Arena Investors commentary for the month ended March 31, 2020, discussing the effects the virus has had on structured finance assets and middle market companies.
Opportunities Since COVID-19 Hit: To date, Arena has seen opportunities pop up in businesses that typically do not operate in the healthcare and biopharma areas or are in those sectors but typically would not be seen as integral to fighting COVID-19 but because of their skills and resources are able to shift into these spaces now to help and add value. They are also seeing value in fintech companies that service tech companies that have seen an uptick in business during this time because of their focus (i.e. companies like Google and Amazon). Here are the specifics on what Arena has seen and is doing:
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The virus has also created upside opportunities in many of Arena’s investments. Examples include: (i) a ~$10 million position (including 15% equity ownership through warrants) in an addiction recovery clinic where local hospitals are referring them detox patients in order to free-up their beds for other cases; (ii) a ~$16.6 million loan that includes 40% equity participation (at a 55% discount to fair market value at inception) to a company that engages in quality control and testing for semiconductor companies that now has adjacent opportunities to expand into doing similar certifications for the biopharma industry; and (iii) Arena’s joint venture that does the factoring of online receivables from companies like Google and Amazon that are payable to small business owners (which, like most of Arena’s relationships is structured as a “fishing pole” where we advance small amounts and then re-underwrite each incremental add-on) where the current environment is producing even more favorable rates on such advances.
Where Arena Sees Opportunities Moving Forward as the Crisis Unfolds:
- Very liquid short-term securities e.g. SPACS: In the midst of the selling and forced selling by investors and investment funds in the panic, Arena saw opportunities in what they refer to as “short-term dollar bills on the floor,” meaning in securities where a combination of risk/return, duration and liquidity was presenting very compelling short-term opportunities without extinguishing their option to deploy in less liquid situations depending on later changes in the market (mainly in securities being sold as part of hedge fund liquidations and redemptions). For example, – Special purpose acquisition companies (SPACs, or also called “blank check companies”) that raise money to do acquisitions, but have to keep that money in a separate trust invested in Treasuries, and where the holders can take their proceeds back if they ultimately decline to participate in the proposed acquisition. During the sell-off, there were situations where Arena’s was finding SPACs trading at 10-15% annualized returns to the trusts’ holdings. Though the spreads on these types of opportunities have now narrowed, Arena’s ability to move across public and private markets leaves it positioned to bite at these opportunities when they present themselves. If the markets retrace as they have after many other post-crash rebounds, Areana would expect to do more in these situations.
- Sectors that were previously “priced to perfection”: Arena is also seeing emerging opportunities in areas that were previously more on the side of the spectrum of being “priced to perfection” where it can now apply “2020-post-virus-level-pricing”. The areas here that interest Arena the most are those that are inherently independent of the cycle (or virus), but this dynamic is starting to flow into many areas of privately negotiated transactions. These range from corporate loans where banks and BDCs have vanished and commercial mortgages where lender warehouse lines have been withdrawn to structured finance assts where over-aggressive hedge funds have had to recede.
- Areas that have been permanently damaged by COVID-19, e.g. aviation and oil and gas: Then there are areas that actually did experience permanent damage as a result of the virus. An example of the former is in aviation, where the current dynamics present one of the most compelling investment environments since 2001…Even before COVID-19, there was a wave of airline failures as a result of overcapacity and high operating costs, and now COVID-19 has upended the sector with a massive grounding of airplane fleets and the probability that a large percentage of older widebody aircraft types like the A340, 777, A330 are likely to be permanently retired. Airlines and lessors are desperately seeking to raise liquidity from asset sales and sale lease-backs and many are not going to survive despite significant government assistance. Another example of this is in oil and gas credit, where producers (across all levels of market capitalization) are navigating a crisis as capital flees the sector – creating distress (on top of a situation that was already facing material distress when we re-entered the space about 3 years ago). The recent price swings have again incapacitated those that took implicit price bets, the banks continue to stay away, “Fossil Fuels” are only increasingly being red-lined by institutional investors, and there is a “private equity apocalypse” among the firms that bought large amounts of land for development, as many in the industry believed that “unconventional shale” was a once-in-a-lifetime land grab, but an unprecedented increase in the efficiency of fracking has reversed that notion of scarcity. The extreme recent volatility globally and among international suppliers will only increase Arena’s ability to finance and purchase assets inexpensively while hedging away commodity price exposure.
Where Arena is Not Seeing Opportunities:
- Leveraged loans, ABS, and mortgage securities: Arena monitored the landscape during the sell-off, but did not see levels that, to them, were more than 1/3 to 1/2 of the way to the level at which Arena would find them compelling (particularly given the evolution of worsening underlying collateral, longer duration, etc.).