Notes from the Desk: Market Update – Merger Arb Volatility

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.