Notes from the Desk: Merger Arb Volatility Continues
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.