In our last update we talked about the wide spreads we were seeing in merger arbitrage but also the greater regulatory risk that we believe was at least partially causing these wider spreads. In the third quarter, we saw some of this uncertainty rear its head.
The quarter started with merger arbitrage still on the back foot after the surprise appointment of Lina Khan as Chair of the Federal Trade Commission (“FTC”) in June¹ instead of being appointed as one of five sitting Commissioners as expected. In July we had the first merger arbitrage deal break in our portfolio for quite some time when Willis Towers Watson and Aon mutually agreed to terminate their deal after failing to secure US regulatory approval. This was believed to be a challenging antitrust review (Willis and Aon being the #2 and #3 players in many key markets) and the market was pricing a roughly 50-50 chance of approval. So, it was not a huge surprise when the deal fell apart (notably not due to the FTC as the U.S. Department of Justice was the US antitrust regulator). What was surprising is how strong Aon traded after the break, leading to a break spread that was materially worse than general expectation. Because of the higher risk profile of this spread, we had a small weight which ultimately cost us approximately 35 bps when the deal broke.
If bad things happen in threes, the third event (after Lina Khan and the Willis deal break) was something we haven’t seen since the 1999 tech bubble. Xilinx, a large semiconductor manufacturer, is being acquired by AMD in an all-stock transaction. In late July, AMD announced very strong earnings and began to trade higher on heavy volume. Normally, this is a non-event for a merger arbitrage, we’re long XLNX and short AMD and should be indifferent to where AMD trades as long as the deal closes. In this case, however, there wasn’t enough arb buying power to keep XLNX in line with AMD ripping higher and the spread began to widen. This caused a cascading effect where some arbitrage investors with very tight stop loss limits (typically at large US multi-strategy funds) were forced to unwind (sell) XLNX. For about a week in early August, while the rest of the financial markets were remarkably calm, the merger arbitrage market was on edge dealing with this tempest. In the following weeks, the spread has been quietly normalizing back towards initial levels (aided by the fact that a similar semiconductor deal, MXIM/ADI, received its approval by the Chinese regulator in late August).
On the special purpose acquisition corporations (“SPAC“) side of the portfolio, the most notable development of the quarter has been the improvement in terms for investors in new IPOs. Warrant coverage has increased but more importantly we are seeing many deals with overfunded trust accounts. This means that a SPAC might start its life with 10.25 or even 10.30 in trust (but still price at $10.00 per unit), providing a meaningful yield tailwind in a world of low interest rates. One notable recent de-SPAC announcement is the acquisition of Algoma Steel by Legato Merger Corp. This Sault Ste. Marie-based steel producer, a close comparable to Stelco, is generating a lot of profits in a hot steel market. The transaction was announced with a 1.9x forward EBITDA multiple² and was well received by the market, trading up 15% during the third quarter.
¹ https://www.politico.com/news/2021/06/15/khan-confirm-ftc-494609
² https://www.sec.gov/Archives/edgar/data/1820272/000121390021028946/ea141600ex99-2_legato.htm
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