Mattress Firm acquisition...how was this likely hedged?

Saw that Mattress Firm (MFRM) popped 100%+ on take-out proposal this morning. The company had a 40%+ short interest, and on its face, appeared to be a decent short (highly levered, specialty retail, declining margins, cyclical business, continued integration pains, etc. etc.). Clearly a huge loss for the HFs who were shorting, but raises the question for me of how HFs typically hedge for an improbable event like this. There are no bonds in the structure, while the loans weren't yielding enough to be a meaningful hedge. How do you L/S equity guys hedge an idiosyncratic event like this when you put up shorts on the equity? Do you keep open interest on calls for an event like this (seems expensive)?

 

Awful, awful short despite the surface level fundamental assessment of the business (which I mostly agree with). Two major risks with a short that should have been pretty apparent:

  1. JW Childs took Mattress Firm private in 2007, as part of its fund III raised in 2003. After holding the investment for nearly 10 years, I'm sure JW Childs wanted to exit their position even though there probably wasn't too much LP pressure given that the fund was recapped. JWC basically had two options given their large position - sell their shares in a secondary at a discount, or try to find a buyer which would obviously be the more advantageous of the two. All in, I don't think an acquisition by either a sponsor or strategic was improbable in this case.

  2. Even if an acquisition never happened, most of the shares have been locked up by principally JW Childs and Berkshire. Thus, a short squeeze was much more likely to occur - more than 50% of total shares outstanding were locked up (that's why there was 40% short interest). The shorts could have easily been burned by some good news, although I don't think this risk really materialized in the last year.

To answer your question in a roundabout way, a fund that didn't do enough diligence to see these factors working against a potential short probably wasn't smart enough to place hedges in the first place (or they sized their position well recognizing some of the risks as some others have stated). I'm sure there were also funds that saw these risks, looked for hedges, and passed on the short because they couldn't find any good hedges.

But then again, hindsight is 20/20, and we'd be circle jerking the shorts if MFRM went to zero.

 

Thanks for the comment. Is the technical setup in #2 is somewhat of an unmitigateable risk? Another similar set-up that comes to mind is WTW, where Artal holds almost half the equity, and the Oprah news last year caused an epic short squeeze, but eventually it's making its way back down this year. It feels like this may be a risk that short investors have to stomach if they truly have a fundamental conviction on the short. Re. #1, just playing devil's advocate, couldn't someone say that because JWC has owned this for as long as it has that there is a reason why it can't sell this thing outright?

 

Re: #2, I can't think of any way to really mitigate the risk without some expensive protection off the top of my head. Let me know if you think of any, would love to bounce some ideas around.

Re: #1, I personally wouldn't look at the situation that way although I take your point. I agree that JWC probably struggled selling the business for one reason or the other; however, just because JWC hadn't sold the business doesn't mean that they weren't actively looking to sell and wouldn't be successful in execution. Basically, I would never be comfortable in betting against a business that was likely trying to sell itself. I wouldn't be comfortable betting against a sponsor's ability to execute in a black box sale process with minimal information on probability of a successful sale/terms of the transaction.

 
Best Response

To add - as long as there isn't a trigger event, ie a refinancing, a sponsor will always kick the can down the road and hope the company/industry/markets rebound. Markets cycle so while maybe they didn't have an ability to sell in the past...I wouldn't base my investment thesis on an inability to do so in the future - clearly those that did got burned. Also, sponsors can do dividend recaps so they are basically playing with free money, depending on how much of a refi there has been in the past. Can't speak for how much skin in the game Childs still had but they did basically by Sleepys for free using MFs balance sheet. Long story short - its not a good thesis to say oh but wait they haven't been able to sell it.

 

this is way too fucking nerdy for me ... you dont need to get too fancy with this shit people - all you need is the holy trinity (profit, balance sheet, cash flow) put them into a simple projection model, conduct a couple of store visits to get to know service/product. if those things yield a funny feeling in your fizzy bits then you buy and hold on to your nuts. anything else is speculative and that means might as well train a chimpanzee to randomly pick the stocks.

"I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing. " -GG
 

Honest question - do you have any idea the cost of carry on a hedge? Maybe you do - personally I didn't until I started working at a HF. From my personal experience, people often say, oh just hedge that away, or put a hedge on without knowing anything about hedging or more importantly the cost of hedging. Often times times to put a hedge on the cost of carry is so high it would eat away the majority of your potential return. Many times good underwriting and diligence are the best hedge you have.

 
Massfinance1995:

100% agree on the speculative aspect. Just to clarify though, you're saying you'd rather just dive head first into the deep end unhedged and if all goes south (like it did) chalk it up as a loss and say oh well?

yes, with one clarification: figure out hat your tolerance for risk is and make it part of your life - go to bed with it, sleep with it, spoon it, shower with it, finger it (whatever rock's your boat). stop loss is a fantastic feature so get to know it real good. same with upside (although when you hit your up target then i recommend running the numbers again to see if you should keep holding - if stock price is driven by speculation and higher volume and not because of tangible reasons (like cost savings, higher revenue etc etc)i would say dump it because who the fuck knows what is coming down the line and might as well capitalize on those paper gains). But then again I am not a pro so what the fuck do i know.

"I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing. " -GG
 

question is, why didn't the shorts consider the possibility of this stock springing back? (see what i did there. ok ill stop)

ot: Spoke to a few analysts/PMs through fintwit - essentially saying shitty a business this was and raving on shorting pos - none of them even remotely considered the possibility of a buyout happening (or anything else in the short-term that would pump this stock). As you pointed out, fundamentally speaking it was a bad business and the short thesis was entirely right, imo. I guess shit just happens.

 

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