The Arbitrage Funds
Advised by Water Island Capital


Notes from the Desk

News & Commentary from Water Island Capital

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May 2019 Market Update

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.

March 2019 Market Update

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.

Water Island Capital Hires New Senior Investment Risk Manager

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.

Arbitrage Funds 2018 Year-End Distributions

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:

Arbitrage Institutional
Class A
Class C
Ordinary Income $0.09841 $0.06303 $0.06867 $0.00000
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 $0.25349 $0.21811 $0.22375 $0.15508
Total % of Record Date NAV 1.90% 1.69% 1.73% 1.26%

Arbitrage Event-Driven Institutional
Class A
Class C
Ordinary Income $0.16619 $0.13867 $0.14493 $0.05361
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 $0.16619 $0.13867 $0.14493 $0.05361
Total % of Record Date NAV 1.74% 1.47% 1.53% 0.58%

Water Island Credit
Class A
Class C
Ordinary Income $0.00000 $0.00000 $0.00000 $0.00000
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 $0.00000 $0.00000 $0.00000 $0.00000
Total % of Record Date NAV 0.00% 0.00% 0.00% 0.00%

Water Island Long/Short Institutional
Class A
Class C
Ordinary Income $0.00000 $0.00000 $0.00000 $0.00000
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 $0.20403 $0.20403 $0.20403 $0.20403
Total % of Record Date NAV 2.09% 2.09% 2.09% 2.09%

October 2018 in Review: Volatility Returns Once Again

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.