Watermark Market Neutral Trust A (WMF0001AU) Report & Performance

The event-driven strategy aims to exploit pricing inefficiencies around corporate activity, in particular M&A events. The Fund’s net performance came in at -3.2% for the month of June. The overall performance was achieved again in a tumultuous market environment: concerns on rising inflationary pressures, bigger then expected interest rates rises, as well as recessionary outlook scenarios in developed markets just to name a few.

The Australian share market (AS51 Index), posted a brutal loss of -8.92% for the month of June, and with the Fund’s historical Beta yardstick of 0.31, the expected loss of the Fund came as no major surprise. Pleasingly, over a 12-month perspective, the Fund delivered a positive return of +9.6% for FY22 compared to a loss of -10.2% for the ASX 200 share market. This is a whopping +19.8% relative outperformance for FY22 as the defensive character of the strategy came to fruition.

The Fund’s key risk metrics show a strong Sharpe Ratio of 2.5, an average since inception net daily Alpha of 6.1 basis points, and monthly win/loss ratio of 66% underlining the consistency of delivering positive performance and as a result the asymmetric return profile. Our directional Alpha exposures, mostly investments in thematic themes such as electrification, nickel, uranium, battery and lithium, have experienced wide negative fluctuations causing the majority of the Fund’s losses. Even though we feel that the long-term investment thesis still holds, we have taken pro-active steps to lower the directional Alpha book from 20% down to 13.4% in response to taking into consideration the probability of recession severely impacting our long-term thesis. Overall Fund gross exposure ended at 286% as we increased the Event (M&A Risk Arb) bucket to 131% from 104%. Our models identified opportunities in proposed companies’ asset sales and subsequent distribution of capital to shareholders, for a significant portion of their remaining equity value. Examples included Prospect Resources (PSC AU) and Ardent Leisure Group (ALG AU). Those capital return trades offer great optionality for a positive re-rate post distribution of the sales proceeds.

We had very positive experience in the past with Cardno Limited (CDD AU) and we believe PSC and ALG will deliver positive outcomes. In PSC, we have built a very large position in the Fund at an average cost of 94c. PSC announced the sale of the Prospect group’s 87% interest in the Arcadia Lithium Project to a subsidiary of the new energy lithium-ion battery material producer, Zhejiang Huayou Cobalt, with an expected cash distribution of A$440m to A$450m equating to approximately 94c – 96c cash distribution. On 17th June PSC announced a capital reduction of 19c and a special dividend of 77c for a total 96c distribution. Note only were we able to build this position at zero equity value, but also benefiting from the higher expected range. Further optionality lies ahead once PSC trades Ex Cash Entitlement, as PSC will remain listed as a going concern, intending to retain a cash balance of A$30-40m equating for a 6.4c per share. As for ALG, we expect a significant re-rate post distribution of the sale of “Main Event” and the remaining stub-business in Dreamworld (and other attractions) is expected to be earning positive cash flows. Another catalyst might be a merger between Village Roadshow and ALG. The biggest return detractor in the M&A book was Humm Group (HUM AU) impacting the overall performance of -65basis points. On June 17th Latitude (LFS AU) and HUM mutually terminated the sale agreement for “humm consumer finance”, in light of the current major disruption in financial markets. It came as a surprise as the Material adverse change (MAC Clause) was specifically excluded from the deal conditions.

In the Volatility sub-strategy, we have successfully unwound our net short position in VIX Futures. We aim to re-establish a long volatility exposure once spot volatility trades in the mid 20s. The Fund continues to find and implement very attractive risk/return opportunities, and with an asymmetric return philosophy in mind is very much resilient towards broader market gyrations.

The event-driven strategy aims to exploit pricing inefficiencies around corporate activity, in particular M&A events. We are pleased to report a positive net performance of 2.9% for the month of March achieved in a tumultuous market environment, as geopolitical risks intensified by Russia’s invasion of Ukraine and volatility ripped through the Asia Pacific markets, particularly in Hong Kong HSCEI index.

MSCI Asia Pacific fell -1.0%, whilst at home the Australian share market (ASX) posted a strong +6.4% gain, mainly the result of a sharp increases in the commodity, and deep value banking sectors. Despite the sharp recovery the maximum drawdown of -10.4% has still not been fully recovered since mid-August 2021, finishing the month at -1.7%. Interesting to note is the asymmetric nature of the Funds resilience towards downside risk evidenced in the month of January but capturing 62% of the upside as markets recovered in Australia posting a net gain of +2.6% for the quarter. The Fund’s key risk metrics show a strong Sharpe Ratio of 3.6, an average since inception gross daily Alpha of 11.2 basis points, and a win/loss ratio of 66% undermining the consistency of delivering positive outcomes when it really matters.

Overall Fund gross exposure ended at 183%, with Events (M&A Risk Arb) bucket down to 66% from 69%. The individual gross exposure reduction in the M&A bucket, continued to be the result of certain M&A deals completing successfully. In Australia, completed deals included Australian Pharma Industries (API AU) acquired by Wesfarmers (WES AU), and the scrip deal between Over the Wire (OTW AU) with Aussie Broadband (ABB AU). The winning trade was the completed acquisition of Senex (SXY AU) acquired by a consortium led by Posco International (047050 KS) following a deal bump from A$4.40 to A$4.60 including dividends. The realized IRR in this trade was >20%p.a. Our existing position in Irongate Group (IAP AU) posted the strongest contribution within the M&A bucket gaining 8.5% in March. To recap: In October 2021 360 Capital Reit (TOT AU) made a cash offer at A$1.65, which seemed at that time fair representing a 1.15x multiple to NAV which is in line to other precedents. However, IAP reported strong uplift in NAV of A$1.61 vs 360 Capital’s proposed offer and consequently rejected the Non-binding-indicative-offer (NBIO). 360 Capital responded with an uplift in consideration to A$1.72. Fast forward to 31st January, IAP announced that it has received a NBIO proposal from Charter Hall and PGGM consortium to acquire all shares at A$1.90 plus dividends. Given that NTA premium in real estate takeovers is typically less than 10%, the proposed offer price at more than 20% premium to NTA will no doubt look attractive to the IAP board. On 30th March IAP entered a binding scheme of arrangement at A$1.9467 thereby sharply increasing the probability of the scheme completing successfully as, together with the agreement for 360 Capital to acquire certain assets post deal, lessens any shareholder vote risk

The event-driven strategy aims to exploit pricing inefficiencies around corporate activity, in particular M&A events. The Fund manager’s estimated net return for September is +3.00%, where the majority of the performance stems from a strategic positioning in a pre-event name in Japan. This positive result is particularly pleasing as the Fund achieved its best quarterly performance of +6.7% during a weak market environment for the Australian market falling -2.7% in September. The Australian market also experienced its biggest drawdown return of -5.7% for the year finishing the month at -4.5%. Our investment results continue to show a low correlation to peers and markets, with positive daily Alpha contribution averaging +13 basis points.

Overall gross exposure was 199%, with Events (Risk Arb) bucket down to 90% from 124%. We have increased the Relative Value bucket to 88% at the expense of two large Japanese scrip-mergers completing successfully. We see a continuation of elevated M&A deal activity which enables the Fund to find new opportunities to replenish the M&A book in an extremely healthy M&A event landscape. The biggest return contributor was our position in Shinsei Bank (8303 JP; Shinsei) rallying 48%. To recap: back in December/January our monitors have picked up a significant stake building activity in Shinsei by SBI Holding (8473 JP; SBI). It was further disclosed that Taiwan’s biggest bank CTBC Financial (2891 TT) showed interest in acquiring Shinsei. However, those takeover rumors were later dismissed. Shinsei also had a significant equity stake in Jih Sun Financial (5820 TT) which was subject to a takeover offer by Fubon Financial (2881 TT) offering TW$13 in December 2020. We accumulated a sizeable, long position in Shinsei ahead of a potential large share buyback (SBB) announcement event as the consideration for the stake sale would be approximately 19% of Shinsei’s market capitalization. In the SBI Financial Results announcement on 29th January, SBI outlined their plan for the “Evolution of Regional Banking in Japan” and reported to have plans to create “Japanese 4th Mega Bank” through its co-creation with other regional banks. SBI’s regional partners are Yamaguchi Financial, Concordia Financial and Shinsei. We viewed Shinsei’s completion of the stake sale in Jih Sun, a subsequent potential large SBB, and the likelihood of SBI to make its move to further increase its stake or even to privatize a cashedup Shinsei, are the next key catalysts for a strong re-rating. On 9th September, SBI announced an unsolicited hostile partial offer to acquire Shinsei at JPY 2,000 per share increasing its equity stake from current 20.3% to 48% via a tender offer process. Shinsei was trading limit-up for the next two trading days post announcement, and the Fund exited the position at JPY 2,030 well above the theoretical pro-rated price of JPY 1,750. In Australia, the first bid being tabled is not necessarily the last one, as history shows that there is a 40% chance of an increase in consideration. This is exactly what happened to our position in Australian Pharmaceutical Industry (API AU). The bidder Wesfarmers Ltd (WES AU) has revised its indicative proposal from A$1.38 to A$1.55 allowing WES to undertake exclusive due diligence on API. On 27th September API has received a competing non-binding indicative scrip/cash offer from Sigma Healthcare (SIG AU) valuing API at A$1.59. We view API to be trading above the WES cash terms given the potential bump in SIG scrip optionality and await further announcement

The event-driven strategy aims to exploit pricing inefficiencies around corporate activity, in particular M&A events. The bulk of this month’s negative return of -0.57% can be attributed to single M&A transaction that failed, as a result of the bidder walking away from a non-binding transaction. The previous strong returns however due to a multitude of counterbids by rival bidders, increase in offer considerations as well as locking-in positive M&A deal spreads, as a result of successful completed M&A transactions. Fortunately for the strategy, there is a deep pipeline of deals on the horizon and counterbids are more of a norm than a rarity. History shows that in Australia, there is a 40% probability of an increase in the offer considerations across all live M&A deal transactions and in terms of deal-break risk, one in five unfortunately fails. The key in a failing M&A deal transaction is to have strong risk management approach to minimize the overall impact to the Fund, as well as strategies in place to manage non-systematic tail-end risk. The position in question is McPherson (MCP AU). Even though MCP hostile low ball on-market takeover offer from Gallin at A$1.34 lapsed, MCP has received a non-binding competing offer from Arrotex at A$1.60.

We factored in a 65% probability of a deal completion as due diligence was granted. However, after providing Arrotex with the agreed four-week due diligence period, the Board announced that the parties have agreed to cease discussions and Arrotex has withdrawn its indicative proposal. We exited the position as MCP traded well below the floor price of A$1.34 realizing an overall loss of – 42bp.

The event-driven strategy aims to exploit pricing inefficiencies around corporate activity, in particular M&A events. Even though the final reported March performance was +0.52%, the Fund would have printed a much higher overall performance due to three big scrip M&A deals in Japan becoming effective on 1st April.

In the first two weeks of April, the Fund’s return is already +2% as a result of the crystallization of those Japanese M&A deals being recognised by the Fund’s accountant. The event landscape continues to remain healthy, with overall gross exposure increasing to 224% compared to 203% from the previous month. The biggest return contributor was our position in WPP AUNZ Limited (WPP AU). To recap, WPP PLC through Cavendish has agreed to acquire the remaining 38.5% of WPP AU that is does not currently own at $0.70 AUD per share by way of scheme of arrangement. The optionality in this trade was particularly evident when WPP AU declared an increase of the fully franked dividend and special dividends of up to $0.20 AUD per share. The Fund took an aggressive long position below $0.69 AUD and whilst WPP traded cum franking credit entitlement above $0.73 AUD, the Fund realized a 6% gain on the long position

The event-driven sub-strategy aims to exploit pricing inefficiencies around corporate activity, in particular hard catalyst events such as M&A and restructuring/spin-offs events. The current M&A deal activity is particularly strong in Australia and Japan, and even in less liquid markets (Thailand and Malaysia) has seen the M&A landscape favouring target companies. History has shown that the 4th quarter is typically associated with little deal activity particularly leading into year-end. However, during November and at the time of writing, we were experiencing, nearly every day, a new deal that came to the market, which offered a unique situation to capture the expected deal spread. During the course of the month, the Event bucket constituted 48.9% of overall gross exposure and contributed -25bp to overall gross performance, as we were building new positions.

We believe the event-driven strategy is well positioned in this environment, and the current M&A tailwind is giving us comfort for a continued elevated M&A deal activity in 2021 to lock-in attractive deal spreads.

There was no contribution from Market Neutral and Trend alpha families to the monthly returns in November as we have made a decision to go slow as market liquidity contracts and election fallout continues to dominate media.