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- 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.
- 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.
- 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.
A credit spread is the difference in yield between a US Treasury bond and a debt security with the same maturity but of lesser quality. High yield bonds have a credit rating lower than investment grade. A spin-off is the creation of an independent company through the sale or distribution of new shares of an existing unit of a parent company. Beta is a measure of the sensitivity of an investment relative to a benchmark. Leverage refers to the use of borrowed money. Special situations refers to investments based on a particular circumstances or catalyst rather than underlying fundamentals.
Past performance is not indicative of future results. Click here to view the most recent top ten holdings.
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.
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.
A basis point is an amount equal to 1/100 of 1%. A credit spread is the difference in yield between a US Treasury bond and a debt security with the same maturity but of lesser quality. High yield bonds have a credit rating lower than investment grade. A spin-off is the creation of an independent company through the sale or distribution of new shares of an existing unit of a parent company. The Bloomberg Barclays US Aggregate Bond Index measures the US investment grade fixed rate bond market. The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad US economy. The Bloomberg Barclays US Corporate High Yield Bond Index measures the US high yield fixed rate corporate bond market.
Past performance is not indicative of future results. Click here to view the most recent standardized performance for the Arbitrage Event-Driven Fund. Click here to view the most recent top ten holdings.
Water Island Capital is pleased to announce Nikhil Miraj has joined our team of skilled professionals as a Senior Investment Risk Manager. Nikhil has a deep background in both risk management and quantitative analysis, with a breadth of experience in portfolio risk decomposition, performance attribution, portfolio optimization, building multi-factor models, building and implementing asset allocation models, and conducting scenario analysis. He arrives from Chilton Investment Company, where he had served as Vice President of Risk and Quantitative Analysis since 2011. Prior to Chilton, Nikhil served as an Equity Analyst at Thomson Horstmann & Bryant, conducting both fundamental and quantitative analysis. He began his career in finance at Standard and Poor’s, serving as both an Associate in Structured Finance and as a Client Quantitative Analyst working with ClariFI. Prior to his career in finance, Nikhil was a successful engineer. Most notably, he worked at General Electric, where he developed processes to manufacture components for NASA and the defense industry, including a new breed of ceramic composite panels that helped resolve issues that helped improve the safety of the Space Shuttle.
Nikhil holds an MBA in Finance and Financial Instruments & Markets from the Leonard N. Stern School of Business at New York University, a Master of Science in Materials Science and Engineering from Virginia Polytechnic Institute and State University, and a Bachelor of Technology in Ceramic Engineering from the Indian Institute of Technology.
Nikhil will partner with our investment team to manage the portfolio and risk optimization processes and to contribute to asset allocation decisions. He will also work closely with our technology and data analytics team, which is responsible for building and maintaining the infrastructure that supports risk aggregation and risk monitoring across our portfolios. We are excited to work with Nikhil and we look forward to the contributions he will make to the future growth of our firm and to our ability to execute on our commitment to our clients. Should you have any questions about Water Island Capital’s approach to risk management, please don’t hesitate to reach out to your client representative.
The Arbitrage Funds will be making the following year-end distribution payments for 2018 with a record date of 12/12/18, an ex-dividend/reinvest date of 12/13/18, and a payable date of 12/14/18:
|Institutional (ARBNX)||Retail (ARBFX)||C Share (ARBCX)||A Share (ARGAX)|
|Short-Term Capital Gain||$0.13372||$0.13372||$0.13372||$0.13372|
|Long-Term Capital Gain||$0.02136||$0.02136||$0.02136||$0.02136|
|Total % of Record Date NAV||1.90%||1.69%||1.26%||1.73%|
|Institutional (AEDNX)||Retail (AEDFX)||C Share (AEFCX)||A Share (AGEAX)|
|Short-Term Capital Gain||$0.00000||$0.00000||$0.00000||$0.00000|
|Long-Term Capital Gain||$0.00000||$0.00000||$0.00000||$0.00000|
|Total % of Record Date NAV||1.74%||1.47%||0.58%||1.53%|
|Institutional (ACFIX)||Retail (ARCFX)||C Share (ARCCX)||A Share (AGCAX)|
|Short-Term Capital Gain||$0.00000||$0.00000||$0.00000||$0.00000|
|Long-Term Capital Gain||$0.00000||$0.00000||$0.00000||$0.00000|
|Total % of Record Date NAV||0.00%||0.00%||0.00%||0.00%|
|Institutional (ATQIX)||Retail (ATQFX)||C Share (ATQCX)||A Share (ATQAX)|
|Short-Term Capital Gain||$0.18401||$0.18401||$0.18401||$0.18401|
|Long-Term Capital Gain||$0.02002||$0.02002||$0.02002||$0.02002|
|Total % of Record Date NAV||2.09%||2.09%||2.09%||2.09%|
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.
Glossary: Volatility is a statistical measure of the dispersion of returns for a given security or market index. The CBOE VIX is a real-time market index that represents the market's expectation of 30-day forward-looking volatility. The Standard and Poor's 500 Index (S&P 500) is a capitalization-weighted index of 500 stocks designed to measure performance of the broad US economy. The Euro Stoxx 50 Index is a market capitalization weighted stock index of 50 large, blue-chip European companies operating within Eurozone nations. The Nikkei 225 Index is a price-weighted index composed of Japan's top 225 blue-chip companies traded on the Tokyo Stock Exchange. The MSCI Emerging Markets Index is a float-adjusted market capitalization index used to measure equity market performance in global emerging markets. A global macro strategy bases its holdings primarily on the overall economic and political views of various countries or their macroeconomic principles. A managed futures strategy consists of an actively managed portfolio of futures contracts. A long/short equity strategy involves buying equities that are expected to increase in value and selling short equities that are expected to decrease in value. A long/short credit strategy involves buying bonds that are expected to increase in value and selling short bonds that are expected to decrease in value. Short term bonds or short duration bonds are investment-grade U.S. fixed-income issues and have durations of one to 3.5 years. Duration risk is the risk associated with the sensitivity of a bond's price to a one percent change in interest rates. A credit spread is the difference in yield between a US Treasury bond and a debt security with the same maturity but of lesser quality. A deal spread, or merger arbitrage spread, is the difference between the price at which a target company’s shares currently trade, and the price an acquiring company has agreed to pay. High yield bonds have a credit rating lower than investment grade. A spin-off is the creation of an independent company through the sale or distribution of new shares of an existing unit of a parent company. Quantitative easing is a monetary policy whereby a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
Past performance is not indicative of future results. Please click here to view the most recent top ten holdings for each of our funds.
New York, New York, Oct. 31, 2018 – The Arbitrage Funds is pleased to announce the appointment of two new trustees, Nancy M. Morris and Christina Chew, to our fund board, effective immediately.
Nancy Morris brings over 30 years of leadership experience in government and the investment management industry. She served as Secretary of the Securities and Exchange Commission and Deputy Chief Counsel of the Division of Investment Management. Her industry experience includes some of the largest asset management and mutual fund firms, including Wellington Management Company, T. Rowe Price, and Allianz Global Investors. Nancy also chaired the Investment Company Institute (ICI) Chief Compliance Officer Committee and served on the ICI’s Liquidity Rule Implementation Working Group. Ms. Morris received a JD from the University of Idaho and a BA from Hartwick College.
Christina Chew is a seasoned investment management professional who joined Water Island Capital, advisor to The Arbitrage Funds, in 2013. In addition to now serving on The Arbitrage Funds trust board, she serves as Senior Managing Partner of Water Island Capital where she has management oversight responsibility for client service and marketing, risk and operational infrastructure, capital raising functions and accounting and administration. She is also responsible for firm-wide strategic planning and new product development. Ms. Chew received an MBA from The Wharton School, an MA from the University of Pennsylvania, and a BA from Columbia College.
Founder of Water Island Capital and Chairman of The Arbitrage Funds Trust, John S. Orrico, stated, “We are delighted that Nancy and Christina are joining our fund board. Both individuals bring unique perspectives and deep experience that will enhance our board discussions. In addition, our board strongly believes that diversity drives better decision making. The appointment of Nancy and Christina will complement the diversity of The Arbitrage Funds’ board – which will benefit our shareholders.”
With the appointment of Mss. Morris and Chew, The Arbitrage Funds' board consists of 7 members, including: John S. Orrico, Founder & Chief Investment Officer of Water Island Capital; John C. Alvarado, CFO of Magnum Development LLC; Robert P. Herrmann, President & CEO of Discovery Data; Stephen R. Byers, Independent Director and Consultant; and Francis X. Tracy, former President, Chief Financial Officer, Treasurer, and Secretary for Batterymarch Financial Management.
About The Arbitrage Funds
The Arbitrage Funds (the “Trust”) is a Delaware statutory trust, which was organized on December 22, 1999, and is registered under the Investment Company Act of 1940, as amended (the “1940 Act”) as an open-end management investment company. The Trust currently offers four series of shares to investors, The Arbitrage Fund, The Arbitrage Event-Driven Fund, The Arbitrage Tactical Equity Fund and The Water Island Credit Opportunities Fund (formerly The Arbitrage Credit Opportunities Fund) (each a “Fund” and, collectively, the “Funds”). For more information, please visit www.arbitragefunds.com.
The Arbitrage Funds will be making year-end distribution payments for 2018 with a record date of 12/12/18, an ex-dividend date of 12/13/18, and a payable date of 12/14/18. As of 10/15/18, the estimated distribution amounts are as follows:
|Arbitrage Credit Opportunities||$0.026816||$0.000000||$0.000000||$0.026816|
|Arbitrage Tactical Equity||$0.059313||$0.000000||$0.000000||$0.059313|
The figures above are PRELIMINARY ESTIMATES. Given the nature of the funds' strategies, these estimates are highly likely to change, and may potentially change dramatically, before figures are finalized at year-end. Distribution estimates calculated as of 10/15/18. Estimates are calculated at the fund level — final distribution numbers may vary by share class.
October commenced with the return of heightened volatility in the markets, with the CBOE Volatility Index breaching 20 for the first time since April and the S&P 500 experiencing a 6.7% decline from October 2-11. The rapid sell-off was exacerbated by the growth in exchange-traded funds, factor models, risk parity funds, and commodity trading advisors, and increasing correlation between asset classes indicates a risk-off mentality is prevailing amongst investors.
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 chose 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 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. The combination of higher rates and potentially lower earnings left many investors uncertain about where equities should trade, and in the face of volatility many simply opted to sell.
In the face of market volatility, event-driven strategies have held up reasonably well. Our outlook for the months ahead remains positive, with a healthy universe of catalyst-driven opportunities to select from. Over the past week, several definitive merger 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. Merger arbitrage spreads for straightforward, fully financed transactions have held steady, while 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 during the sell-off. Spin-off activity also remains on track. We expect during Q4 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. 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 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 due to positive economic activity and low default rates, we think a flatter credit curve has created good short-duration opportunities for investors without the need to take excessive duration risk.
Glossary: A credit spread is the difference in yield between a US Treasury bond and a debt security with the same maturity but of lesser quality. A deal spread is the difference between the price at which a target company’s shares currently trade, and the price an acquiring company has agreed to pay. High yield bonds have a credit rating lower than investment grade. A spin-off is the creation of an independent company through the sale or distribution of new shares of an existing unit of a parent company. The CBOE Volatility Index is an index that is commonly used as a measure of domestic equity market volatility. The S&P 500 Index is an index of US equities meant to reflect the risk/return characteristics of the large cap universe, and is one of the most commonly used benchmarks for the overall US stock market. Duration risk is the risk associated with the sensitivity of a bond's price to changes in interest rates. Risk parity funds use an approach to investing that focuses on allocation of risk rather than allocation of capital. Factor models are financial models that employ multiple macroeconomic, fundamental, or statistical factors to attempt to explain market phenomena or asset prices.
Past performance is not indicative of future results. Please click here to view the most recent top ten holdings for each of our funds.
This past weekend, we witnessed the end of a protracted bidding war for one of the premier telecommunications companies in the UK – Sky plc. Sky is a provider of internet and pay television broadcasting services including news, movies, sports, and pay-per-view events. The fight to acquire the company is one of the more interesting merger situations in which we have been involved lately, and it concluded with a rather uncommon mandatory auction process in the UK.
UK takeover code is unique in that strict requirements are outlined which can dictate the timeline of a deal and the actions of an acquirer. Our team in London has decades of combined experience in UK and European markets, putting us in a strong position to understand the intricacies of this jurisdiction. For example, if a person or group acquires more than 30% of the voting interest of a company, they must make a cash offer to all other shareholders at the highest price paid in the 12 months before the offer was announced. The “Put Up or Shut Up” rule, which was designed to prevent UK companies from facing the prolonged threat of a hostile takeover, can require a company to make a binding offer within 28 days, or be forced to walk away for six months. UK-based deals go “riskless” in their final weeks once certain closing conditions are met, as the acquirer is then legally bound to complete the transaction. Yet another interesting component of UK takeover code is the auction process that is enacted in a competitive bidding situation, which was triggered in the battle for Sky.
The saga began in December 2016 when Fox – the US-based television and film company, which already owned 39% of Sky – offered to acquire the remaining 61% of the company for $23 billion. (Notably, this was not Rupert Murdoch’s first attempt to acquire Sky. Six years prior, News Corp – of which Fox was a part at the time – abandoned a bid for Sky amidst a phone-hacking scandal at one of its UK-based newspaper holdings, which made the deal politically untenable.)
In December 2017, while Fox’s acquisition of Sky was still undergoing regulatory review, Fox entered into a definitive agreement to sell its entertainment assets – including its existing Sky stake – to Disney for $52 billion. This eventually led to two separate bidding wars involving Comcast. First, Comcast made a rival offer for Sky (at £12.50 per share, 16% above Fox’s bid) in February 2018. Second, Comcast challenged Disney with a topping bid for Fox, offering $65 billion in June 2018.
In July, several developments unfolded. On July 11, Fox (with permission from Disney) raised its offer for Sky from £10.75 to £14 per share – only to be outbid by Comcast yet again, which offered £14.75 per share later that same day. Later that month, on July 19, Comcast abandoned its pursuit of Fox in order to focus its efforts on Sky, after Disney increased its offer to $71.3 billion.
Since neither Fox’s nor Comcast’s offer for Sky were deemed “best and final,” a competitive situation as defined in the UK takeover code continued to exist. In situations like this and in order to provide an orderly framework, the UK takeover panel conducts an auction process with the relevant parties in which both parties are able to provide their best and final offers for the company. The UK takeover panel and the parties agreed to hold an auction process on September 22, consisting of a maximum of three rounds. In the first round, only the bidder with the lowest offer (Fox) was allowed to make an increased bid. In the second round, only the bidder that was not eligible to make an offer in the first round (Comcast) was allowed to make an increased bid. If the auction was not concluded after the second round (i.e., if Comcast increased its bid in round two, thus extending the auction), there would be a final round, in which both bidders may make an increased final offer.
The auction went the distance, with both Comcast and Fox increasing their offers and making their best-and-final bids in round three. The final price Fox offered (with permission from Disney) was £15.67, and the final price Comcast offered was £17.28. Under UK takeover code, neither of these offers could be re-raised, and the prices were published by the UK takeover panel on the evening September 22. Ultimately, Comcast’s final bid represented a 60% increase over Fox’s original offer from December 2016.
While Comcast’s offer is clearly superior to Fox’s, it stipulates a 50% acceptance condition. Fox had publicly stated it was still assessing its options regarding its existing 39% ownership stake. If Fox decided to maintain its stake, Comcast would have needed an 82% acceptance rate across the rest of the shareholder base to be successful in taking control of Sky. (While we believed this was achievable given the superiority of Comcast’s offer, some risk of slippage nonetheless remained. Subsequently, news emerged that Comcast had acquired over 30% of Sky on the open market and that Fox – with permission from Disney – had decided to sell its stake to Comcast, thus satisfying the acceptance condition and helping the transaction move closer to wholly unconditional as per UK takeover code.) We continue to monitor the position and will look to re-add in the event we are able to capture an appropriate spread to the final deal terms.
Water Island UK, Ltd. Is a wholly-owned subsidiary of Water Island Capital, LLC. Please click here to view the most recent top ten holdings for each of our funds.
Mergers & Acquisitions (M&A)
With $1.17 trillion of M&A announced by US firms year-to-date, 2018 remains on track to surpass 2015's record-setting volumes. Despite headlines related to global trade disputes, we have seen several large and significant transactions announced over the past few weeks across various industries. In the Real Estate Investment Trust (REIT) space, Brookfield Asset Management announced that it will acquire Forest City Realty Trust for $25.35 in cash per share. The trend towards REIT deals has been triggered by selling in the sector that has pushed many REITs to trade at discounts to their net assets values. We expect this trend will continue. In healthcare, RegionalCare Hospital Partners, owned by Apollo Global Management, entered into a definitive agreement to acquire LifePoint Health for $65 per share. In chemicals, Platform Specialty Products (PAH) agreed to sell its Arysta LifeScience division to UPL Ltd for approximately $4.2 billion in cash. Proceeds from the deal are expected to be used to pay down debt at PAH. Banking consolidation also appears to be accelerating as rising short-term rates and softer regulatory hurdles for community and regional banks benefits the sector. Most recently, FCB Financial Holdings agreed to be acquired by Synovus in a stock-for-stock deal. The transaction was valued at approximately $2.7 billion.
Overall, transactions that require regulatory approval from the Committee on Foreign Investment in the US (CFIUS) or China’s State Administration for Market Regulation (SAMR), such as Rockwell Collins/United Technologies, 21st Century Fox/Disney, and XL Group/AXA, are leading to wider deal spreads. The lack of clarity on the process and the difficulty in assessing political risks have weighed on these deals.
Despite regulatory headwinds that recently impacted some large deals (Time Warner/AT&T, Tribune/Sinclair Broadcasting), The New York Post reported “US regulators believe three national 5G wireless providers are needed to ensure robust competition. … After studying the Sprint-T-Mobile proposal for more than three months, the Department of Justice [DOJ], while not yet making a decision on the merger, now believes three carriers are needed to establish a true competitive marketplace, according to a source with direct knowledge of the thinking within the DOJ.” While this deal isn’t likely to be assessed until 2019, it will attract attention given the level of investor ownership in both the stocks and bonds of the companies involved.
Lastly, the Wall Street Journal recently published an article entitled How Investors Can Cash In on the M&A Boom (subscription required). The piece highlights the use of merger arbitrage funds as a way to capitalize on the rise in merger and acquisitions, and notes that a rising interest rate environment could lead to more favorable deal spreads.
Last week, Jamie Dimon, Chairman and CEO of JPM Chase, made headlines when he noted that investors should be prepared for a 5% 10-year yield. While Dimon’s comment did not contain any suggestion of a timeframe to reach such a yield, it certainly highlighted a known tail risk in the market.
Even prior to Dimon’s weekend comments, fixed income investors were concerned about rising interest rates, particularly amid solid US economic growth and the prospect of inflation. The primary solution for cautious fixed income investors has been to increase allocations to floating rate products, such as levered loans, or to invest in short-duration credit as higher short-term rates appear more compelling relative to longer-term yields. Consequently, flows to levered loan and short-duration funds has risen during 2018, and levered loans have outperformed high yield bonds year-to-date.
Investor demand for floating rate bank loans provided cheaper financing for many companies, but lending standards have weakened in the process. Since June, the trend toward loan issuance has taken a pause as investors push back on terms. This has pushed issuers to tap the high yield bond market again for capital, but the excess supply could create a negative impact on credit spreads. This could ultimately lead to opportunities to purchase new issues bonds with more attractive terms.
We think both the levered loan and high yield bond markets will remain active in the near-term as private equity (PE) funds have plentiful cash reserves, evidenced by KKR’s purchased of BMC Software and Envision Healthcare, Apollo’s purchase of Lifepoint Healthcare, and various smaller PE acquisitions including Mitel, Essendant, and Web.com.
Glossary: A credit spread is the difference in yield between a US Treasury bond and a debt security with the same maturity but of lesser quality. A deal spread is the difference between the price at which a target company’s shares currently trade, and the price an acquiring company has agreed to pay. High yield bonds have a credit rating lower than investment grade.
Please click here to view the most recent top ten holdings for each of our funds.
Water Island Capital, the adviser to the Arbitrage Funds series trust, is pleased to announce that the Arbitrage Credit Opportunities Fund (“the Fund”) will be renamed the Water Island Credit Opportunities Fund effective immediately. This name change will not impact the Fund’s ticker symbols or CUSIPs. In addition, Water Island Capital will be reducing the expense caps for the Fund and has implemented breakpoints in the management fee. None of these changes will alter Water Island’s investment objective, strategy, or personnel, and the adviser believes they will positively impact the Fund’s shareholders, as explained below.
To simplify the Fund’s name and to highlight Water Island Capital’s broad investment capabilities, the Arbitrage Credit Opportunities Fund has been renamed the Water Island Credit Opportunities Fund. Water Island Capital has been the adviser to the Fund since inception and has nearly two decades of experience managing alternative strategies in a mutual fund format. Water Island believes the new name more clearly delineates the Fund’s strategy, while highlighting the firm’s capabilities in catalyst-driven long/short credit investing.
Additionally, Water Island Capital is implementing breakpoints in its management fee, which will reduce the fee as the Fund grows, and lowering the level at which the Fund’s expenses are capped (the adviser has agreed to limit the total annual operating expenses of the Fund, so they do not exceed 0.98% for Class I shares, excluding the impact of borrowings, dividends and interest on short positions, and other extraordinary costs1). Water Island believes these changes will further align its catalyst-driven long/short credit strategy with the interests of its clients and facilitate Water Island’s goal of providing a compelling credit strategy to investors. Gregg Loprete, co-portfolio manager of the Fund, said, “These changes are consistent with our dedication to delivering attractive investment strategies to our investors at the most effective cost. My team and I remain committed to managing a portfolio focused on idiosyncratic corporate events that seeks to deliver absolute returns with low correlation to and lower volatility than the broader markets.”
All changes above are effective as of August 6, 2018.
1 Total Annual Fund Operating Expenses for ACFIX (institutional shares), ARCFX (retail shares), ARCCX (C shares), and AGCAX (A shares) are 1.69%, 1.94%, 2.69%, and 1.94%, respectively. Total Annual Fund Operating Expenses After Fee Waiver are 1.16%, 1.41%, 2.16%, and 1.41%, respectively. The Fund has entered into an Expense Waiver and Reimbursement Agreement with the Fund’s investment adviser pursuant to which the adviser has contractually agreed to limit the total annual operating expenses of the Fund, not including taxes, interest, dividends on short positions, brokerage commissions, acquired fund fees and expenses and other costs incurred in connection with the purchase or sale of portfolio securities, so that they do not exceed 0.98%, 1.23%, 1.98%, and 1.98% for ACFIX, ARCFX, ARCCX, and AGCAX, respectively. The agreement remains in effect until September 30, 2020. Without such fee waivers, performance numbers would have been reduced.
RISKS: The Fund uses investment techniques that incur risks that are different from the risks ordinarily associated with credit investments. Such risks include merger arbitrage risks (in that the proposed reorganizations in which the Fund invests may be renegotiated or terminated, in which case the Fund may realize losses), high portfolio turnover risks (which may increase the Fund’s brokerage costs, which would reduce performance), options risks, borrowing risks, short sale risks (the Fund will suffer a loss if it sells a security short and the value of the security rises rather than falls), foreign investment risks (the securities of foreign issuers may be less liquid and more volatile than securities of comparable U.S. issuers), convertible security risks, credit default swap risks, interest rate swap risks, credit risks, and interest rate risks, which may increase volatility and may increase costs and lower performance.
On July 25, 2018, Qualcomm’s (“QCOM”) tender offer for NXP Semiconductor (“NXPI”) shares officially expired. The merger agreement was initially struck on October 27, 2016. In the ensuing months, Qualcomm bumped its bid as the semiconductor industry rallied and activists agitated for a richer offer. In early 2018, the companies appeared to be headed toward a successful marriage, having received regulatory approval from all required agencies except for one: China’s Ministry of Commerce (“MOFCOM”). Then, on April 19, 2018, MOFCOM requested additional time to review the deal. In response, Qualcomm withdrew and refiled its application, and extended the offering period.
At the time, we firmly believed the transaction would ultimately be blessed by Chinese authorities. Now, three months later, as the trade war between the US and China intensifies, Qualcomm has announced its intent to abandon its pursuit of NXPI, and instead conduct a $30 billion stock-buyback program.
As we look back on this investment and examine what we could or should have done differently, we do see areas where – especially knowing what we know now – we may have taken a different tack. At the same time, we also see instances where we likely would have stayed the same course.
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On the evening of June 12, 2018, Judge Richard Leon determined that AT&T can proceed with its planned acquisition of Time Warner with no conditions. The decision supports decades of precedent antitrust law, and we expect the pending mergers between Aetna/CVS and Express Scripts/Cigna will be impacted positively.
We also see a high probability of a major bid to the media and telecom space. On June 13, Comcast bid $65 billion for 21st Century Fox. If a bidding war erupts between Comcast and Disney, with whom Fox has already agreed to a $52.4 billion deal, press reports suggest Comcast could go as high as $80 billion without putting its credit rating in jeopardy.
In another high-profile deal, NXP Semiconductor (NXPI) last week traded higher when a deal to remove US sanctions on ZTE appeared imminent. It seemed that a group within the Trump administration was pushing a quid pro quo deal to gain antitrust approval for the Qualcomm/NXPI merger from China, in exchange for relaxing the sanctions on ZTE. This week, however, NXPI traded lower, after it was reported that an amendment to the National Defense Authorization Act would include actions “to curtail the president’s ability to mitigate sanctions against ZTE.” While a more benign version is more likely to be passed, the news led to continued volatility in NXPI’s stock.
Corporate spin-offs also continue to be a focus for event-driven equity investors. These transactions often create valuation dislocations between the pre- and post-spin off entities. Recently, several companies have concluded the spin-off process including the following:
- DXC Technology, a provider of information technology services, spun off its government services business into Perspecta Inc. (PRSP), leaving the remaining company with a clean balance sheet and focused on commercial IT services.
- Spirit Realty Corp (SRC), a real estate investment trust, spun off its distressed assets into Spirit MTA leaving the remaining company with a clean portfolio of triple net lease retail assets.
- Wyndham Worldwide (WYN) spun off its hotel management business into Wyndham Hotels (WH), leaving the remaining company focused on the timeshare business (WYND).
- La Quinta (LQ) sold its hotel management business to WYN and then spun-off its hotel real estate into a REIT called Corepoint Lodging (CPLG).
Such corporate transactions offer idiosyncratic ways to invest both long and short, with opportunities during both the pre-spin stage and the post-spin stage.
This week two rumored names, Envision Healthcare (EVHC) and USG Corp (USG), ended up being acquired. EVHC agreed to be acquired by KKR for $46 per share in cash, while USG entered into a definitive acquisition agreement for $44 per share.
Rent-A-Center (RCII), which announced last fall its plans to conduct a strategic review following a $13 per share cash approach by Vintage Capital during the summer, concluded its strategic review. Management decided not to sell the company, but Vintage submitted a best and final offer to acquire RCII at $14 per share immediately following RCII’s announcement.
Many moving pieces around the world are keeping investors cautious going into the summer.
This week, the Federal Open Market Committee (FOMC) met on Wednesday where the market is increasingly focused on whether the committee will drop language it has used since late 2015 that says rates would remain below historical levels “for some time” to come.
According to Reuters, that small change would mark a broad acknowledgement that, nine years into the second-longest US economic expansion on record, monetary policy and the economy in general are starting to look increasingly normal, both domestically and abroad.
Adding to the theme of interest rate policy normalization, the European Central Bank (ECB) meets on June 14 to debate ending its massive bond purchase scheme later this year, taking its biggest step in dismantling crisis-era stimulus. The end of the purchases is a foregone conclusion, and the key question is how the ECB will guide markets on the interest-rate outlook.
Recent volatility in Europe, created by Italian political dynamics, subsided this week after the new Italian Minister of Finance over the weekend rejected the idea of Italy leaving the European Union. His comments were well-received by markets and led to a rebound in European indices.
A spin-off is the creation of an independent company through the sale or distribution of new shares of an existing unit of a parent company. A triple net lease is a lease agreement on a property where the tenant or lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement.
Please click here to view the most recent top ten holdings for each of our funds.
While US/China trade relations have dictated spreads (and volatility) over the past month (as we previously discussed in our last update), we have just encountered one of the busiest weeks for merger announcements in some time. While each of these transactions will trade on its own timeline and merits, the list is encouraging as it reflects definitive efforts by corporate boards and management teams across various industries to take actions to further growth and invest in future performance. It also supports our optimistic view of a robust deal environment for 2018 and gives event-driven investors a broader pool of transactions in which to invest.
Sprint (S)/T-Mobile US (TMUS): On April 29, 2018, Sprint – a US provider of wireless and landline telecommunications services – agreed to be acquired by T-Mobile – a US provider of wireless communications – for $59 billion (including debt). Under current terms, Sprint shareholders will receive 0.10256 TMUS shares for an implied per share value of $6.62 and a total equity value of approximately $26.5 billion based on TMUS’ previous closing price. The offer represents a premium of approximately 29% to Sprint’s closing price from April 9 (before reports that the companies re-engaged in discussions regarding a deal). It appears that the deal came together again after Sprint’s largest holder, SoftBank, and its leader Masayoshi Son, agreed to cede majority control to TMUS.
Andeavor (ANDV)/Marathon Petroleum (MPC): On April 30, 2018, ANDV – a US downstream energy company – agreed to be acquired by MPC – another US downstream energy company – for $30.4 billion (including debt), or $152.27 per share in cash and stock. ANDV shareholders may elect to receive 1.87 MPC shares or $152.27 in cash, subject to proration. The consideration represents a total equity value of approximately $23.3 billion based on MPC’s previous closing price. The offer represents a premium of approximately 24% to ANDV’s previous closing price.
DCT Industrial Trust (DCT)/Prologic (PLD): On April 29, 2018, in a transaction centered in the global storage and logistics business, DCT – a US real estate investment trust – agreed to be acquired by PLD – another real estate investment trust – for $8.2 billion (including debt), or $67.91 per share in stock. DCT shareholders will receive 1.02 Prologic shares for an implied per share value of $67.91 and total equity value of approximately $6.5 billion based on PLD’s previous closing price. The offer represents a premium of approximately 16% to DCT’s previous closing price.
ILG (ILG)/Marriott Vacations Worldwide (VAC): On April 30, 2018, after year-long negotiations and approaches, ILG – a US provider of membership and leisure services to the vacation industry – agreed to be acquired by VAC – a US developer and manager of vacation ownership and related products – for $5.6 billion (including debt), or $36.93 per share in cash and stock. ILG shareholders will receive $14.75 in cash and 0.165 VAC shares for a total equity value of approximately $4.6 billion based on VAC’s previous closing price.
SteadyMed (STDY)/United Therapeutics (UTHR): On April 30, 2018, UTHR – a US developer of pharmaceuticals to treat vascular diseases – agreed to buy STDY – a US pharmaceutical company focused on the development and commercialization of therapeutic products – for $4.46 per share in cash plus an additional $2.63 per share in cash upon achievement of a milestone related to the commercialization of Trevyent, a leading drug candidate for the treatment of pulmonary arterial hypertension. The upfront consideration represents a premium of approximately 68% to STDY’s previous closing price and the total consideration, including the milestone payment – approximately $200 million – represents a premium of approximately 168% to SteadyMed’s previous closing price.
Asda Group/J Sainsbury: This year has brought with it a significant uptick in deal volumes in Europe as well, On April 30, 2018, J Sainsbury, the UK’s second largest food retailer, struck a deal to take over Walmart subsidiary ASDA, which is the UK’s third largest grocer. If approved, Walmart would hold 42% of the new business. The transaction is being viewed as a response to the threat from Amazon and rival Tesco’s tie-up with wholesaler Booker.
Other Market Color:
As the Federal Reserve continues to increase short-term rates and economic activity moves higher, the front-end of the yield curve has flattened relative to the longer end of the curve. With the US six-month Treasury Bill at 1.96%, the one-year Treasury Bill at 2.17%, and the two-year Treasury Note at 2.48%, short-term rates are providing some interesting alternatives for investors. Given our focus on short-duration catalysts and events, we anticipate that overall deal spreads will increase to reflect these higher risk-free rates, which could present a more attractive set of returns especially when compared to the zero-rate environment that investors have experienced since the financial crisis. Last week, Rick Rieder, the CIO of global fixed income at BlackRock, noted during a CNBC interview that, “The story is…the front end of the yield curve. It is now an alternative to buying equities, to buying risk assets, to buying high yield, and people aren’t focused on it. It is a big deal.” We agree, and believe our strategies are well-positioned across the equity and credit markets to benefit from this trend.
Glossary: A deal spread is the difference between the price at which a target company’s shares currently trade, and the price an acquiring company has agreed to pay. The yield curve is a curve showing several yields or interest rates across different contract lengths for a similar debt contract. The curve shows the relation between the (level of the) interest rate (or cost of borrowing) and the time to maturity, known as the “term,” of the debt for a given borrower in a given currency. A six-month Treasury Bill is a six-month-dated government security, yielding no interest but issued at a discount on its redemption price. A one-year Treasury Bill is a one-year-dated government security, yielding no interest but issued at a discount on its redemption price. A two-year Treasury Note is a marketable U.S. government debt security with a fixed interest rate and a two-year maturity.
Investing involves risk, including potential loss of principal. The securities mentioned were selected for discussion purposes only and may not represent current holdings of the Arbitrage Funds.
Tensions between the US and China have risen in recent months, with the fallout impacting regulatory approval processes in some mergers and acquisitions. For more information on the historical context and what it means for our strategy, please read this note from the desk.
Following a year of historically low volatility, the market exhibited demonstrably higher uncertainty in the first quarter of 2018. The CBOE Volatility Index (“VIX”), a popular measure of domestic equity market volatility, rose from 10 at year-end to a peak of 37 in early February. Since February, VIX levels have continued to fluctuate between 15 and 25. This volatility reflects the recalibration of market valuations with respect to the removal of the Federal Reserve’s quantitative easing policies, higher short-term interest rates, steady economic growth, and higher potential inflation.
Increases in Treasury yields have not led to significant increases in credit spreads, which continue to be near the tights seen in mid-2014. Most bond price pressure has instead been driven by interest rates. Lower medium grade bonds and non-investment grade speculative bonds have seen the biggest increase in credit spreads during this most recent move up in Treasury yields, reflective of lower appetite for bonds with more rate sensitivity.
The event-driven landscape was not immune to the effects of the quarter’s volatility spikes. While continued economic growth and recent changes to the US tax code have led to more investment opportunities in mergers and acquisitions, assets sales, and spin-offs, there are currently five deals that are primarily responsible for driving returns and volatility in the merger arbitrage space:
- Qualcomm for NXP Semiconductors (QCOM/NXPI)
- Microchip Technology for Microsemi (MCHP/MSCC)
- United Technologies for Rockwell Collins (UTX/COL)
- AT&T for Time Warner (ATT/TWX)
- Bayer AG for Monsanto (BAYN GR/MON)
The major factor impacting QCOM/NXPI, MCHP/MSCC, and UTX/COL is the trade dispute between the US and China. Headlines, tariffs, and possible trade negotiations between the two countries have led to stricter scrutiny and delays in the CFIUS (Committee on Foreign Investment in the United States) and MOFCOM (Ministry of Commerce of the People’s Republic of China) approval processes required for these deals to conclude. The outcomes of ATT/TWX and BAYN GR/MON, on the other hand, are being governed by US antitrust approval processes.
We continue to believe that the resolution of these deals will influence spreads, performance, and volatility in the near-to-medium term, and we look forward to providing our insights as these events evolve.
The CBOE Volatility Index (“VIX”) is an index that is commonly used as a measure of domestic equity market volatility. A credit spread is the difference in yield between a US Treasury bond and a debt security that are identical in all respects except credit quality. A Treasury yield is the return on investment of a US government debt obligation. Quantitative easing is a monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to stimulate the economy and increase liquidity.
Please click here to view the most recent top ten holdings for each of our funds.
We are pleased to announce that we have named Chief Investment Officer John Orrico to both our Arbitrage Credit Opportunities Fund and our Arbitrage Event-Driven Fund as a Co-Portfolio Manager. Robert Ryon, who had been a Co-Portfolio Manager since June 2016, will be departing the firm effective March 31, 2018 to pursue other opportunities.
Water Island Capital has a team-based approach to managing all our investment strategies. With the addition of John Orrico as a named Co-Portfolio Manager, the Arbitrage Credit Opportunities Fund will be led by Gregg Loprete and John Orrico. The Arbitrage Event-Driven Fund will be led by Ted Chen, Roger Foltynowicz, Todd Munn, Gregg Loprete, and John Orrico. The investment objectives, investment strategy, and all other attributes of our funds remain unchanged.
We continue to see opportunities in today’s markets and are fortunate to have an excellent team of investment professionals who are dedicated to meeting the high expectations of our investors.
Interest rates have been a focal point of conversations this past week. Regarding the impact to the overall equity and credit markets, here are our thoughts:
- The market is undergoing a crucial period where Central Banks are removing quantitative easing from the system, while deficit spending is expected to increase longer-dated treasury issuance. Although economic growth indicators continue to show positive momentum, interest rates are recalibrating higher with expectations that growth will lead to higher inflation.
- The US 10-Year Treasury yield increased from 2.41% at year-end to 2.90% last week. The move was a significant contributor to the market volatility seen over the prior month.
- Further contributing to the rates discussion, minutes of the Federal Open Market Committee’s January meeting were released last week. The notes indicated a more positive view on the growth outlook citing recent tax legislation, the global economic outlook, and easier financial conditions as supportive of growth “over coming quarters.” Despite this upbeat assessment, committee members did not yet see strong signs of wage pressure.
- During the market’s recent volatility, credit markets appeared more driven by rate fears rather than credit concerns, but credit trading has been orderly. We think that future volatility in fixed income markets will come more from the velocity of rates changes rather than actual higher levels.
- Primary issuance activity remains on track and we would expect to see continued demand for levered loans as the product provides floating rates and a hedge against rising rates. (Loans are also a key component to deal financing.)
Beyond the broader markets, the rate conversation is also affecting the event-driven space. Our recent observations:
- Event-driven strategies have held up relatively well during the recent market volatility and provided a buffer to investor equity and fixed income portfolios.
- We continue to see investor interest in strategies that are less impacted by rising interest rates and high volatility.
- During the most volatile market period, merger arbitrage spreads widened, primarily in transactions with longer-dated timelines.
- In equity special situations, event premiums remained relatively stable. Long re-ratings that were paired with market hedges traded flat to slightly better as the alpha long positions outperformed the market. (Conversely, short re-rating positions did the opposite as long market hedges underperformed alpha shorts.)
- Wider spreads and lower prices provided the investment team with favorable opportunities to add to specific equity and credit positions.
- Several recent deal announcements highlight continued activity in the mergers and acquisitions space (e.g., Qualcomm raised its offer for NXPI from $110 to $127.50 per shares; Rite Aid entered into a merger agreement with privately-held Albertsons for the remainder of its stores that are not being sold to Walgreens; and Comcast proposed an all-cash offer to acquire Sky, placing it in direct bidding competition with a pending offer from 21st Century Fox).
Spreads, or deal spreads, refers to the difference between the price at which a target company’s shares currently trade, and the price an acquiring company has agreed to pay. An alpha security, or alpha position, refers to the primary security of an investment idea (i.e., excluding hedges). A re-rating occurs when the market changes its view of a company sufficiently to make valuation ratios (such as price-earnings ratio) substantially higher or lower. The US 10-Year Treasury yield is the return on investment on US government debt obligations with a maturity of ten years, the amount and direction of which is a commonly-used economic indicator.
Please click here to view the most recent top ten holdings for each of our funds.
Volatility and the Illusion of Diversification
As we observe recent market events, what is extraordinary to us is not the sharp rise in volatility over the past couple weeks, but rather the extended periods of subdued volatility over the previous eight years. We don’t know if this marks the beginning of a “new normal.” We don’t pretend to know the future direction of the equity markets, or whether bond yields have begun an inexorable path upwards, or even whether volatility will remain at elevated levels. However, what the past fortnight has reminded us of is that volatility is a mean reverting asset, and reversion to the mean can have unexpected consequences.
It is not just investors who shorted the fear gauge through inverse VIX exchange traded funds or through option volatility mutual funds who had a brutal awakening. Many investors were likely surprised (and disappointed) to observe correlations converge across the breadth of their investments. This phenomenon where different asset classes – stocks, bonds, real estate and alternative investments – all lose value to some degree at the same time is commonly referred to as “short volatility.” In fact, our research indicates the majority of asset classes lose value when volatility rises. This raises the inevitable question: what type of portfolio will be able to withstand the impact of spikes in volatility and preserve capital?
At Water Island Capital, we have analyzed the historical data across various investment strategies with the goal of identifying those asset classes that have demonstrated resilience in withstanding large drawdowns from the re-pricing of risk. Our work indicates that while many alternative investments will likely fail to protect when markets become more volatile, there is a subset of strategies, including Merger Arbitrage, Market Neutral and Managed Futures, that can potentially protect against capital loss and deliver sustainable diversification benefits, regardless of the volatility environment.
In today’s environment, we believe our research paper on this phenomenon (“Short Volatility and the Illusion of Diversification”) is particularly relevant. If you would like to learn more, please click here to access the paper.
The "VIX," also known as the CBOE Market Volatility Index, is an index that is commonly used as a measure of domestic equity market volatility.
Past performance is not indicative of future results.
Over the past few trading days we have witnessed a spike in volatility that caught many market watchers off guard, with the CBOE Market Volatility Index, aka the “VIX,” having closed above 20 for the first time since November 2016. The market sell-off was largely a reaction to fears of rising inflation and the potential for interest rates to rise more quickly than expected, and it has caused some investors to review their portfolios and reset their near-term expectations for global equity markets.
We at Water Island Capital are always cognizant of the volatility environment. Volatility can be one of the drivers of returns for event-driven investment strategies, and we believe that for a prudent and prepared investor, bouts of volatility can serve more as opportunity than as misfortune. With that said, how has this recent shake-up in the market impacted our strategies, and how are we reacting?
- Large scale market movements have resulted in derisking by market participants across the board. This has led to wider spreads in certain transactions and better profit opportunities across event-driven strategies, most specifically merger arbitrage.
- Entering 2018 our expectations for renewed volatility and a market pullback drove our decision to maintain above-average cash levels. This “dry powder” has allowed us to take advantage of opportunities across the event landscape. We’ve added capital to our highest conviction ideas at attractive entry points, effectively enhancing the portfolios’ potential return profile.
- In our merger arbitrage strategy, there have been some mark-to-market impacts to specific deals as spreads have widened, but we believe that these will be among the first to recover given the definitive contracts that are in place.
- Importantly, our sizing and positioning procedures during volatile periods follow the exact same processes utilized during normalized market conditions: we continue to focus on high conviction, strategic, definitive situations.
- In managing our portfolios, we attempt to reduce or eliminate short-volatility exposure, with the goal of generating a market neutral stance that can endure the types of conditions that we’ve witnessed over the past few days.
In our communications with clients, we have consistently emphasized how interest rates and volatility can drive returns for spread-based strategies such as merger arbitrage. Given the recent trends in these areas, we believe the marketplace is moving in a direction that can prove beneficial for our event-driven strategies and, ultimately, our clients.
Spreads, or deal spreads, refers to the difference between the price at which a target company’s shares currently trade, and the price an acquiring company has agreed to pay. Mark-to-market refers to the valuation of investments based on current market values. To derisk means to take steps to make something less risky or less likely to involve a financial loss, and frequently involves exiting or reducing positions. The CBOE Market Volatility Index, or VIX, is an index that is commonly used as a measure of domestic equity market volatility.
The recent passage of the new U.S. tax code has confirmed our optimism for event-driven opportunities in 2018. Corporate management and boards have greater clarity around taxes, and we believe the decrease in the corporate tax rate from 35% to 21%, coupled with a one-time tax on the repatriation of foreign cash to the US, will lead to increased corporate activity.
A trend is beginning to emerge in the biotech space as recent transactions were announced with very large premiums. Celgene paid a 91% premium for its acquisition of Juno Therapeutics while Sanofi paid a 64% premium for its acquisition of Bioverativ. Despite sound, stable buyers, these deal premiums have led to high initial deal spreads as pre-announcement holders are less sensitive to selling and booking a profit (given the massive run-ups in these stocks).
We have also seen robust activity of “strategic alternatives” for companies such as Xerox, Microsemi Corp., and Akamai. These situations may develop into compelling special situation opportunities including speculative mergers and acquisitions, spin-offs, assets sales, and debt repurchases.
Please click here to view the most recent top ten holdings for each of our funds.