Alternative Arbitrage – August 2022
The Pender Alternative Arbitrage Fund (PAAF) marked one year since its inception on September 8, 2022 with performance of 4.3% since inception. The Fund was up 1.1% in August, bringing year to date performance to 2.2%.
The Pender Alternative Arbitrage Fund was launched with the goal of providing investors with a low-risk, low-volatility, absolute return-focused investment strategy that offers diversification benefits to investors with low correlation to traditional assets. A key motivation to launch the Fund was to focus on less followed small and mid-cap North American merger deals leveraging Pender’s research, due diligence and trading expertise in smaller cap securities. Leveraging Pender’s unique M&A expertise and our historical track record of investing in companies with M&A catalysts would also benefit the Fund as a source of high-quality organic deal flow. We believe that both the Fund’s positioning in smaller cap merger deals and leveraging Pender’s equity fund take-outs have benefitted performance and may provide a sustainable advantage to our investment process going forward.
Launching the Pender Alternative Arbitrage Plus Fund
With the strong relative and absolute performance of the PAAF, we have launched a leveraged version of the strategy, the Pender Alternative Arbitrage Plus Fund (PAAP). Since launching the PAAF, we have implemented the strategy with net exposure never exceeding 100% of NAV. Typically, merger arbitrage strategies are managed with the use of leverage, which can enhance returns while also increasing volatility. Due to its historical low-risk and low-volatility performance, merger arbitrage is a strategy particularly well suited to be implemented with the use of leverage. Merger arbitrage has been among the most consistent alternative investment strategies, with the HFRI ED: Merger Arbitrage Index delivering positive results in every year of the past decade. Adding leverage to an arbitrage strategy may enhance returns while still maintaining relatively low volatility compared to other alternative or traditional investment strategies. The PAAP will maintain the same holdings, utilize the same strategy and have the same risk process in place as the PAAF, but will target 150% to 200% of the exposure of the PAAF.
M&A Market Update
In the first eight months of the year, $2.6 Trillion of M&A deals have been announced, making it the sixth highest year-to-date total on record2. While global deal activity has fallen 33% in August relative to the peak levels of last year, US deal activity continues to remain robust with eight of the largest 10 deals in the month being US domestic deals. Technology continues to lead global M&A activity with over 480 deals worth over $55 Billion announced during the month. The tech sector has now led deal activity for 32 consecutive months, supported by a strong demand led by private equity funds.
SPAC yields continued their summer surge, reaching new highs in August. Redemption rates on SPACs have exceeded 90% in the past few months as investors would rather SPACs return their capital than invest in their proposed acquisition. SPAC liquidations have also increased as sponsors fail to find and successfully close a business combination and return capital to shareholders3. With the SPAC IPO bubble peaking in Q3 2020 through to Q1 2021, and the typical SPAC maturing two years after forming, we believe we are entering the peak of the SPAC maturity cliff. From September through to the end of Q1 2023, over $110 Billion worth of SPACs are expected to mature, and we believe the vast majority will end up liquidating and returning their capital to investors. This should provide an abundance of opportunities for SPAC arbitrage, and we are positioning the Fund to take advantage of this expected short window of low-risk and currently high-yield opportunities.
At the end of August, SPACs searching for targets were trading at a discount to trust, which provides a yield-to-maturity in excess of 5.8%4. With SPAC arbitrage effectively reflecting acquiring a treasury bill at a discount, SPACs currently provide a higher yield than US Corporate Investment Grade Bonds5 with lower credit risk, shorter duration and a tax advantage as SPAC returns are primarily capital gains.
The Fund had strong performance in August, driven by a tightening of merger arbitrage spreads, the successful closing of several merger deals, SPAC liquidations and key contribution from a raised offer for fund holding Hill International, Inc. (NYSE: HIL). Hill is an American construction consulting firm operating in over 40 countries with a primary focus in project management. The company received an acquisition offer in mid-July from a private equity firm. This offer likely brought other suitors to the table with Global Infrastructure Solutions Inc., a large privately owned construction manager making an offer and entering into a definitive merger agreement on August 16, 2022 to acquire Hill for $2.85 in cash per share. With other parties likely still interested and possibly engaging with Hill’s board, Global Infrastructure increased its offer by 19.3% to $3.40 on August 27, 2022. As a US small-cap merger deal, the deal was underfollowed, allowing us to analyze and initiate a position in the deal, which we believe has a high probability of success and the potential to close in a shorter duration than management’s guidance.
The Fund initiated positions in 17 new or previously announced merger deals in August, with 11 deals closing during the month. At the end of August, the Fund had 32 investments in small-cap deals under $2 Billion, with 25 of those deals valued at under $1 Billion.
It appears the market’s takeaway from the highly anticipated Jackson Hole conference is that fighting inflation is a key priority for the Fed, even if this will “bring some pain to households and businesses.” With a hawkish stance from central bankers and expectations of further rate hikes, an uncertain and potentially volatile market may be here to stay for the foreseeable future. A rising rate environment will be challenging for equity and fixed income investors to navigate in what has already been a year with the worst beginning first half for performance in 50 years. In this environment, investors would benefit from allocating a portion of their portfolios to a non-correlated, event-driven investment strategy with merger arbitrage particularly well-positioned due to its historical performance correlation to rising interest rates.
With SPAC yields continuing their surge higher and SPAC redemption and liquidation expected to increase in the coming quarters as more SPACs meet their maturity dates, we see a compelling opportunity for SPAC arbitrage. The environment for merger arbitrage remains highly attractive with a high level of deal activity, mergers continuing to benefit from a high success rate of closing and wider than historical relative and absolute spreads. We continue to focus on high-quality small and mid-cap merger deals with a preference for those with a shorter expected duration. With wider spreads, historically high levels of M&A activity and surging SPAC yields, the opportunity for both merger arbitrage and SPAC arbitrage is compelling.
Amar Pandya, CFA
September 14, 2022
 All Pender performance data points are for Class F of the Fund. Other classes are available. Fees and performance may differ in those other classes.