Recent Events

Last week Silicon Valley Bank (SIVB) was closed by the California Department of Financial Protection and Innovation, which appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. The FDIC took steps over the weekend to protect both insured and uninsured depositors, and the Federal Reserve (Fed) established a new Bank Term Funding Program, through which any US depository institution can obtain financing for eligible collateral at full par value for up to one year. While these actions quelled speculation about the event’s outcome and provided a safety net for the bank’s depositors, large questions remain about whether enough has been done to address deposit flight from other institutions and whether there is now more systemic contagion.

Although SIVB’s closure was an unexpected tail event, as of this writing most agree it is not a credit event where poor asset quality caused the issues (as with highly levered, poor-quality mortgage-backed securities in 2008, or during the savings and loans crisis of the 80s). SIVB had deposits that were heavily skewed toward its large venture capital and private equity clients, whereas its assets were invested in longer-dated fixed rate assets. As interest rates rose rapidly, the bank’s funding costs increased while its longer-dated assets experienced price declines due to large duration risks. As asset prices fell, the bank felt compelled to sell part of its portfolio – thus incurring realized losses – to raise capital to fund its business.

Macroeconomic View

Prior to the SIVB-related events, 2023 started with a very positive tone in January. We believe rising optimism was driven by a combination of factors, including the market’s perception that interest rate hikes were mostly done, that the Fed had engineered a soft landing and was on the road to curbing inflation, and models shifting to favor more fixed income and yield. Since February, and prior to the events of last week, inflation had remained sticky and the Fed had shifted its tone to reflect smaller, but more possible, rate hikes. While market sentiment changed to a more cautious stance, over the last few trading days (since the SIVB-related news emerged), interest rates have declined dramatically as seen below in the graph which compares US Treasury yields across tenors between March 6 and March 13.

Figure 1: US Treasury Yields by Tenor – Current (3/13/23) vs. 1 Week Prior (3/6/23)

Source: Bloomberg. As of: March 13, 2023. The US Treasury Actives Curve – also known as a yield curve – depicts the yield of Treasury securities of various maturities at a point in time.

In addition, market stress is causing economists to now forecast that the Fed, despite being in the midst of a difficult fight to curb inflation, will pause rate hikes and may even cut rates during 2023. While we do not know the certainty of these actions or the impact that SIVB could have on banks and consumers, we can clearly see below the changes between forecasts for rate hikes from mid-February (Figure 2) to the present (Figure 3).

Figure 2: Implied Federal Funds Rate Projections – 2/15/23

Source: Bloomberg. As of: February 15, 2023.

Figure 3: Implied Federal Funds Rate Projections – 3/14/23

Source: Bloomberg. As of: March 14, 2023.

Over the last 18 months, inflation expectations have shifted along with economic data and Fed priorities. After trending downward since March 2022, expectations began to rise once again beginning in January 2023, only to be reduced again with the fallout from this past week’s events.

Figure 4: 5-Year Inflation Expectations

Source: Bloomberg. As of: March 13, 2023. The 5-Year Breakeven Inflation Rate (USGGBE05 Index) is a representation of expectations for inflation five years into the future, derived from 5-Year Treasury constant maturity securities and 5-Year Treasury inflation-indexed constant maturity securities.

Water Island Credit Opportunities Fund – Portfolio Commentary

Over the first two months of 2023, two big factors have been the primary drivers of performance. First, many of the transactions behind our merger-related positions are in the process of closing or have closed. These are situations where target company bonds or loans are expected to be retired as part of the transaction. Annualized yields on these positions have been in the range of 6%-8%. We have not been impacted by any broken deals, and when we invest in mergers we typically seek to limit downside to 20 basis points of risk based on our estimates, using hedges where possible, and avoid controversial deals unless downside is minimal.

Second, investments predicated on companies refinancing debt prior to its stated maturity have been positive contributors. As capital markets reopened in January, these companies were able to place new debt in the market and used proceeds to retire debt and extend maturities. Several of our positions were first lien bonds, and the news of their refinancing led to gains in their bond prices. We think this trend will continue throughout the year as management teams are looking to take advantage of more stable markets, and corporations are also looking to proactively extend their maturity profiles in response to interest rate uncertainty.

Given this trend, we are building positions of what we believe to be solid-performing credits, with maturities less than three years, and secured status where available. We are also using equity and options to seek to mitigate downside. We expect to see approximately 30% of the portfolio roll over during Q1 as deals close, which could benefit the fund during a volatile time as the prices of bonds involved in concluding catalysts trade to par or to their deal price. We have several potential catalysts on our radar, and we further anticipate many of these to result in the announcements of definitive merger deals which can replenish this portion of the portfolio. Overall, we are positive on our view for corporate catalysts, encouraged by more attractive yields, and eager to capitalize on these opportunities as we seek to deliver our clients attractive risk-adjusted returns – though we are cognizant of the need to remain extremely vigilant when investing following events like those experienced over the last week. In the short-term, we expect equity and rate market volatility to become elevated and for credit spreads to widen, but we ultimately believe that corporate management teams will continue to seek strategic alternatives whether they be mergers, spin-offs, assets sales, or refinancings – all events that are key to our strategy.

GLOSSARY: A basis point is an amount equal to 1/100 of 1%. A credit spread is the difference in yield between a US Treasury security and a debt security with the same maturity but of lesser quality. Duration is the approximate percentage change in a bond’s price that will result from a 1% change in its yield. A first lien bond is debt that is secured by collateral, the holders of which are paid back before all other debt holders. Maturity profile refers to the overall view of a company’s issued debt by year of maturity. The par value, or face value, of a bond is the amount of money that an issuer promises to repay bondholders at the maturity date of the bond. Secured debt is debt that is backed by collateral. Tenor refers to the length of time remaining on a financial contract before its expiration or maturity.

Commentary represents the manager’s current opinion and may contain certain forward-looking statements. Actual future results may differ from our expectations. Our views may change at any time, and we have no obligation to update them. Commentary should not be regarded as investment advice or a recommendation of any security or strategy. Investing involves risk, including loss of principal. Past performance is not indicative of future results.

RISKS: Investments are subject to risk, including possible loss of principal. There can be no assurance that the fund will achieve its investment objectives. The fund uses investment techniques and strategies with risks that are different from the risks ordinarily associated with credit investments. Such risks include event-driven risk; merger arbitrage risk (in that the proposed reorganizations in which the fund invests may be renegotiated or terminated, in which case the fund may realize losses); active management risk; credit risk; convertible security risk; liquidity risk; market risk; sector risk; interest rate risk; short sale risk; hedging transaction risk; large shareholder transaction risk; leverage risk; high portfolio turnover risk (which may increase the fund’s brokerage costs, which would reduce performance); counterparty risk; temporary investment/cash management risk; swap risk; options risk; preferred security risk; investment company and ETF risk; derivatives risk; LIBOR rate risk; currency risk; and foreign securities risk. Risks may increase volatility, increase costs, and lower performance.

Many clients are attracted to our approach to the merger arbitrage strategy as we execute it in the Arbitrage Fund for its typically even-keeled nature, with a fairly stable historical risk/return profile. Merger arbitrage generally seeks absolute returns with low levels of volatility over the long term, but returns are traditionally sourced from equity securities. While these equities typically trade based on the fundamentals of the announced mergers and acquisitions (M&A) transactions in which they are involved, rather than overall market direction, during times of heightened market volatility we often see correlations converge, and merger-related names are not entirely immune to these market events. We have seen this several times before – for example, in the midst of the Global Financial Crisis of 2008, more recently at the onset of the COVID-19 pandemic in the first quarter of 2020, and now once again during Q2 2022.

The reasons for recent market volatility are numerous – geopolitical tensions, inflation, rising interest rates, and recession fears, to name just a few. The net effect for the merger arbitrage strategy has been a dramatic widening in deal spreads across nearly all pending M&A names. Merger arbitrage is not an inversely correlated strategy, and when arbitrageurs unwind positions en masse – which can happen due to forced de-risking (especially amongst levered investors) and panicked selling – spreads dislocate, as the arbitrage community is simply not large enough to offset widespread selling with new buying. To give a sense of the scale of the spread widening we have seen, the table below presents the average spread of the 25 largest deal holdings in the Arbitrage Fund as of May 31, 2022, at various points in time.

	1 Day Post Deal Announcement	4/1/2022	5/2/2022	6/16/2022
Average Gross Spread – Top 25 Deals	3.5%	4.1%	5.0%	11.4%

Source: Water Island Capital. As of June 16, 2022. Represents 25 largest positions by long exposure to alpha security, as a percent of net assets. Reflects direct investments only.

The spread of a deal the day after it is announced can generally be considered a baseline rate of return for the deal (assuming its successful completion), and this is often the widest point at which a transaction will trade as all hurdles to completion remain outstanding. Yet as of June 16, the 25 largest deals in the portfolio on average traded at rates of return more than three times greater than their average spread the day after each deal was announced.

We understand such spread widening can lead to drawdowns that may seem alarming, especially for a strategy that tends to only move in small increments, but it is important to remember that this volatility reflects nothing but mark-to-market movements, not any changes to the fundaments of the underlying deals in the portfolio. While these drawdowns are hard to avoid if one intends to remain invested, in our prior experience their duration has been short-term in nature – after the volatility subsides, deal spreads begin to narrow as each transaction proceeds to a successful close. Historically, according to Dealogic data, more than 90% of announced M&A transactions successfully close, while in our own portfolio on average just 1% of the deals in which Arbitrage Fund has invested have broken while held in the portfolio. We expect the success rate of announced M&A to remain consistent with historical norms, as merger contracts have become increasingly strong since the Global Financial Crisis and it has become exceedingly difficult for even the most remorseful buyer to extricate itself from a definitive merger agreement.

As we see it, there are three reactions a merger arbitrage investor could have in response to this type of volatility. The first is to capitulate, which we see most often amongst levered multi-strategy hedge funds as they close out their arbitrage book to focus on other strategies they deem more attractive. Another is to go to cash and sit on the sidelines in an attempt to wait out the volatility. The last, and the course we have chosen, is to see opportunity amongst the chaos and remain fully invested. We have a high degree of conviction in the deals in which we have invested and we believe diverging spreads have led to attractive rates of potential return. We believe the transactions in the portfolio will eventually close, freeing up capital to be redeployed in newly announced deals, with the added benefit of rising interest rates (which have historically served as a tailwind for merger arbitrage returns). Deal flow remains robust, and widespread dislocations in valuations can often lead to shareholder activism, potentially spurring additional M&A or topping bid scenarios. Lastly, ongoing market volatility can provide the ability to trade around spreads and find opportunistic entry points. All in all, we are optimistic about the return potential for the strategy, but we do anticipate relatively higher volatility to remain present in the months ahead. As such, we intend to adhere closely to our stringent risk management protocols as we navigate these choppy waters.

Commentary represents the manager’s current opinion and may contain certain forward-looking statements. Actual future results may differ from our expectations. Our views may change at any time, and we have no obligation to update them. Commentary should not be regarded as investment advice or a recommendation of any security or strategy. Investing involves risk, including loss of principal. Past performance is not indicative of future results. Visit the glossary for definitions of terms.

RISKS: Investments are subject to risk, including possible loss of principal. There can be no assurance that the fund will achieve its investment objectives. The fund uses investment techniques and strategies with risks that are different from the risks ordinarily associated with equity investments. Such risks include merger arbitrage risk (in that the proposed reorganizations in which the fund invests may be renegotiated or terminated, in which case the fund may realize losses); short sale risk (in that the fund will suffer a loss if it sells a security short and the value of the security rises rather than falls); concentration risk; high portfolio turnover risk (which may increase the fund’s brokerage costs, which would reduce performance); foreign securities risk (in that the securities of foreign issuers may be less liquid and more volatile than securities of comparable US issuers, and may be subject to political uncertainty and currency fluctuations); market risk; sector risk; derivatives risk; LIBOR rate risk; hedging transaction risk; counterparty risk; swap risk; options risk; liquidity risk; active management risk; investment company and ETF risk; leverage risk; small and medium capitalization securities risk; currency risk; and temporary investment/cash management risk. Risks may increase volatility and may increase costs and lower performance.

Lockheed Martin is a US-based aerospace, arms, defense, information security, and technology company and one of the world’s largest defense contractors. Aerojet Rocketdyne is a US-based developer and manufacturer of propulsion systems for defense and space applications. In December 2020, the companies announced they had reached a definitive agreement for Lockheed to acquire Aerojet for $4.3 billion in cash. Lockheed is one of Aerojet’s largest customers, making the acquisition an attractive avenue for the firm to vertically integrate key capabilities. The deal is subject to customary closing conditions, including shareholder and regulatory approvals, and the companies initially guided toward a closing date in the second half of 2021 – longer than a typical deal timeline, reflecting their expectations for a lengthy antitrust review process.

While shareholder approval was received without issue in Q1 2021, the (not entirely unexpected) protracted regulatory review forced the companies to extend the initial walk date by three months, to March 21, 2022, from December 21, 2021. Alas, on January 25, 2022, the US Federal Trade Commission (FTC) announced its intent to sue to block the deal, alleging that if the deal were allowed to proceed, Lockheed would use its control of Aerojet to harm rival defense contractors and further consolidate multiple markets critical to national security and defense.

We are disappointed, but not surprised, by the FTC’s actions. Under Lina Khan, the new chair of the commission in President Biden’s administration and a noted antitrust hawk, the FTC has becoming increasingly hostile toward certain types of consolidation. (Understanding this risk, we had sized our exposure to this deal at less than 50% of a typical max position in our own funds.) The US Department of Defense (DOD), for its own part, has not publicly voiced its opinion on the transaction, though it is broadly believed to be supportive. (Indeed, the DOD participated in the FTC’s review process, and we believe the fact it released a statement that did not publicly support the FTC’s lawsuit, referring all inquiries to the FTC, is telling.) Furthermore, the deal has received public support from a bipartisan group of lawmakers who claim it would restore competitive balance amongst defense contractors, following the acquisition of rocket propulsion firm Orbital ATK by Lockheed competitor Northrup Grumman. To bolster Aerojet with the resources of Lockheed Martin would provide the government with two well-resourced suppliers for defense and space propulsion.

It is exceedingly rare for a transaction that has the support of the DOD to be blocked by the government. Historically, national security concerns have trumped potential pricing pressures from reduced competition. Now that the FTC has sued, Lockheed has the option to walk away from the deal under the merger agreement, though we believe there is a possibility the company will instead seek to defend the lawsuit in court if it is as eager to garner the asset as it has indicated.

Overall, we believe the prevailing view amongst the merger arbitrage community and its response to the news has been overly pessimistic. Once again, a negative development in a single deal was met with widespread selling across other pending mergers, driving deal spreads wider. Ever since the failure of the merger of Willis Towers Watson and Aon in Q3 2021, performance across many merger arbitrage portfolios has been challenged, and there has been little patience amongst arbitrageurs to wait to see events like Aerojet/Lockheed play out – especially given the unusually heightened volatility that has already occurred at the start of 2022.

As always, we see potential opportunity when spreads broadly dislocate like this, and we were able to take advantage of the volatility to incrementally increase our exposure to several positions – including Aerojet/Lockheed – at what we believe to be favorable entry points. Given the improvements in Aerojet’s business since the deal was struck and the potential for other suitors to emerge, we believe the swiftly negative move in the company’s share price was an overreaction, and we have adjusted our downside estimates accordingly.

Whenever a deal encounters well-publicized antitrust objections, we inevitably get questions about whether we implement additional hedges or why we even bother to participate at all in mergers and acquisitions (M&A) with heightened antitrust risk. We typically don’t seek to implement unique hedges in these situations, as our standard hedging methodology is designed to mitigate market risk in idiosyncratic M&A deals, and to do otherwise could actually increase correlation and volatility. Instead, we typically seek to limit our exposure through adjusting our position sizing based on our expectations for potential downside in the event of a deal failure, and continually monitor our valuations and downside projections for any changes. There is a fine line between avoiding or accepting the exposure to deals with heightened antitrust risk, and our job ultimately is to put capital to work and attempt to properly strike this balance. It’s impossible to avoid regulatory reviews altogether – 100% of transactions require regulatory approval in some form. More often than not, even transactions with perceived heightened antitrust risk proceed to a successful closing (and approximately 90% of all announced deals close, whether at their original terms or after agreeing to remedies with regulators). To avoid all such transactions would do a disservice to our clients. Furthermore, we believe it is worth noting the impact of the Aerojet/Lockheed deal contributed to just a fraction of our portfolios’ overall performance on the day the FTC announced its lawsuit. The remainder was a result of widespread forced and panicked selling across the merger arbitrage universe – even in deals deemed to have minimal antitrust risk – which, as discussed, we see as an opportunity to put cash to work at what we believe to be favorable rates of return.

Commentary represents the manager’s current opinion and may contain certain forward-looking statements. Actual future results may differ from our expectations. Our views may change at any time, and we have no obligation to update them. Commentary should not be regarded as investment advice or a recommendation of any security or strategy. Investing involves risk, including loss of principal. Past performance is not indicative of future results. View top ten holdings. Visit the glossary for definitions of terms.

On July 26, Willis Towers Watson (WLTW) and Aon (AON) announced they had abandoned their planned $30 billion merger, which would have created the world's largest insurance broker, rather than go to court to defend against an attempt to block the deal by the United States Department of Justice (DOJ). Now that we, like many arbitrageurs, find ourselves in a deal-break situation, we have several questions to answer in order to determine the most appropriate path forward:

1. Who was the party that pushed for deal termination – WLTW or AON?

   Based on our interpretation of the press release, we believe WLTW felt their business was being hindered by the lengthy duration of the deal and the company did not want to wait any longer. If WLTW’s business had been deteriorating, they likely would have agreed to any extension in the timeline or even a cut in terms.

2. What is the opportunity now?

   WLTW is set to receive a $1 billion termination fee from AON, and the company announced it has already approved a $1 billion increase in its stock buyback program. This shows confidence on the part of WLTW management in the company’s underlying fundamentals, and it may help members of the event-driven community exit their positions. WLTW may now also entertain talks with Arthur J Gallagher (AJG), the buyer of many assets that were set to be divested in the WLTW-AON deal. Furthermore, we are witnessing a disconnect in the post-break spread in WLTW-AON. While our analysis of the fundamentals suggests it should trade around $30, it is currently trading in the upper $50s as of this writing on the day of termination. Thus, the primary opportunities we see at this point are the potential for WLTW to enter talks with AJG and for the break spread to begin trading at more normalized levels.

3. Why is there a disconnect in the break spread?

   The failure of the WLTW-AON transaction is yet another adverse outcome in a series of challenges event-driven investors have faced for the past couple months. WLTW-AON has been one of the most widely held positions in the merger arbitrage and broader event-driven community. It has also been a top position in many portfolios given the high levels of conviction in the deal and the timing of the termination, which likely caught many arbitrageurs by surprise with it coming so early in the legal process against the DOJ. With all that in mind, there seems to be little tolerance for additional portfolio losses within arbitrage portfolios, as we are seeing spread pressure not just in WLTW-AON, but also in several other deals as investors exit their positions en masse.

4. What are we doing?

   Both WLTW and AON are currently in a blackout period ahead of scheduled earnings calls, so while the amount of information we can glean currently is limited, we may get more clarity in a few days. For now, we are looking to increase our exposure to WLTW-AON opportunistically, to take advantage of the post-break spread dislocation. While there is no longer a hard catalyst attached to this situation, we see potential for multiple near-term and medium-term soft catalysts to emerge. We are also monitoring other spreads in our universe, and should any of those reach dislocation levels, we expect to add to those positions as well.

Commentary represents the manager’s opinion and may contain certain forward-looking statements which may be different than actual future results, is subject to change, and is under no obligation to be updated. Commentary should not be regarded as investment advice or a recommendation of any security or strategy. Investing involves risk, including loss of principal. Past performance is not indicative of future results. View top ten holdings. Visit the glossary for definitions of terms.

In prior commentary, we have often mentioned how mergers and acquisitions (M&A) activity can experience an increase in competitive or topping bids in periods following a market downturn. Intuitively, this makes sense – after a period in which asset prices are depressed, stronger players can find opportunities to take out their weaker peers, and deals can often be had even if one must outbid a competitor or raise one’s offer in response to shareholders agitating for a better price. Furthermore, situations like these are more likely when acquirers have different views of the market. One company may be more optimistic about the prospects for a recovery – economic, from a pandemic, or otherwise – while another may be factoring more risks or bad outcomes into their valuation of the target. In 2009 – the year immediately following the Global Financial Crisis – no fewer than 16% of completed deals targeting public companies valued at $500 million or greater experienced an increased bid, whether from a competing bidder or a bump in terms from the original acquirer, according to FactSet data. That marked the highest share of competing or topping bid situations of any year in the past two decades, and more than 35% higher than the average.

In 2021, we have begun to witness a similar trend unfold. Through April 30, the share of completed transactions that experienced a competing or topping bid was nearly 20% higher than the average – including the acquisition of Acacia Communications by Cisco Systems, which increased its own offer by more than 60%, to $5.0 billion from $3.1 billion, in order to prevent Acacia from walking away after delays in the regulatory review process caused the original deal to arrive at its termination date without all required approvals. After the companies agreed to renegotiated terms, the deal eventually received all outstanding regulatory approvals and closed successfully in March. In addition, several more still-pending transactions experienced increased offers through competitive bids or bumps in consideration in 2021. At the close of Q1, the Arbitrage Fund held positions in a dozen different pending M&A transactions that had seen their consideration revised higher, with one target (Coherent) having received nine separate rounds of bids from three competing acquirers.

Arbitrage Fund: Competitive/Topping Bidding Situations Held as of Quarter-End

Target	Target Ticker	Position Size	Original Offer	Revised Offer	Change in Offer
Aegion Corp	AEGN	1.3%	$26.00	$30.00	+15%
CA Immobilien Anlagen AG	CAI AV	0.6%	€34.40	€36.00	+5%
Cardtronics PLC	CATM	2.5%	$35.00	$39.00	+11%
Coherent Inc	COHR	3.5%	$212.11	$282.22	+33%
CoreLogic Inc	CLGX	0.6%	$66.00	$80.00	+21%
Cubic Corp	CUB	2.3%	$70.00	$75.00	+7%
Natixis SA	KN FP	0.4%	€3.94	€4.00	+2%
Kansas City Southern	KSU	1.0%	$208.00	$276.69	+33%
Pluralsight Inc	PS	3.3%	$20.26	$22.50	+11%
Scapa Group PLC	SCPA LN	0.4%	£2.10	£2.15	+2%
Signature Aviation PLC	SIG LN	0.4%	$5.50	$5.62	+2%
Tikkurila Oyj	TIK1V FH	1.1%	€25.00	€34.00	+36%

As of March 31, 2021. Source: Water Island Capital, Bloomberg, FactSet. Position size represents percent of net assets. Revised offer represents the prevailing bid accepted by the target as of March 31. Offers represent price per share in local currency.

As we saw in 2009, a higher-than-normal share of multiple bid scenarios – particularly in the absence of an increase in broken deals – has the potential to act as a tailwind for merger arbitrage returns. Topping bids are already contributing to the fund’s performance this year, as the aforementioned Acacia and Coherent deals were the Arbitrage Fund’s top contributors during the first quarter. Given the current market environment, we expect no shortage of opportunities for acquirers to disagree on valuation – which could lead to additional bidding wars and provide further opportunities for the fund to generate non-correlated returns for investors.

Commentary represents the manager’s opinion and may contain certain forward-looking statements which may be different than actual future results, is subject to change, and is under no obligation to be updated. Commentary should not be regarded as investment advice or a recommendation of any security or strategy. Investing involves risk, including loss of principal. Past performance is not indicative of future results. View top ten holdings.