The Arbitrage Funds
Advised by Water Island Capital
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Commentary

Notes from the Desk

Market & Event Updates from the Water Island Capital Investment Team

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Notes from the Desk: March 2019 Update

Market Review and Color

Markets have rebounded strongly following large declines during Q4 2018. Year-to-date through March 20, the S&P 500 index has returned 13.19% while the Bloomberg Barclays US Aggregate Bond index has returned 2.08%. The Bloomberg Barclays US Corporate High Yield index has rallied 6.81%, as yields declined from 7.95% at year-end to 6.5%, while spreads have contracted 140 basis points from 526 to 386. The market has been orderly, with a strong January followed by a steadier February and March.

Although market volatility effectively shut down high yield bond issuance during December, markets re-opened in January leading to more refinancing activity. Gross loan volume has totaled $58.5 billion year-to-date, which is down 69% versus the same period a year ago ($189.8 billion). This reflects both the large amount of refinancing activity from one year ago as well as the demand for floating rate paper amid the backdrop of rising short-term interest rates. Net high yield activity is running well ahead of last year’s pace after accounting for a drop-off in refinancing activity. According to JP Morgan, YTD gross new-issue volume totals were $59.2 billion versus $65.8 billion over the same period a year ago (-10%), but if refinancing is excluded, then net issuance is $24.0 billion versus $15.8 billion YTD in 2018 (+52%).

Further Central Bank support was confirmed at the March 20 Federal Reserve (Fed) meeting. A large majority of Federal Open Market Committee participants now expect zero hikes this year, down from a median projection of two hikes in December. This was more dovish than the market anticipated, leading to a rally in Treasuries, a decline in the US Dollar, and an initial reversal in equity losses. Going forward, the major question for investors will be whether the market can be sustained by Central Bank support or whether slowing global growth (and earnings) become larger concerns for risk assets. We think investors, rightfully so, will continue their focus on Central Bank guidance in the US, Europe and Japan; global trade talks; and sustainability of earnings.

Event-Driven Update

Large headline deals continue the trend that began in January following Bristol-Myers’ stock-and-cash acquisition of Celgene for $88.9 billion, Fiserv’s agreement to buy First Data Corp for $38 billion, and Newmont Mining’s purchase of Goldcorp. During February and March, BB&T and SunTrust Banks agreed to merge in a $28 billion transaction, Nvidia announced the purchase of Mellanox Technologies for $6.8 billion, and Fidelity National agreed to acquire Worldpay Inc for $40 billion in cash and stock.

Since January, leveraged buyout (LBO) activity as a percentage of overall deals has increased from ~5% to ~20%. This is in line with our view that private equity firms continue to have ample cash to deploy into the public and private markets. Away from all-cash LBO transactions, it appears that stock is being used more frequently as acquisition currency during 2019. This may reflect the creep upward of valuations, the increase in borrowing costs as rates and spreads are generally wider than during 2018, and – following the Q4 market sell-off – that target companies may wish to participate in any upside through a merged company. Stock mergers can add an additional risk given that acquirer shareholder approval is often a deal condition, and the if the acquirer itself becomes an acquisition target (as Bristol-Myers has) the shorts can contribute to losses for investors who short the acquirer stock and purchase target shares.

Looking ahead, we may see more merger activity in the banking industry. As was reported in the Wall Street Journal recently, the time needed by regulatory agencies to approve bank mergers – typically a drawn-out process – has declined in recent years. Indeed, the median approval time for the Fed was 3.8 months in the first half of 2018 compared to 5.6 months for the same time period one year prior. During 2015, the timing was 7.0 months. At the Office of the Comptroller of the Currency, the average time for handling all mergers dropped to 1.9 months in 2018 from 2.6 months in 2016. These improvements may remove some market risk for merging parties, which could encourage future consolidation.

As credit markets opened following Q4, refinancing activity has increased. Loans appear to be in less demand compared to a year ago, as interest rate hikes have moderated, and new activity in collateralized loan obligations has been muted.

While overall default rates remain low by historical standards, distressed investors have been focused on the bankruptcy filing of PG&E. The company filed for bankruptcy protection on January 29 due to massive liabilities resulting from the 2017 and 2018 California wildfires. The situation has attracted many distressed and event-driven investors, but the process is likely to be lengthy, contentious, and bring about the confrontation of creditors, politicians, and victims. Another high-profile case for distressed investors during Q1 was Windstream Holdings. The US telecom provider suffered a defeat in US Bankruptcy Court when Judge Robert Drain ruled that a 2015 sale and leaseback transaction was impermissible and a violation of one of the company’s bond indentures. The judge ruled that the plaintiff, Aurelius Capital Management, was entitled to a money judgement of $310 million plus interest. The decision triggered cross defaults in the company’s capital structure, which caused Windstream to file for Chapter 11 protection.

Overall, opportunities in the event space remain positive. The theme of corporations focusing on core businesses remains intact and is likely to stimulate mergers and acquisitions (M&A) activity, asset sales and spin-offs. We are encouraged by the YTD M&A calendar while we see approximately 18 spin-off deals planned for 2019. On the credit side, we are seeing refinancing activity brought about by rolling maturities and M&A activity as specific drivers.

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