Our arbitrage funds were modestly negative for the quarter (-1.11% and -2.23%, respectively for Picton Mahoney Fortified Arbitrage Fund Cl F and Picton Mahoney Fortified Arbitrage Plus Fund Cl F) in what were very challenging markets for most asset classes. The attribution of this quarter’s performance was roughly two-thirds due to merger arbitrage and one-third due to special purpose acquisition corporations (“SPACs”).
The merger arbitrage side of the portfolio benefitted from the closing of our largest position, Oracle Corporation’s acquisition of Cerner Corporation, as well as several smaller positions. However, merger arbitrage spreads widened this quarter due to numerous factors, including general market weakness, rising rates, increasing risk aversion as investors demand higher risk premiums on assets, and the deleveraging of competitor funds. One area of specific concern for arbitrage investors has been private equity transactions, which are typically leveraged. As government interest rates increases, access to credit has declined, and credit spreads on leveraged loans and high yield bonds have widened dramatically. As noted in our last quarter’s commentary, we have always taken a skeptical view of leveraged transactions and so we have not felt the need to reduce exposure in this space and have been able to take advantage of weakness occasionally in certain transactions. The reason for such skepticism was borne out recently when Thoma Bravo reduced the price of its Anaplan Inc acquisition by 3.4% in response to what they alleged was a breach of the merger agreement. This had a small impact on the portfolio but did lead to the widening spreads for several other private equity deals. The counter to this was that a number of leveraged buyouts recently closed on original terms, for example Clearlake Capital’s acquisition of Intertape Polymer Group and Kaseya’s purchase of Datto.
On the SPAC side of the portfolio, despite the modest negative performance, we have been generally pleased with how stable the common shares of those SPAC that are actively looking for deals, given the largely unprecedented increase in short-term rates. That said, most SPAC portfolios are levered and as the financing for market participants increases versus the hypothetical yield being earned on the cash sitting in trust, we are seeing a modest widening of the yield spread over risk-free rates. More notable is the concern discussed in our last commentary that SPAC warrants will expire worthless if the sponsor can’t close a deal before the liquidation date, and so warrant prices continue to be under pressure from sellers. We have always been cautious around this potential for warrants and despite having a small position we have continued to reduce it where feel appropriate such that the total portfolio weight of warrants is now less than 25 basis points.
Despite the challenging market backdrop, we are optimistic that better days are ahead as merger arbitrage spreads are now at very wide levels that we believe price in a lot of risks, and SPAC common shares will likely be pulled to par as they soon close in on their liquidation dates.
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