Fund Focus: Water Island Capital

Nov 7 2013 | 10:18am ET

Water Island Capital was founded by John Orrico in 2000 as a single-mandate, merger-arbitrage mutual fund, but the firm's ambitions were always loftier.

Todd MunnTodd Munn“[T]he real goal was to turn it into an event-driven advisor shop,” Todd Munn, a portfolio manager at the firm, told FINalternatives. “The only way we could do that was to gather assets and hire expertise in different spaces.”

Thirteen years later, Water Island has successfully gathered assets worth $3.5 billion and hired the expertise of 40+ people, including portfolio managers Gregg Loprete, previously of Ramius Capital; Ted Chen of Jefferies; Roger Foltynowicz of Jacobs Engineering (and the Cincinnati Reds, where he played professional ball); and James Powers, formerly of Torchlight Investors.

In addition to the flagship “pure-play” Arbitrage Fund, which now manages $2.9 billion, the firm runs the recently launched Arbitrage Credit Opportunities Fund ($9 million) and, “in the middle,” according to Munn, the Arbitrage Event-Driven Fund ($90 million) that “takes all the best ideas from all the different skill-sets.”

Water Island also offers hedge fund and managed account products.

Munn, a portfolio manager on the Arbitrage and Arbitrage Event-Driven funds, said that in evaluating deals the members of his team are “kind of like detectives.”

“Our job is to look at a deal and say, 'Okay what can go wrong here?'...When you specifically think about a merger-arb transaction, your risk there is that the deal doesn't close. So it's our expertise and it's our mandate to make sure we're in the deals where we think you have the highest probability of that deal closing and being able to capture that spread.”

“The risks that are involved there are regulatory, financing risks, shareholder risks, there's lots of different nuances...What's the merger agreement like? What's the landscape of the industry that these players are in? What's the environment like for these two companies? Is it a strategic merger? What's the quality of the deal and the buyer?”

“And then, of course, you have to rank that deal against all the other deals in the universe. So, our job is to be in the 70 best deals out of the 200 deals that are going on at any current period of time around the globe.”

Gregg LopreteGregg LopreteLoprete, who runs the Arbitrage Credit Opportunities Fund and is co-manager on the Arbitrage Event-Driven Fund, said his goal is to find “catalysts that can unlock value in a particular bond or a particular stock.”

“We're not just going out and picking stocks the way a traditional growth fund would or picking bonds the way a traditional high-yield fund might do. What we're looking for are really defined events, and we look at mergers and acquisitions, and in the bond world we will look at any kind of corporate change that might be brought about by mergers and acquisitions, but also things like recapitalizations, restructurings.”

“In the Arbitrage Credit Opportunities Fund...we're looking at bonds and loans and convertibles and the like. In the Arbitrage Event-Driven Fund, there we have a sleeve of credit, but we also have a sleeve that does merger arbitrage and then we have another sleeve that invests in equity special situations...We wanted to maintain the flexibility, particularly in the Event-Driven Fund, because we realize that there may be cycles where M&A or merger arbitrage may not be as attractive or have the same risk or reward as something in equities special situations or in credit.”

Munn said, "given current low interest rates, we are currently seeing an annualized rate of return in the merger-arb space of approximately 4 – 6%. In the past, merger-arb has tended to perform, on average, about 400 basis points above the interest rate of the 90-day U.S. Treasury bill."

If rates do begin to rise, Munn believes his fund will be able to pursue the higher potential returns of the new environment: “As we’ve experienced in the past, we'll be looking for an additional 400 basis points on top of whatever that new rate environment is.  With a 75 day average deal duration for our portfolio, we can redeploy quickly as deals come off, and roll into new deals...the fund can react very quickly to a higher interest rate environment and seek to capture a better rate of return."

Asked if they have sectors they like, Munn replied, “We do have sectors we don't like.”

“We've been involved in a satellite company...and one of our satellites fell out of the sky and the deal was scuttled. Airline deals we're not very fond of, we don't necessarily like the industry. And not that we don't invest in restaurants, but they're tough businesses and they're typically private equity transactions and we're more looking towards strategic transactions where's there's two public companies looking at the next 20 or 30 years of a marriage and not a private equity or an LBO where they're trying to re-engineer the balance sheet and maybe IPO in the next few years.”

“But that said, we still invest in LBOs, mainly given the fact that we do have a credit team in place that can really help us chew through the commitment letters and the financing risk of the deals and that's what an LBO is really going to be predicated on, the financing risk and being able to place the debt in order to place the deal.”

And there are, actually, sectors they like—technology, for example—but as generalists, said Munn, they're “really going to go where the deal flow is” and actually have, in the Arbitrage Fund, a self-imposed 20% limit on sector exposure.

“That's an internal rule but we feel it's a prudent rule to have to stay diversified and to be good stewards of the fund, to not get too sucked into one sector because you can have an oil spill and if you have 50% of your portfolio in oil and exploration deals, you're going to be in trouble.”

Loprete said they're seeing interest in Water Island's offerings from a couple of sources. On the one hand are advisors looking to “liquid alternative” mutual funds to provide portfolio diversification. But on the other hand, in a market where “everybody's talking about rising rates,” Loprete is seeing investors looking to merger-arbitrage as a fixed-income alternative.

“Short-term rates are zero at this point. Any rise in short-term rates is going to increase returns in the merger-arb market, and without the duration you have in, say, a bond fund...So, really, some people are looking at it as an income alternative. I don't think anybody out there is going to be looking to these types of funds to replace their entire fixed-income allocation but people do look at it as a portfolio diversifier.” 


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