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: May 2019 Update

Market Overview

  • Following strong year-to-date returns through April, investors are facing increased volatility as trade negotiations between the US and China have stalled. The US will increase tariffs by $200 billion on Chinese goods while China has imposed $60 billion on a target list of US imports.

  • Adding more uncertainty to markets, last week the Trump administration added Huawei Technologies Ltd to a trade blacklist, immediately enacting restrictions that will make it difficult for the company to do business with US counterparts.

  • Offsetting some of the negativity was the US announcement of a 180-day delay in European Union auto tariffs, and a new agreement to end tariffs on steel and aluminum in North America.

  • While the dynamics around the US/China tariff discussions are uncertain, markets are generally anticipating a trade deal (or some progress) at the June 28-29 G20 summit.

  • Markets generally seem apathetic about trade negotiations, and JP Morgan recently noted that, “the impact on US growth directly from the increase in tariffs will be minor, though likely negative.”

  • Most companies guided full-year 2019 estimates in early Q1 (when the trade war was heightened) with the assumption that tariffs would jump to 25% in March, so earnings numbers are not coming down considering these renewed tariff issues.

  • A further increase to an additional $300 billion would be more concerning as that is not baked into numbers across the street and could be a larger hit to US consumers when wage inflation remains weak.

  • Most companies see the latter half of 2019 as the point at which they will “make their numbers,” citing better compares and a resolution of trade issues. Should the trade war remain extended and global growth dampen, it is likely that earnings estimates may have to come down. Few appear to believe this will be the base case as hope remains for an earlier resolution.

Event-Driven Update

  • In general, trade issues have not had a direct impact on special situations investments, but softer catalyst names do carry higher beta exposure than investments predicated on more definitive events and thus could be more prone to volatility if markets swoon.

  • For merger arbitrage investors, the China/US trade war is the main reason for spreads widening as arbitrageurs are pushing out timing expectations for all deals requiring regulatory approval in China until the end of 2019.

  • If no solution comes out of the G20 meeting in late June, arbitrageurs will likely begin using 2020 closing expectations. If that occurs, deals requiring approval in China should see even wider spreads, decreasing the likelihood that those transactions can generate positive returns in 2019.

  • Leveraged buyout activity remains robust, with Q2 bringing the second private equity deal over $10 billion since the credit crisis (Zayo Group). We are seeing more infrastructure-focused acquisitions, likely due to the hard asset and durable cash flow streams of these types of businesses.

  • Spin-offs remain active this year with VF Corp spinning off Kontoor Brands (maker of Lee, Wrangler, and Rock & Republic jeans) and DowDupont spinning off agriculture business Corteva in the next few weeks.

Other News

  • Federal Communications Commission (FCC) Chairman Ajit Pai announced that he will recommend that the FCC approve the Sprint/T-Mobile merger citing commitments not to raise prices, the divesture of Boost Mobile, and a commitment to rural America. Chairman Pai is expected to present his draft order to FCC colleagues in the coming weeks in order to resolve the matter. Sprint stock surged 25% on the news.

  • The next hurdle for this transaction will be the approval by the Department of Justice (DOJ) which will opine on the competitive aspects of any transactions.

  • Other recently announced mergers and acquisitions (M&A) include the purchase of Andeavor Logistics LP by MPLX LP for $13.5 billion in stock (pipelines); the purchase of Zayo Group Holdings by EQT Partners & Digital Colony GP for $14.1 billion in cash (communications infrastructure); IFM Investors Pty Ltd’s purchase of Buckeye Partners LP for $11.1 billion in cash (pipelines); and Hewlett Packard’s purchase of Cray Inc for $1.4 billion in cash (computers).

  • Amid M&A deal flow and market volatility, high yield and investment grade credit issuance continues unabated. High yield spreads have dropped significantly from +537 on January 3 to +388 on May 20. Spreads, however, remain ~35% above last September’s tights of +303.

  • Aided by a resilient Treasury market, investment grade credit has generated attractive year-to-date returns. Spreads have declined from +157 on January 3 to +118 on May 20. This space has been the subject of recent headlines ranging from over supply, excess leverage, and credit ratings deemed too high relative to financial metrics.

  • Event-driven bond activity has been focused on the bankruptcies of PG&E Corp and Windstream, while privately held wound care specialist KCI is being purchased by 3M Corp.

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