The Arbitrage Funds
Advised by Water Island Capital


Notes from the Desk

Market & Event Updates from the Water Island Capital Investment Team

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Notes from the Desk: July 2019 Update

Market Overview

Risk markets (both equities and credit) have moved higher due to a combination of better earnings, positive macro tone, and supportive central bank policy.

The US Ten-Year Treasury is hovering near 2.05%, which is a three-year low for this leading benchmark. Short-term rates have also declined, such as the US 3-Month Treasury which moved from 2.45% in March to 2.07% as of July 23. While short-term rates reflect lower anticipated Fed Funds rates following the Federal Reserve’s (Fed) more dovish public posture, longer-term rates reflect a very benign view of inflation.

Washington reached a debt ceiling and budget agreement as expected; the head of the People’s Bank of China said Chinese interest rates were at appropriate levels; Boris Johnson was named the next UK Prime Minister; and Q2 2019 earnings season continues to unfold in a positive manner.

US-China trade headlines are more upbeat as US tech firms met with administration officials and President Trump on Monday to discuss Huawei. A White House statement noted Trump agreed on the need for timely decisions on Huawei reprieve. This comes amid reports China is looking to buy more US agriculture products as a sign of goodwill. Secretary of the Treasury Steve Mnuchin and US Trade Representative Robert Lighthizer are also reportedly going to Beijing for talks next week.

The European Central Bank (ECB) met on July 25 where a series of supportive measures are expected to be announced in response to sluggish European economic activity. While the ECB held rates steady, outgoing President Mario Draghi indicated a willingness to ease monetary policy in the future with the outlook for growth deteriorating. (A recent JPMorgan survey indicated that about 45% of accounts expect asset purchases to resume in September, and about 75% expect a restart by December.)

The Federal Reserve is meeting on July 31. Markets are currently anticipating an 80% probability of a 25 basis point rate cut and a 20% chance of a 50 basis point rate cut. The biggest question is why the Fed is cutting when earnings are relatively positive and trade negotiations have become less contentious. Is it a lack of inflation? Is the Fed capitulating to Trump’s interest rate rhetoric? Or is the Fed worried about the pace of growth outside the US?

Deal Environment

Recent US deal activity has continued to be robust, though cracks are starting to emerge in Europe. Some of the current themes we’re seeing in the region include:

  • Expectations that Europe will enter a recession within the next 12 months are rising, and investors are beginning to witness earnings misses in large cap names with more frequency.

  • For the time being, private equity (PE) appears content to sit on the sidelines in the region, making selective opportunistic bids. PE firms may believe valuations are still very high, opting to wait for a meaningful correction before undertaking large-cap buyout offers.

  • In the current climate, there is less of a focus on larger deals from strategic acquirers, as most are concentrating their efforts internally. Many corporations are looking at joint ventures or acquisitions in the technology space that will help bolster their supply chains amidst geopolitical tensions.

  • Long only investors in Europe also appear to believe valuations are near the peak, and are very open to accepting premium on their shares in the current market.

Deal Updates

On July 19, the New York Post reported that a deal to make satellite TV provider Dish Network the nation’s fourth largest mobile carrier was mere days from being finalized. T-Mobile and Sprint had been trying to sell assets to Dish to gain Department of Justice (DOJ) approval for their $26 billion merger. The talks had stalled due to T-Mobile’s demands that Dish not sell more than a 5% stake to a potential wireless partner, such as Google. The DOJ’s antitrust team reportedly told T-Mobile to drop the demand and the story indicated the parties were moving toward a settlement that could lead to approval of the deal. The Post’s reporting was borne out late last week when, on Friday, July 26, the Sprint/T-Mobile transaction received DOJ approval after the companies agreed to a substantial divestiture package with Dish.

According to a Wall Street Journal article, leaders of Occidental Petroleum Corp are pushing their shareholders to reject billionaire investor Carl Icahn’s bid to replace four directors at the company. Icahn is seeking board representation given his claim that the company’s current directors made several mistakes in pursuing Anadarko Petroleum. Occidental is set to acquire Anadarko for $38 billion, after waging a bidding war with Chevron Corp earlier this year. While no longer seeking to override the Anadarko deal, Icahn told The Wall Street Journal that he seeks to prevent Occidental from striking future deals that would hurt the value of the company.

Quad Graphics and LSC Communications, two leaders in the corporate printing industry, agreed to terminate their merger after the DOJ announced on June 20 that it had filed a lawsuit in US District Court to enjoin the acquisition of LSC. (We had no exposure to this transaction.)

In perhaps a positive development with respect to deal financing and risk, Covenant Review recently released data which indicates that private equity firms are contributing higher levels of their capital in order to structure recent buyouts. According to the data, during Q2 2019 PE firms contributed 52% of the funds needed to buy target firms. This compared to only 45% in Q1 2019 and an average of 47% since 2017. The most likely reasons for the higher contributions are higher stock prices and valuations, PE firms looking at longer deployments of capital (7-10 years vs. historical averages of 5-years), and the possibility that PE firms are looking toward the next recession when they would prefer their companies to have lower debt levels.

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