David: My goal is to provide value to investors and hopefully germinate a profitable idea or two.

I sort of stumbled into a formal newsletter. I wanted to digitize a system for my own idea generation purposes. Substack is very user-friendly and made the process incredibly easy. I started in January with no existing email list or social media following. But hundreds of investors found it, liked it, and subscribed, much more quickly than I’d expected.  It’s been rewarding to me personally, and I’ve met many great people (and investors).

I have no current plans to change my content strategy. I’ll send a free email updating you on the latest in special situations every week. Every few weeks, I’ll publish an editorial piece that goes in-depth on a particular thesis, with my analyses and ideas.

Part of what makes ‘now’ so interesting is that there are so many opportunities.  We’re amidst a merger wave, experiencing a surge in investor activism, and digesting a historic number of new offerings driven by speculative IPOs and SPAC offerings, many of which have now fallen precipitously. It’s a fertile hunting ground for an enterprising investor.

Conor: When we first spoke, you remarked that you are fairly new to the social sphere that is Twitter/Fintwit. How have you found your bearings, and has anything surprised you thus far?

David: There are many intelligent investors online, either posting content or consuming it. Twitter is a valuable tool for aggregating this supply and demand. When I was working on Wall Street, compliance concerns restricted me from creating an account or being active.

I’m still experimenting with how to best use the platform, but I’m focused on providing value for my followers. I figure, that if I control the quality of my output, the outcome should be positive over time.

I’m both surprised and thankful that I have been able to get traction so quickly. I have been able to connect with many savvy investors and creators, including yourself!

Conor: Too kind David, thank you. I look at my own collection of substacks, all scribed by investors with more experience, tackling different niches, and deploying different styles, as an extension to my own research. Somewhat like outsourcing a bunch of analysts. Analysts who are kind enough to answer any questions I may throw their way. It’s also great for idea discovery.

One thing I am always curious about is the individual’s process for idea generation. In special sits land, opportunities are not always floating on the surface like sitting ducks. Oft, there is some level of heightened time sensitivity involved. What does your discovery process look like?

David: I approach the world with an open mind. I try to stay up to date with what’s going on, not only in terms of economic trends but also political and social developments.

I consume “traditional” newspaper and magazine publications, like the Wall Street Journal and the Financial Times. I subscribe to “new” mediums such as digital newsletters, blogs, and podcasts. And there are good ideas on certain social forums, including Twitter (although there is also a lot of noise).

I have no shame in taking ideas from others. I read letters from hedge fund managers and industry professionals. I track the pitches and dialogue at investing conferences. I listen to other investors’ perspectives.

I have developed news and quantitative screens that I regularly deploy. And I track my old ideas for attractive entry points.

Conor: Given the time-sensitivity, how do you manage the process of (a) discovering a potential opportunity, (b) researching said opportunity effectively and (c) completing steps a and b before the catalyst ignites? 

David: Generally, I’m not too time-sensitive.

In analyzing companies and special situations, I’m looking at least 12-24 months out and comparing my view of the future with the current state of affairs. Then, I buy and patiently hold.

If I miss a profitable investment or two because I was taking too long to act, I probably wasn’t informed enough yet to have any real edge over the market. So, I don’t lose any sleep over it.

Conor: With time being such a finite resource, the adage of turning over many rocks comes to mind. Let’s say you discover a potential situation and begin the legwork of researching the idea.

What has to materialise, pop up, or be present, for you to hastily conclude that this is not an idea you want to pursue. Whether it be a red flag or a matter of risk/reward, I’d be interested to know what factors make you say “nope” and move on to the next rock?

David: I think it’s important to be incredibly informed and educated about a particular topic or sector to have an edge over the market. My “I don’t understand this well enough” filter eliminates a broad swath of potential opportunities.

I generally avoid most new IPOs. Particularly in recent times, offerings are being done at stretched valuations. If you are patient, the market will give you an opportunity to purchase at a price below the IPO.

I avoid companies that are losing money without a clear line of sight to cash flow generation. I try to avoid value traps and high-flyers with poor competitive positioning. I look for businesses with long runways for reinvestment but avoid those with poor returns on capital. Companies in overly competitive or overly regulated industries have a very high bar. 

Conor: When it comes to catalysts, are all created equal? I would love to hear you riff on which varieties you find to be more attractive to yourself, and possibly outline which tend to be weaker or stronger.

David: Catalysts can hold an important place in an investor’s toolbox. Generally, they give you greater predictability that you will, in fact, make money and aren’t subject to the vagaries of the market, economy, and business cycle over a long period of time.

Given my background and expertise, my primary focus is on special situations: takeover targets, spin-offs, asset divestitures, announced strategic processes/business transformations, investor activism, and M&A rumours, among other topics.

There are several other types of special situations in public equities. Each has merit as an individual strategy or part of a broader portfolio. For example:

·      Merger/risk arb

·      Liquidations

·      Rights offerings

·      Tender offers

·      Thrift conversions

The relative merits of the various strategies depend on your expertise, risk/reward profile, and investment objectives.

Conor: In a previous post (“The Anatomy of a Takeover Target”) you cited a 2016 paper that suggested that in a given year, the probability of a public company becoming an acquisition target was 4.3%. That same paper proceeded to delve deeper into 6 characteristics of a potential acquisition target in; growth, profitability, leverage, size, liquidity, and valuation.

Would the fact a company has the markers of being an attractive M&A target ever be a considerable part of your thesis, or would it simply be gravy? Secondly, what, in your mind, are the tell-tale signs of a business that might one day soon be acquired?

David: I view takeover targets as a strategy to supplement, rather than supplant, any given approach to investing. It provides value as a slice of investor allocation. Or it could be a lens for any other strategy, such as value, growth, income, etc.

It is vital to consider an investment on its stand-alone merits, putting aside its likelihood of being acquired. Because a company may lay in wait for a number of years before being acquired.

There are a few things I look for. I look at the incidence of takeover activity in a particular sector or industry. I try to find ongoing or upcoming consolidation trends. I look for the presence of an outside beneficial shareholder with a history of takeover bids, particularly when they are buying more shares in the open market. I pay attention when an activist investor emerges. My ears perk up when companies announce a plan to simplify operations to focus on their core business, announce plans for spin-offs or asset divestitures, or announce that they plan to “maximize shareholder value” or “explore strategic alternatives.”

If a company is buying back its stock, particularly in large volumes, it suggests a belief that its shares are too low and perhaps concern over a lowball bid. If insiders buy stock in the open market with their own cash, perhaps they have a “hunch” regarding upcoming catalysts that may drive value. And why would insiders sell if there was good news on the horizon?

Most importantly, I look for a confluence of factors. When a company ticks many or all of these boxes, I start to pay more attention.

Conor: A few weeks ago I was reading over a report from Schroders titled “the great stock market takeover boom” and in that report, they showed the number of investigations initiated by the Department of Justice for antitrust concerns has dwindled considerably over the last few decades. The report concludes that US authorities have taken a more relaxed stance on industry consolidation.

Why do you think that might be? I would love to hear any thoughts you may have.

David: Great study, thank you for sharing. Generally, as the graph indicates, the scope and interpretation of antitrust laws have been narrowed since the 1970s.

A driving factor is the emergence and prevalence of the Chicago School of economics. The Chicago School emphasizes the power of free-market economics and is associated with a more conservative approach to antitrust enforcement. The prevailing argument is that markets are efficient and will naturally correct a lack of competition.

Recently there has been increased regulatory pressure on mergers and acquisitions. For example, the FTC successfully blocked Lockheed Martin’s purchase of Aerojet Rocketdyne. The Department of Justice sued to block UnitedHealth’s acquisition of Change Healthcare. The FTC and DoJ are sending letters warning companies to close deals at their “own risk.” Senator Elizabeth Warren and Representative Mondaire Jones introduced legislation to block deals of more than $5 billion, or deals that lead to high market share. Maxine Waters, the Chair of the House Financial Services Committee, called for a cessation of deals that resulted in a bank having over $100 billion in assets. And FDIC Chairman Jelena McWilliams resigned after partisan disputes over the bank merger process.

Conor: Lastly, where can readers find you and your work, and do you have any concluding items you’d like to say?

David: I publish weekly to my subscribers at www.thespecialsituationreport.com. And I am active on Twitter @InvestedComms.

I enjoy the work you are doing at Investment Talk. Keep it up, and I look forward to following your journey.

Conor: Thanks again David, for the kind words, and for taking the time.

Conor,

Author of Investment Talk