Notes from the Desk: An Update on Aerojet Rocketdyne/Lockheed Martin

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.