Alternative Arbitrage Fund – July 2024
Highlights
- July was another positive month for Fund as several of the larger holdings closed allowing us to harvest and redeploy capital. Key deals included: Apartment Income REIT, Vericity Inc, National Western Life Insurance Co, Everbridge Inc and Argonaut Gold Inc.
- Performance also benefitted from buoyant equity markets, robust deal activity and outperformance of small cap equites driving a tightening of yields in the majority of deals in the Fund.
- The Fund initiated positions in 19 new merger deals and 14 deals in the Fund closed.
Dear Unitholders,
The Pender Alternative Arbitrage Fund was up 0.7%[1] in July 2024. The Fund’s benchmark, the HFRI ED: Merger Arbitrage Index (USD) returned 2.5% during the same period.
M&A Market Update
Global M&A activity reached over $1.8 trillion through the end of July 2024, up 14% from the same time last year.[2] Dealmaking continues to show signs of momentum in the third quarter of the year as the Fed has signaled interest rates would be cut this fall following other central banks around the world. A lower rate environment and a favorable market for deal financing is expected to drive increased private equity firm buyouts of public companies as they seek to deploy their trillions of dry capital. While we have seen a healthy mix of strategic deal flow through the year, we are yet to see PE deals recover to their 2021/2022 levels. Nevertheless there has been a notable increase in PE deals and several LBOs this year. Commentary from large US private equity firms including The Carlyle Group Inc and KKR & Co Inc. are optimistic about M&A activity picking up into the back half of 2024. Private equity firms represented more than half of all public company acquirers in 2022, and we could see that figure exceeded in the quarters and years ahead.
The CEO and founder of Canadian technology company Nuvei Corp (TSX: NVEI), which accepted a $6.3 billion offer to be acquired this spring, was recently interviewed by the Globe and Mail and gave some insights into the drivers and motivations behind his decision to go private. This included several dynamics we have previously discussed as core drivers of privatization including the complexity, cost and distraction of being a public company; the short-term bias impact of incentives and employee morale when tied to a share price; the challenges of managing expectations as a public company and the steep discount in current valuations between public markets and private markets. These are common dynamics which are currently impacting numerous Canadian technology companies. Of the 20 Canadian technology companies that went public on the TSX in 2020 through 2021, nine have subsequently gone private as their share prices languished.[3] Investor patience can wear thin with time as the businesses they own continue to underperform and trade well below their intrinsic value. Eventually seller expectations fall, or buyer expectations rise to a level where a deal can materialize. Shareholder activists can help speed up this process forcing management and the boards’ hand to run a sales process. With small cap valuations still at a deep discount behind large caps, many more small cap technology companies and broader small cap businesses are likely to explore take-private transactions in the coming quarters.
“With considerable small cap M&A activity, this is an opportune time for the Fund. We have fully deployed cash into dozens of high-quality merger deals offering attractive potential yields.”
SPAC Market Update
The SPAC appears to be back with billions of dollars raised over the past couple months and filings suggesting that billions more could be raised in the months ahead. This wave of SPAC issuance is largely led by serial SPAC sponsors with good track records of finding, targeting and successfully completing a business combination or De-SPAC. While longer-term performance of De-SPACs has been abysmal and performance of more recent De-SPACs have been mixed, there seems to be ample demand for new SPACs if the sponsor has a decent track record of sourcing deals and the SPAC offers favorable financial terms for investors. With the traditional IPO market still closed for many private businesses looking to go public, SPAC mergers provide an alternative route particularly for early-stage companies with elevated needs for capital. This reemergence of SPACs is far from the bubble of 2020-2021 and more of a return to pre-pandemic levels as the size of the SPAC sector has shrunk dramatically over the past few years and the pendulum was due to swing back toward an equilibrium.
July saw a notable uptick of SPAC new issuance with four SPAC IPOs raising $0.5 billion in capital, eight SPAC deals also closed during the month with two SPAC liquidations[4]. As of the end of July, there were 209 active SPACs in the market with assets of $12.7 billion with 99 of them actively searching for targets. With several SPAC IPOs having high quality sponsors, and favorable deal terms, the Fund participated in three new SPAC IPOs during the month. This is a notable shift in our SPAC strategy as the Fund has primarily focused on SPAC liquidations and redemptions since the launch of the strategy. This shift is indicative of an improved environment for SPAC arbitrage from new issuances with SPAC warrants and sponsors overfunding the trust account with their own capital, thus providing investors with an attractive low risk return.
With the summer months seeing a pickup in SPAC expirations, we are seeing elevated SPAC redemption and liquidation activity resulting in a widening of SPAC arbitrage yields. At the end of July 2024, SPACs searching for targets were trading at a discount-to-trust value, which provided a yield-to-maturity of 8.27%.[5] With SPAC arbitrage effectively equivalent to acquiring a Treasury Bill at a discount, SPACs currently provide a higher yield to US Corporate Investment Grade Bonds with lower credit risk, shorter duration and a tax advantage as SPAC returns are primarily capital gains.
Portfolio Update
July was another positive month for Fund performance as several of the larger holdings in the Fund received their final approvals and closed during the month allowing the fund to harvest and redeploy that capital. Some of the key deals that closed during the month included: Apartment Income REIT, Vericity Inc, National Western Life Insurance Co, Everbridge Inc and Argonaut Gold Inc. Fund performance also benefitted from a favorable deal environment with buoyant equity markets, robust deal activity and outperformance of small cap equites together driving a tightening of yields of the majority of deals held by the Fund. During the month, the Fund initiated positions in 19 new merger deals as well as 14 deals held within the Fund closing. With considerable small cap M&A activity, this is an opportune time for the Fund to deploy cash into dozens of high-quality merger deals with a mix of strategic and financial merger deals offering attractive potential yields. The Fund’s positioning in merger arb remains focused on high quality small and mid-cap merger deals targeting a short duration and attractive expected yield. We have also increased our SPAC exposure in the PAAF to more than 20% as we take advantage of the ample number of SPAC liquidations and redemptions in these summer months while also participating in a handful of SPAC IPO’s which offer favourable SPAC arbitrage terms. We would expect our SPAC exposure to decline over the next few months as we redeploy that capital into new merger arb deals.
Canadian M&A market activity has really picked up in the past few months with dozens of deals announced this year in our core universe of small and mid-cap companies. This is a sharp rebound from a 23-year low of activity experienced last year and clearly indicates an improvement in the economy, investor confidence and improved risk appetite. In several sectors like technology, industrials and resources, Canada has numerous high-quality businesses trading at steep discounts to their US peers. With lower interest rates, an improving macro-outlook and favorable funding conditions, we believe these companies are attractive targets for both strategic and financial acquirers. Small and mid-cap merger deals are the key focus for the Fund as we can typically leverage our research, relationships, trading expertise and insights to add value to these under-followed deals which tend to be mispriced. During July several current and former Pender equity holdings announced definitive acquisition offers including Hamilton Thorne Ltd (TSX: HTL), Heroux-Devtek Inc (TSX: HRX), Stelco Holdings Inc (TSX: STLC) and Sleep Country Canada Holdings Inc (TSX: ZZZ). We see continued momentum for Canadian small and mid-cap merger deals through the year as the macro and sentiment backdrop for deal activity continues to improve. At the end of July 2024, the Fund had 37 investments in small cap deals under $2 billion, 28 of which were valued at under $1 billion.
Outlook
July saw a notable rotation into small caps from large caps driving a 10.2% gain in the Russell 200 while the NASDAQ declined by 0.7%. Equity markets continued their positive streak with the S&P 500 and S&P/TSX up 1.3% and 5.6% bringing their year-to-date returns to 15.8% and 10.3% respectively. With inflation, employment and other economic data suggesting a cool-down in the economy, the market’s attention has shifted to rate cut expectations for the year and the potential for a hard landing if rates are not cut soon enough and significantly enough. In addition to the economic uncertainty, 2024 is also ripe with political uncertainty as nearly 100 countries are expected to go to the polls this year with almost half the global population eligible to vote.[6] The majority of these countries, including the United States, have elections that have yet to be called adding further uncertainty to an investment environment already experiencing high volatility and geopolitical stress. With a higher probability of entering a global rate cutting cycle, there is pent up demand for M&A which could be unleashed as interest rates fall.
After a strained M&A environment with two consecutive years of declining total deal value, activity in 2024 has demonstrated a sustained recovery with an improving macro backdrop. With interest rates, valuations and economic conditions providing ample tailwinds for merger activity, we expect M&A volume to remain elevated, particularly for small and mid-cap companies. Several holdings within our equity funds are well positioned in this environment with inexpensive valuations, several identifiable catalysts and shareholder activists which we believe makes them attractive takeover targets. The rally in small caps which started this summer still has considerable runway ahead and many acquirers are likely to sign a deal before valuations re-rate further. This creates an ideal environment for our merger arb strategy with ample high-quality deal flow and wide spreads. We believe the non-correlated and absolute return potential for merger arbitrage should be a compelling addition to investors’ portfolios in this environment.
Amar Pandya, CFA
21 August 2024
[1] 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.
[2] Deal Intelligence I as of August 8, 2024
[3] https://www.theglobeandmail.com/business/article-nuvei-ceo-phil-fayer-on-the-perils-of-running-a-public-tech-companyand/?login=true
[4] https://www.spacresearch.com/
[5] https://www.spacinsider.com/
[6] https://www.lseg.com/en/insights/data-analytics/deal-makers-hold-their-nerve-as-h2-takes-off
