Alternative Arbitrage – Manager’s Commentary – March 2022
The Pender Alternative Arbitrage Fund (PAAF) ended the month of March 2022 with a NAV of $10.28 per unit.
M&A activity ended Q1 with over $1 trillion of global deal activity, down 21% from last year as the impact of rising inflation and geopolitical tensions may be causing some acquirers to hit the pause button. Despite increased regulatory scrutiny on “Big Tech” and large-cap mergers, mega-deals worth more than $10B are up 46% from last year, while large and mid-sized mergers between $1B and $5B are down 40%. The technology sector continues to lead activity, with nearly $259B of deals announced in the quarter followed by the financial and real estate sectors. There is a notable dichotomy, with record levels of private equity buyouts, which are up 18% from last year and account for nearly a third of all deals, while acquisitions by SPACs fell by 87% and account for only 3% of total deal value. M&A activity in North America, which is the focus for the Fund, remains robust with the highest Q1 for deal values in the last five years, with notable activity from financial acquirers indicating high confidence and favourable market conditions for mergers. Spreads remain wide, with a high success rate of deals closing year-to-date, providing an attractive yield in general, particularly relative to bonds.
SPACs which were already beaten-down this year were dealt another blow as the SEC proposed new rules for SPACs at the end of March, which would remove some of the key advantages SPACs have, relative to traditional IPOs. Specifically, the advantages that have helped SPACs take early stage, concept, pre-revenue or high cash burning companies public via a business combination have been removed. The changes included (1) amendments to safe harbour rules, which would now make SPAC sponsors and management legally accountable for forward guidance and estimates; (2) requirements for target companies to be co-registrants on filings; (3) more disclosures on fees, conflicts of interest and shareholder dilution (4) and new limitations on the types of financial statements that can be shared with investors.
These proposed rules are a negative development for SPACs, with many underwriters pausing SPAC IPOs until there is more clarity on the legal risk of these rules. These rules will likely make it far more challenging for SPACs to find and successfully close a business combination with a target. The Fund’s SPAC strategy is focused entirely on investing in SPACs trading at a discount to trust value and realizing that value through redemption on maturity or the vote on a proposed deal. In our view, this development could result in SPAC arbitrage spreads widening as the probability of a SPAC sponsor announcing a deal decrease, which would improve yields on investments, especially as we enter a SPAC maturity cliff next quarter. At the end of March, SPACs searching for targets were trading at a discount to trust which provides a potential yield-to-maturity in excess of 2.7%.
March was an active month for the Fund which initiated positions in over 20 new or already announced merger deals, with a dozen held mergers closing by the end of the month. Higher inflation, rate hikes and increasingly hawkish commentary from central banks and the continued geopolitical crisis in Ukraine has driven increased volatility in equity and bond markets. In our view, the conditions for merger arb remain favourable with wide spreads, a high success rate of mergers closing and elevated levels of deal activity, particularly in North America, the investable universe for the Fund. While our focus is on small and mid-cap merger deals, we are also finding opportunities with SPACs and other merger deals. One area where we are finding opportunities is investing in large and mega-cap deals late in the approval process, when the merger has been largely de-risked but still provides a relatively attractive spread. We are also finding opportunities to trade around volatile spreads such as the acquisition of GreenSky, Inc. (NASDAQ: GSKY) by The Goldman Sachs Group, Inc. (NYSE: GS). A notable merger deal which saw its spread widen considerably during the month without any corresponding change in risk, and which we took advantage of by adding to our position. We have also narrowed our SPAC focus to SPACs with a short duration which are trading at a discount to trust and providing an attractive yield-to-maturity.
Among merger deals initiated in the Fund during March were Tenneco Inc. (NYSE: TEN), Veoneer, Inc. (NYSE: VNE), Resonant Inc. (NASDAQ: RESN), Cedar Realty Trust, Inc. (NYSE: CRD), Prudential Bancorp, Inc. (NASDAQ: PBIP), Intertape Polymer Group Inc. (TSX: ITP), Intricon Corporation (NASDAQ: IIN), Healthcare Trust of America, Inc. (NYSE: HTA), Citrix Systems, Inc. (NYSE: CTXS), Renewable Energy Group, Inc. (NASDAQ: REGI), Arena Pharmaceuticals, Inc. (NASDAQ: ARNA), Alleghany Corporation (NYSE: Y), Anaplan, Inc. (NYSE: PLAN), Summer Infant, Inc. (NASDAQ: SUMR), Cerner Corporation (NASDAQ: CERN), Intersect ENT, Inc. (NASDAQ: XENT), Leucrotta Exploration Inc. (TSXV: LXE), Ferro Corporation (NYSE: FOE), Nielsen Holdings plc (NYSE: NLSN) and QuestEx Gold & Copper Ltd. (TSXV: QEX).
Among merger deals that closed during March were Cominar Real Estate Investment Trust (TSX: CUF.UN), McAfee Corp. (NASDAQGS: MCFE), FTS International, Inc. (NYSE: FTSI), Del Taco Restaurants, Inc. (NASDAQ: TACO), Phillips 66 Partners LP (NYSE: PSXP), Arena Pharmaceuticals, Inc. (NASDAQ: ARNA), Hexion Holdings Corporation (OTCPK: HXOH), Kraton Corporation (NYSE: KRA), CyrusOne Inc. (NASDAQ: CONE), Resonant Inc. (NASDAQ: RESN), Apria, Inc. (NASDAQ: APR), GreenSky, Inc. (NASDAQ: GSKY) and Verso Corporation (NYSE: VRS).
At the end of March, the Fund had 24 investments in small-cap deals under $2B, with 19 of those deals under $1B. One of these small-cap deals is a new holding, Intertape Polymer Group Inc. (TSX: ITP), which entered into a definitive agreement to be acquired by private equity group Clearlake Capital Group, L.P. on March 8, 2022. A core holding in the Pender Small/Mid Cap Dividend Fund, Pender’s equity team had been following the company and the industry for years. We had thorough research and valuation analysis on the company, data on precedent transaction multiples in the packaging sector which ITP operates in, and insights into shareholder expectations. This allowed the Fund to benefit from our existing research to determine that the offer was fair and was likely to be accepted by shareholders. Also, that the acquirer would be unlikely to face significant regulatory scrutiny resulting in a high probability of the merger closing. We were able to act quickly and initiate a position, with the merger deal now one of the top 10 holdings in the Fund. With more regulatory pressure on larger merger deals, including a new US bill introduced in March, the Prohibiting Anticompetitive Mergers Act which would block mergers valued at more than $5B and scrutinize mergers more closely, our focus in the Fund remains on smaller mergers that still offer attractive spreads while reducing our regulatory risk exposure.
The market environment remains challenging for investors to navigate with the ongoing geopolitical crisis from the invasion in Ukraine, rising inflation with more commodity prices spiking and higher interest rates. Inflation reached a 30-year high in Canada, rising to 5.7% in March, while the US inflation rate is the highest in 40 years at 7.9%. As central banks scramble to combat inflation, the Fed and BOC approved the first rate hikes in years during March, with expectations of interest rates rising at every scheduled meeting this year, including the potential for several 50 basis point hikes. Investors concerned about higher inflation and rising interest rates could consider adding exposure to investment strategies which have historically performed well in rising rate environments like merger arbitrage. The strategy may also provide a hedge against the declining value of bonds as interest rates rise, as it is a compelling substitute given the low volatility and low correlation of merger arbitrage to bonds and the wide spreads for merger deals. A flattening yield curve, which has crossed into inverting, may be signaling that inflation is too hot and growth may moderate or even decline. In that context, investors could consider diversifying their direct market exposure by diversifying into non-correlated, absolute return focused event-driven strategies like merger arbitrage. In our opinion, the case for merger arbitrage as a substitute for a traditional fixed income allocation or a complement to an equity allocation is compelling in this market environment.
Amar Pandya, CFA
April 11, 2022
 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.