The market continued to gain momentum in May as investors focused on further stimulus and easing restrictions, reinforcing optimism that global activity has bottomed and will recover. The May US jobs report stoked expectations for a strong recovery, reporting that unemployment fell to 13.3% from 14.7% – contrary to what many economists had forecast. However, markets are clearly still highly sensitive to COVID-19. Following what had been a stunning weeks-long rally, fears of a second wave in the US led to the return of volatility on June 10, with the S&P 500 experiencing its largest single-day pull back since March.

Brent Crude prices rallied in early June to levels not seen since March 6 on the news that the Organization of the Petroleum Exporting Countries (OPEC) would reach an agreement to extend production cuts through July. Prices have subsequently retreated with broader markets, however.

The yield on the 10-Year US Treasury widened 0.07% to 0.896%¹, its highest level since March 19. Issuance of senior secured debt in April ($16.5 billion) and May ($14.4 billion) were the second and fourth largest on record as companies tap this debt capacity for rescue financing across COVID-19 affected sectors. The new-issue high-yield market also continues to be very active, as last week’s new issue volume totaled $14.0 billion. High-yield new-issue volume has climbed to $170.9 billion ($72.5 billion net of refinancing) year-to-date¹, which is up 49% (and 86%) year-over-year.

Eight companies filed for bankruptcy or missed an interest payment in May, affecting $11.2 billion in bonds and loans. This followed a record 20 defaults or distressed exchanges in April which totaled $36.0 billion. Among the largest filings over the past month were Hertz Global ($24.4 billion in liabilities), Latam Airlines ($18.0 billion in liabilities), Intelast ($16.8 billion in liabilities), and JC Penney ($8.0 billion in liabilities). Mergers and acquisitions (M&A) activity has been muted as corporations cautiously navigate the post-COVID-19 market, but bankers and investors believe that activity will increase later in 2020.

We have been busy through earnings season as companies provided investors with much needed information around liquidity, cash flow, and steps taken during the pandemic. This led to several large positive moves in the energy and aerospace part of the portfolio. We have also looked at numerous high-profile financings by companies such as Boeing, which have tapped the new issue markets in order to increase liquidity. Another large area of recent interest has been the convertible bond market. Although new issuance in that market is at decade highs, we focused our attention in March and April on busted or out-of-the-money bonds which generally moved higher with the strong equity rally.

¹ As of June 5, 2020.

Material represents the manager’s opinions and should not be regarded as investment advice or a recommendation of any security or strategy. Investors should not rely on these opinions in making their investment decisions. Our views are a reflection of our best judgment at the time of the commentary and are subject to change at any time based on market and other conditions, and we have no obligation to update them. Investing involves risk, including loss of principal. Past performance is not indicative of future results. View top ten holdings. Visit the glossary for definitions of terms.

Simon Property Group and Taubman Centers are both mall-focused REITs operating in the US. In February 2020, shortly before markets peaked, Simon arrived at a definitive agreement to acquire Taubman in an all-cash deal worth $3.2 billion. The $52.50 per-share deal value represented more than a 50% premium over where Taubman shares traded the day before announcement. As the novel coronavirus spread, mall properties across the US were temporarily shuttered due to quarantines and shelter-in-place orders. We have been following this deal very closely and we are well aware of the investors and commentators that have voiced fears that Simon was exhibiting signs of buyer’s remorse and might attempt to abandon the deal. Over the past several months we have maintained our exposure to the deal as we believe the definitive merger agreement in this transaction is one of the strongest contracts in our space today, and we believe Simon has very few – if any – avenues to escape its obligation to complete the merger.

On June 10, Simon filed to terminate the transaction, claiming Taubman has been disproportionately impacted by the pandemic and has breached its obligations under the merger agreement. The termination was not mutually agreed upon, and in fact Taubman publicly responded the same day, claiming Simon’s termination is invalid and without merit, and the company believes Simon continues to be bound to the transaction in all respects. Our conviction in our position has not wavered, as we believe Taubman by far has the stronger case for several reasons. The merger agreement, which has been described as “iron clad” in media reports, carves out pandemics as reasons by which a material adverse change (MAC) may be claimed. Furthermore, Taubman’s obligations under the agreement only call for the company to exercise “commercially reasonable” efforts in conducting its ordinary course of business. There are no financing contingencies on this deal, and it is being funded solely from Simon’s balance sheet. We have reviewed Simon’s court filing, which we believe makes what are at best dubious claims to support the company’s argument for termination (even more so as malls reopen and foot traffic resumes). Lastly, the case was filed in Michigan, where Taubman is both domiciled and headquartered. In our experience through similar court cases and appraisal rights processes, a “home court” advantage in such proceedings is very much a real thing. If this case goes to trial, we are highly confident that Taubman can emerge victorious and require Simon to complete the deal on its original terms.

That said, we are skeptical Simon’s endgame is truly to terminate the deal. Simon knows how strong the merger agreement is. Not only that, Taubman is a highly strategic asset for Simon. Taubman’s properties are typically higher end, Class A malls with upscale tenants. In a world where brick-and-mortar retail has been faltering – even before the pandemic – these are the stores and properties that are more likely to survive and retain greater value in the long term. Conversely, Simon has many Class B, C, and D properties in its existing portfolio. We believe Simon is highly incentivized to own Taubman, and this lawsuit may simply be posturing in an attempt to secure a price cut. Taubman’s shareholder vote is scheduled for just two weeks from now, and Simon was quickly running out of time before the deal would have closed on its negotiated terms. While we believe this deal will ultimately get done in one form or another, we do expect volatility in the spread to be prevalent. With that in mind, we intend to maintain our core position, and we will likely trade the spread opportunistically as it widens and tightens.

While the spread on the Taubman/Simon deal was sent significantly wider on the day’s news, it was not the only merger arbitrage situation that was impacted. Arbitrageurs exited positions in other transactions showing signs of buyer’s remorse, sending those spreads wider as well. Most notably, this included the acquisition of Tiffany & Co by Moët Hennessy Louis Vuitton SE (LVMH). Last week reports emerged in the press that LVMH was looking to find a way to renegotiate terms. While we don’t believe LVMH is wavering in its desire to own Tiffany, we do believe the company regrets having to sweeten its bid in order to convince Tiffany to come to the table shortly before the pandemic, which will clearly impact Tiffany’s business in the near term. Nonetheless, Tiffany is a one-of-a-kind asset that is highly strategic to LVMH, and its value is not found solely over the next two to three years, but the next two to three decades. Even if LVMH decides to try its hand in court in an attempt to convince Tiffany to agree to a price cut, this is another transaction with a strong merger agreement and we have a high level of conviction it will achieve a successful conclusion.

If we can leave you with one key takeaway, it is to never forget a definitive merger agreement is a binding contract. With few exceptions (such as a MAC, a regulatory block, or failure to secure a shareholder vote or financing), the parties to the deal must see it through to completion. We have nearly two decades of experience dissecting merger agreements – looking for loopholes, the avenues for escape – and we have seen when companies try to get creative in abandoning a deal or securing a price cut, when they succeed, and when they fail. Ultimately, when uncertainty and fear emerge and spread volatility spikes, our breadth of experience is what gives us the ability to maintain our conviction and see opportunity rather than misfortune.

Material represents the manager’s opinions and should not be regarded as investment advice or a recommendation of any security or strategy. Investors should not rely on these opinions in making their investment decisions. Our views are a reflection of our best judgment at the time of the commentary and are subject to change at any time based on market and other conditions, and we have no obligation to update them. Investing involves risk, including loss of principal. Past performance is not indicative of future results. View top ten holdings. Visit the glossary for definitions of terms.

Forced selling to meet redemptions has caused the investment grade curve to invert. This is because short-dated paper is easier to sell, but the lower levels have increased yields tremendously. As an example, the Bloomberg Barclays US Corporate 1-5 Year Bond Index (short-dated investment grade credit) was down 5.6% year-to-date through this past Monday, March 23, while the Bloomberg Barclays US High Yield 0-5 Year Bond Index (short-dated high yield credit) was down 18.2% for the same period. The Bloomberg Barclays US Corporate Bond Index (comprised of investment grade credit) was down 10.0% year-to-date with a yield-to-worst of 4.4% (before the crisis the yield was 2.2%). The Bloomberg Barclays US Corporate High Yield Bond Index was down 19.8% year-to-date with a yield-to-worst of 10.8% (yield was 5.1% prior to the crisis).

Liquidity reminds us of 2008. Panic selling and forced selling has caused even the best credits to gap down multiple points. We’re hearing from sell-side traders that the worst selling occurred in the middle of last week, and pressure seems to have paused for the moment. But the dislocation in prices has been relentless and widespread. Investment grade credits impacted by the virus have blown out by 100 basis points or more. Disney is a prime example, with its 10-year bonds down 15 points and its 20-year bonds down 30 points. Distressed investors are seeing opportunities in energy and investment grade bonds that are trading with high-yield-like yields. Credit in announced merger-related situations is trading like there is no deal on the table, with exchange-traded funds and other sellers pushing bonds down to high-yield market levels.

The Federal Reserve has been very proactive and positive in seeking to stabilize the various funding markets, most recently announcing a massive series of programs designed to support municipalities and businesses both big and small. These actions are incredibly important for the functioning of capital markets and assisting investors with liquidity. However, they do not and cannot solve the ultimate problem, which is containment and treatment of the novel coronavirus. The duration and scale of the eventual impact to the economy remains uncertain, and at this point only the passage of various support measures from the federal government, a resumption of more normal activity (as we are hearing about in China), and/or developments on a COVID-19 treatment or vaccine are likely to spur markets to move upward again.

Material represents the manager’s opinion and should not be regarded as investment advice or a recommendation of any security or strategy. Our views are a reflection of our best judgment at the time of the commentary and are subject to change any time based on market and other conditions, and we have no obligation to update them. Investing involves risk, including loss of principal. Past performance is not indicative of future results. Short-term performance may not be indicative of long-term performance. Indexes are unmanaged and one cannot invest in an index. Visit the glossary for definitions of terms and indexes.

March 16 saw significant spread widening and price dislocations across the merger arbitrage space, leading many of our investors to ask us for further updates on our market outlook and a review of the portfolio’s positioning. As experienced arbitrageurs, we believe the markets are offering us unprecedented opportunities. Some of the biggest one-day movers in our portfolios included deals involving companies or industries that have associated exposures to prevailing concerns in the market, such as coronavirus impact (gaming) or oil prices (energy), and deals involving private equity buyers.

Tech Data Corp/Apollo Global Management Inc: In November 2019, Apollo Global Management Inc – a US listed private equity firm – agreed to acquire Tech Data Corp – a wholesale distributor of technology products – for $4.6 billion in cash. The transaction is expected to close in Q2 2020.

Caesars Entertainment Corp/Eldorado Resorts Inc: In June 2019, Eldorado Resorts Inc – a US based holding company for casino hotels – agreed to acquire Caesars Entertainment Corp – a US company that provides casino gaming and hospitality services – for $10 billion in cash and stock. The transaction is expected to close in Q1 2020.

Tallgrass Energy LP/Blackstone et al (consortium): In December 2019, a consortium led by Blackstone Infrastructure Partners LP – a US-based infrastructure fund – announced they had agreed to acquire the remaining 55% stake not already owned of Tallgrass Energy LP – a US-based provider of natural gas transportation and services – for $7.0 billion in cash. The transaction is expected to close in Q2 2020.

LogMeIn Inc/Francisco Partners Management LP et al (consortium): In December 2019, private equity firm Francisco Partners Management LP and hedge fund Elliott Management Corp announced they had reached an agreement to acquire LogMeIn Inc – a US-based technology provider of on-demand, remote connectivity solutions – in a joint bid worth $4.2 billion in cash. The transaction is expected to close in mid-2020.

The rationale behind these transactions and their fundamental underpinnings have not altered. We believe private equity buyers remain committed and financing remains in place. However, portfolio managers, particularly in the hedge fund and long-only community, are being forced to capitulate to meet margin calls, to raise capital to meet client cash flow requests, or to acquiesce to risk managers instructing them to exit. We have seen large swaths of the mergers and acquisitions target universe trading at the same levels as before deal announcement. We have always believed it is important to maintain “dry powder” for periods when fear overwhelms rationality. Our cash balances are allowing us to step into this market, albeit with discipline, and put capital to work where we believe the deal rationale remains sound, the risks are generally knowable, and the duration of the deal is fairly short-term. Take for example the Allergan/AbbVie transaction. This is probably one of the most widely held deals among arbitrageurs. The spread on the deal widened from less than $4 with three weeks remaining to expected close, to over $18 on March 16, while nothing related to the likelihood of deal closure or the deal terms has changed. We maintain our position in this transaction and have confidence that this deal will complete by the companies’ expected completion date of April 1, 2020.

Given our firm’s focus on capital preservation, we believe it important to dynamically assess risk at both the position and portfolio level. In a market characterized by such extreme turmoil, properly gauging downside can be a moving target. Our approach is to run scenario analysis according to a base case, a bear case, and a bull case and to consider the total range of potential outcomes as it relates to the potential impact that the novel coronavirus may have on market sentiment and board room confidence. In the base case scenario, we assume the coronavirus is contained but markets remain at current levels. This base case scenario leads us to anchor at a fairly conservative position. The bear case assumes either an extended pandemic with the economy entering a recession, or the economy entering recession despite containment of the virus. The bull case assumes the virus is contained and stimulus plans come into effect and we see a swift market recovery. In deriving our assumptions behind each scenario, we consider market conditions during the 1987 crash and the 2008 global financial crisis for historical discount multiples. With these three separate scenarios, we arrive at a range of potential NAV impacts for each transaction held within the portfolio. We are clearly maintaining our conservative posture in terms of placing capital to work, but we will add incremental capital to those deals that we believe offer asymmetric risk/return opportunities. We do this because we have the experience to know how to weather market dislocations and we do this because it is our job as investment managers.

The novel coronavirus and its impact on the global economy is an unprecedented event. However, the market’s dislocations are not new to investors with depth and experience. The portfolio managers on our investment team have weathered the 1987 crash, the 2001 tech crash and the 2008 financial crisis. In looking back towards history, our team believes the current environment feels very similar to both 2008 and the 1987 crash. Similar to 2008, there are fears that financing for deals will dry up, but to-date banks are voicing their commitment to the agreements they have struck. Also similar to 2008, investors are relentlessly selling in search of liquidity and the merger arbitrage community is too small to fully absorb the price dislocations, especially given the sizeable impact of exchange-traded fund selling. During the 2008 global financial crisis, the Arbitrage Fund’s (ARBNX) worst drawdown was -14.42%, reaching its lowest point on 10/9/2008, based on daily returns. Its worst drawdown based on monthly returns was -6.33%, reaching its lowest point on 11/30/2008. We subsequently saw spreads come in over Q4 2008, as the fund ended the calendar year with a return of -0.55% in 2008. Therefore, while the recent daily gyrations in the market and the portfolio may be discomfiting to some investors, our team has experienced similar conditions in past crises and anchors on that history to navigate this market.

Finally, we want to highlight that despite the recent turbulence, new deals continue to be announced. For example, last night (March 16) it was announced that Brookfield Renewable Partners – a Canada-based provider of hydroelectric power and transmission – would acquire the remaining 39% stake of TerraForm Power – a US-based holding company for the operation of contracted clean power generation assets – which it did not already own for $1.5 billion in cash and stock. The transaction is expected to close in Q3 of this year. Even during times of market stress, consolidation is an enduring theme. Sometimes companies seek to merge as a means to survive. Sometimes companies see opportunity to make acquisitions at more attractive prices than would otherwise have been possible. Regardless, we anticipate no detriment to our ability to do our jobs and continue to assess deals for investment in the portfolio.

We are humbled to have your trust in these difficult times. Please know that we are all fully operational and are focused on investing the capital that has been entrusted to us with prudence and discipline. Thank you. We hope you and your families remain safe and healthy.

Material represents the manager’s opinion and should not be regarded as investment advice or a recommendation of any security or strategy. Our views are a reflection of our best judgment at the time of the commentary and are subject to change any time based on market and other conditions, and we have no obligation to update them. Investing involves risk, including loss of principal. Past performance is not indicative of future results. View top ten holdings. Visit the glossary for definitions of terms.

Performance through 12/31/19: ARBNX (I class): 3.83% (one year), 2.70% (five year), 2.32% (ten year). The Total Annual Fund Operating Expense for ARBNX is 1.69%. The Total Annual Fund Operating Expense excluding the effects of dividend and interest expense on short positions and acquired fund fees is 1.23%. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Arbitrage Fund performance data current to the most recent month end may be obtained here.

RISKS: The fund uses investment techniques and strategies with risks that are different from the risks ordinarily associated with equity investments. Such risks include active management risk; concentration risk; counterparty risk; credit risk; currency risk; derivatives risk; foreign securities risk (in that the securities of foreign issuers may be less liquid and more volatile than securities of comparable US issuers); hedging transaction risk; high portfolio turnover (which may increase the fund’s brokerage costs, which would reduce performance); interest rate risk; investment company and ETF risk; leverage risk; market risk; merger arbitrage risk (in that the proposed reorganizations in which the fund invests may be renegotiated or terminated, in which case the fund may realize losses); options risk; short sale risk; small and medium capitalization securities risk; temporary investment/cash management risk; and total return swap risk. Risks may increase volatility and may increase costs and lower performance. Foreign investing involves special risks such as currency fluctuations and political uncertainty.

In the past two weeks, the outbreak of COVID-19 has spurred fears of disruption in economic activity across the globe. With factories and even entire cities shuttering – dampening both supply and demand simultaneously – investors have slowly come to realize that while the ultimate impact of the coronavirus is still unknown, it nonetheless seems all but certain to lead to a significant reduction in global economic output. Through Friday, March 6, equity markets had shed trillions of dollars in value, with the S&P 500 index dropping over 12% from its peak. Even an emergency 50 basis point cut in interest rates from the Federal Reserve did nothing to stem the tide. Investor anxiety has now been exacerbated after Saudi Arabia initiated a crude oil price war with Russia over this past weekend. On Monday, March 9, US equity markets triggered circuit breakers upon plummeting 7% immediately after markets opened, and the entire US yield curve fell below 1% for the first time in history.

What does this mean for us, as event-driven investors? While our portfolios have weathered this storm relatively well, we nonetheless experienced our own share of volatility in the past week. The source of this volatility, however, is only partially related to broader coronavirus fears. It is true, we have seen some indications of buyer’s remorse as acquirers gauge, with growing concern, the virus’ potential impact to the businesses they seek to takeover. We continue to monitor these situations closely, poring over the merger agreements, analyzing termination fees, looking at where the companies are domiciled. (Seemingly minor details matter – it is increasingly difficult in the Delaware courts, for example, to claim a material adverse change that could allow a company to get out of a deal.) These fears have caused spreads to widen significantly on transactions involving private equity buyers, such as the acquisition of Tech Data Corp by Apollo Global Management (who may now be regretting the bidding war it entered to win the asset), the acquisition of Tallgrass Energy LP by a consortium which includes Blackstone, and the acquisition of LogMeIn by a consortium including Francisco Partners. The LogMeIn transaction alone saw its deal spread more than quadruple in one week, widening from $0.88 to more than $3.60 from March 4 to March 9, taking what had been approximately a 3% annualized rate of return – assuming a June 30, 2020 closing date – to an annualized rate of return of more than 14%. The broader merger arbitrage community is clearly concerned that big, private acquirers may see this as an opportunity to cut terms, to delay closing, or simply to walk away and pay a termination fee. Other deals which saw their spreads impacted by coronavirus concerns include the acquisition of gaming giant Caesars Entertainment by Eldorado Resorts, the tie-up between luxury good purveyors LVMH Moet Hennessy Louis Vuitton and Tiffany & Co, Simon Property Group’s takeout of mall real estate investment trust Taubmann Centers, and the purchase of aircraft financing and leasing provider Aircastle by a Japanese consortium. The Aircastle transaction seems particularly vexing, as we expect it to close imminently, yet the spread was sent from $0.11 on March 4 to $0.76 on March 5, just days before its anticipated completion, only to see somewhat cooler heads prevail on March 6 and bring the spread back to $0.22.

In a case of rather unfortunate timing, in the midst of these coronavirus fears, the merger arbitrage space encountered an entirely different source of volatility on March 6 when Infineon’s proposed acquisition of Cypress Semiconductor appeared to encounter regulatory approval issues. The semiconductor industry overall has been deemed increasingly sensitive from a national security standpoint. Many believed the merger between Infineon and Cypress to be safe in this regard, as Infineon is a semiconductor manufacturer based in Germany – one of the U.S.’s closest partners. Infineon, however, also receives a substantial amount of its revenue from China. Cypress shares dropped precipitously late last week after reports emerged that the Committee on Foreign Investment in the United States (CFIUS) had decided to recommend the Trump administration should block this transaction to protect national security. Notably, we initially avoided this deal – and even took a reversed short position – as we anticipated there was an overlap that would not be able to be remedied through a regulatory approval process that required sign-off from both the U.S. and China, who were likely to have demands at odds with each other.

The Cypress/Infineon transaction was nonetheless widely held, and the volatility following the initial rumors of a CFIUS block led to indiscriminate selling across merger situations – and further examples of seemingly nonsensical spread widening. To wit, last week AbbVie and Allergan announced their pending tie-up had received regulatory approval in Europe and they are on track to consummate the merger by April 1. Mere days later, the spread has blown out to more than a 100% annualized rate of return, with no deterioration in the prospects of the deal in our view. The situation reminds us of the behavior of some spreads during the Financial Crisis, when we saw some transactions trading at annualized rates of return greater than 1000% the day before the deal closed. It is this very experience, and our long tenure as merger arbitrageurs, that we believe has us well prepared to shepherd our clients’ assets through this volatility. We do not look at these scenarios with lament. Rather, we see such dramatic spread dislocations as a chance to enter or add to positions at favorable rates of return. It is exactly when forced sellers, panicked sellers, or levered players are running for the exits that we see our greatest buying opportunities in those deals where we have high conviction, and we look forward to watching events unfold in the weeks and months ahead.

Material represents the manager’s opinion and should not be regarded as investment advice or a recommendation of any security or strategy. Our views are a reflection of our best judgment at the time of the commentary and are subject to change any time based on market and other conditions, and we have no obligation to update them. Investing involves risk, including loss of principal. Past performance is not indicative of future results. View top ten holdings. Visit the glossary for definitions of terms.