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.

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.

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.

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.

Past performance is not indicative of future results. View top ten holdings. Visit the glossary for definitions of terms.

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.

Past performance is not indicative of future results. View standardized performance. View top ten holdings. Visit the glossary for definitions of terms.

October witnessed heightened volatility returning to the markets yet again in 2018. The CBOE Volatility Index (VIX) started the month at its lows (closing under 12 on October 3), only to breach 20 for the first time since April just one week later, on October 10. The VIX later reached an intra-day high of 28 on October 29. The S&P 500 index experienced a 6.8% decline for the month after having fallen as much as 9.3% during the period. The rest of the world’s markets suffered similar declines, with the Euro Stoxx 50 index, the Nikkei index, and the MSCI Emerging Markets index falling 8.2%, 8.8%, and 8.7%, respectively. (This brings emerging markets stocks down over 15% year-to-date.) We believe rapid changes in sentiment have been exacerbated by the growth in exchange traded funds (ETFs), factor models, risk parity funds, and commodity trading advisors (CTAs). Increasing correlation across asset classes surely indicates a risk-off mentality is prevailing amongst investors, and many alternative strategies – such as global macro, managed futures, and long/short equity – have not escaped the turmoil unscathed.

The foundation for this largescale recalibration of prices began on September 26, after the Federal Reserve decided to once again raise interest rates amid strong economic data and positive consumer confidence. At the time, investors seemed to de-emphasize the impact of potential tariffs on corporate earnings, and inflation expectations remained subdued. Yet on October 3, Federal Reserve Chairman Jerome Powell suggested rates are still a “long way” from neutral, setting expectations for another rate hike in December (and several more in 2019), and Amazon announced it would raise the minimum wage for all its employees to $15 per hour, rekindling inflationary fears. Furthermore, Ford guided earnings downward, citing increased costs due to tariffs.

Sharp increases in volatility should hardly come as a surprise to investors. Since the financial crisis, markets have been massively supported by central banks, quantitative easing, and low interest rates. We are now undergoing the massive unwinding of Federal Reserve asset purchases amid a scheme to normalize short-term interest rates. We believe markets will continue to reprice amid higher interest rates and less government support, and volatility is a natural biproduct. Nonetheless, the combination of higher rates, tariffs, and fears that corporate earnings have peaked has left many investors uncertain about where equities should trade. When faced with this uncertainty and increasing volatility, many have simply opted to sell.

Amidst this environment, event-driven strategies, including merger arbitrage, have generally performed better than the major equity market indices. Long/short credit and short duration bonds also performed admirably over the course of the month. Our outlook for the months ahead remains positive, as we believe a healthy universe of catalyst-driven opportunities remains. Early in the month, several definitive transactions were announced – including the stock-for-stock acquisition of Rowan Companies PLC by Ensco PLC, GFL Environmental acquisition of Waste Management Industries, and TransDigm’s all-cash acquisition of Esterline Technologies. More recently, ITE Management LP announced the purchase of Amercian Railcar industries for $1.4 billion, CMA CGM SA announced the acquisition of Ceva Logistics AG, Chesapeake Energy announced its acquisition of WildHorse Resource, and IBM announced plans to acquire Red Hat Software for $34 billion.

Volatility may create further opportunity for merger arbitrage investors who can take advantage of spread widening and lower prices in specific deals. While merger arbitrage spreads for straightforward, fully financed transactions have generally held steady, longer-dated deals and transactions requiring approval from the Committee on Foreign Investment in the United States or China’s State Administration for Market Regulation widened. Due to the short timelines of most mergers, these spreads often snap back as volatility subsides or as the deals near completion.

In the special situations space, spin-off activity remains on track. During Q4 we expect to see the completion of several high-profile spin-offs including Resideo Technologies from Honeywell, Equitrans Midstream from EQT Corp, and Arcosa Inc from Trinity Industries.

In the credit space, selling by high yield ETFs along with ETF arbitrage activity has caused a more pronounced sell-off in the more liquid part of the market (i.e., those bonds eligible for inclusion in ETFs). This has permitted bond investors who are unconstrained by benchmarks to outperform indices and peers, and to increase positions at more advantageous prices. We also continue to see private equity (PE) firms driving new transactions. The deals either involve public companies being taken private or PE firms purchasing privately-held assets or companies. Both situations may present investment opportunities for catalyst-driven credit investors. Even with general selling in high yield, we still see credit spreads near the tightest levels in the past five years. While this may be warranted if positive economic activity and low default rates persist, we think a flatter credit curve provides for more attractive short-duration opportunities without the need to take excessive duration risk.

Past performance is not indicative of future results. View top ten holdings.