Alternative Arbitrage – Manager’s Commentary – February 2022

Written by Amar Pandya

Dear Unitholders,

The Pender Alternative Arbitrage Fund (PAAF) ended the month of February 2022 with a NAV of $10.18 per unit[1].

Despite equity market volatility, record inflation, rising rates and a geopolitical crisis, M&A activity shows no signs of slowing with over $740B of global deal activity in the first two months 2022, the second highest total in history. The tech sector continues to lead deal activity with over $187B of deal volume in the sector, up 24% from last year[2].

The Russian invasion of Ukraine has driven volatility in equity and bond markets, but the risk from rising geopolitical tensions is low for North American-based merger deals, which are the target of the Fund. This is due to the general low exposure of North American corporations to that region of the world and also because the conditions that support a robust merger arbitrage environment remain present. Deal activity is still elevated, with the end of February seeing a wave of merger deals announced. Spreads remain wide, with the expected spreads for the 20 largest all-cash mergers in the US well in excess of 1000bps[3] and success rates for merger deals remaining high with several mergers, including larger deals, subject to significant regulatory scrutiny being approved in the past month.

The bear market in SPACs, created as a result of the oversupply of nearly 600 SPACs searching for a limited pool of deals and under the pressure of approaching maturity, is creating a compelling low-risk investment opportunity for SPAC arbitrage. The popularity of SPACs took off in the back-half of 2020 and continued into the first quarter of 2021, with hundreds of SPACs raising billions of dollars. With a typical maturity of two years, we are about to enter a period where we believe the vast majority of SPACs are likely to be unsuccessful in finding a target and maturing, and many will be required to return their trust value to shareholders.

Even if a SPAC is successful in finding a target, SPAC holders can elect to redeem back trust value with the added benefit of a shorter holding period and higher IRR. The capital raised by SPACs are held in trust and invested in short-term U.S. Treasury Bills, widely considered the safest asset in the world, so buying a SPAC trading at a discount to trust value is like buying a Treasury Bill at a discount. For investors searching for capital preservation and yield who have concerns about the negative impact on bond prices from rising rates, we view that the opportunity in SPAC arbitrage represents a compelling alternative. At the end of February, SPACs searching for targets were trading at a discount to trust which provides a yield-to-maturity in excess of 2.9%[4], a higher yield with a shorter duration than that of an investment grade bond index[5]. This opportunity may be short-lived and transitory, but we are going to “make hay while the sun shines.”

Portfolio Update

Market volatility remains elevated, as investors who were focused on inflation and the implications of a rate hike cycle were shocked with an escalating geopolitical crisis and the reality of war in Europe. Deal activity remains high and, with many large mergers closing during the month, we expect part of that capital to be recycled into newly announced deals.

We have also noticed a recent trend where many deals trade at a relatively wide spread, even after all key regulatory approvals have been achieved and the merger is only weeks from closing. We believe this provides the setup for a low-risk investment opportunity with a highly attractive IRR, and we will continue to take advantage of these opportunities while they are available. We have also increased our SPAC exposure to deals that offer a combination of short duration while also trading at a significant discount to trust value, which provide an attractive yield-to-maturity in our view.

The National Security Group, Inc. (NASDAQGM: NSEC), Arena Pharmaceuticals, Inc. (NASDAQGS: ARNA), Exterran Corporation (NYSE: EXTN), Goodness Growth Holdings, Inc. (CNSX: GDNS), SOC Telemed, Inc. (NASDAQ: TLMD), Spirit Airlines Incorporated (NYSE: SAVE), US Ecology, Inc. (NASDAQ: ECOL), Macro Enterprises Inc. (TSXV: MCR), Moneygram International Inc. (NASDAQ: MGI), R. R. Donnelley & Sons Company (NYSE: RRD), Meritor Inc. (NYSE: MTOR), Houghton Mifflin Harcourt Company (NASDAQ: HMHC), Tenneco Inc. (NYSE: TEN), South Jersey Industries, Inc. (NYSE: SJI) and Healthcare Trust of America, Inc. (NYSE: HTA) were among several new holdings for the Fund in February.

Great Western Bancorp, Inc. (NYSE: GWB), Xilinx, Inc. (NASDAQGS: XLNX), Millennial Lithium Corp. (TSXV: ML), Vocera Communications, Inc. (NYSE: VCRA), Castlight Health, Inc. (NYSE: CSLT) R. R. Donnelley & Sons Company (NYSE: RRD) and PAE Incorporated (NASDAQ: PAE) were among deals that closed during the month.

At the end of January, the Fund had 24 investments in small-cap deals under $2B, with 17 of those deals under $1B. One of these small-cap deals is a new holding, Moneygram International Inc. (NASDAQ: MGI), which announced an acquisition offer by private equity group Madison Dearborn Partners LLC. Our investment in MGI is a great example of how the Fund can leverage the full Pender bench strength. Moneygram is a small-cap, underfollowed and, in our opinion, misunderstood business. But employing the scuttlebutt and the “private equity approach to public markets” thinking that is core to Pender’s equity investment process, we believed that expectations, incentives and conditions were right for an acquisition offer to emerge, and we initiated a position in the Pender Special Situations Fund in November.

When the deal was announced on February 15, we had all the background information on the business, understood shareholder expectations and management incentives and had estimates of the private market value of the business in hand. This allowed us to act quickly, leveraging our existing research and insights to initiate a position in the PAAF, with MGI now a top-10 position in the Fund. Our positioning remains focused on smaller deals that provide attractive spreads, mispricing opportunities resulting from a lack of followers and are subject to lower regulatory risk. Additionally, smaller cap North American mergers are more likely to have domestic or cross border-focused businesses with minimal or no exposure to Eastern Europe, insulating them from current geopolitical events.

Outlook

With geopolitical tensions from the invasion of Ukraine resulting in equity market volatility, sanctions against Russia causing a spike in an already inflationary environment and with central banks proceeding with a rate hike cycle, investors are facing an increasingly difficult market to navigate. The Bank of Canada’s 25bp rate increase and indications that more hikes are to be expected, along with Chairman Powell’s support for a 25bps hike, signals the start of a tightening cycle which may be difficult to pause given higher inflationary expectations.

In environments such as this, we view the low correlation, low volatility and absolute return-focused nature of merger arbitrage makes it a compelling investment strategy to allocate to within a portfolio. As merger arbitrage is among a limited number of investment strategies positively correlated to interest rates, the strategy could be a hedge to higher inflation as central banks employ monetary tightening. The idiosyncratic nature of merger arbitrage, where each deal invested in by the Fund has deal risk specific to that transaction with low correlation to other deals, provides the potential ability for the strategy to deliver absolute returns with a low correlation to equity market performance.

We view that the short duration and wide spreads at hand for arbitrage make it an effective alternative to fixed income allocations and a hedge against rising rates. We also believe the opportunity set for the strategy is ideally positioned with favourable conditions for both merger arbitrage and SPAC arbitrage.  

Amar Pandya, CFA
March 7, 2022

[1] All Pender NAV data points are for Class F of the Fund. Other classes are available. Fees, NAV price and performance may differ in those other classes.

[2] https://www.investmentexecutive.com/news/research-and-markets/global-ma-party-rages-on/

[3] https://mergerarbitragelimited.com/spreads/

[4] https://spacinsider.com/stats/

[5] Source: Bloomberg Global Aggregate Bond Index