Arrow Global (ARW.L) – Merger Arbitrage – 14% Upside

Current Price: £2.68

Offer Price: £3.05

Upside: 14%

Expected Closing Date: TBD (potentially 8th of March)

European distressed debt purchaser Arrow Global has received strong takeover interest from PE firm TDR Capital. The buyer had apparently already made a number of consecutive indicative proposals – the first 3 offers were not disclosed and got quickly rejected as undervaluing the company:

• 2nd Dec’20 – TDR Capital made a first possible all-cash offer for Arrow at £2.50/share. The pre-announcement price was £1.80/share;
• 8th Dec – TDR presented a second offer at £2.65 (6% increase);
• 26th Jan’21 – the buyer increased the proposal one more time to £2.90/share (9.4% increase);
• 5th Feb – TDR announced (publicly) a fourth preliminary conditional offer at £3.05/share (5% increase). This time Zachary Lewy, founder, and Group Chief Investment Officer entered into a support agreement. Mr. Lewy holds 2.1% of the shares. ARW shares jumped to £2.98 upon release of the offer.
• 8th Feb – Arrow announced that the board is now considering the offer.

No further updates have been made by either party so far, however, the PUSU (put up or shut up) date for a firm offer stands at the 8th of March.

There are a number of aspects indicating a high likelihood of successful closure:

• Support from the founder – who is also Chief Investment Officer – is important, although he holds only a minor 2% stake in the business. Mr. Lewy is the key man behind all of the investment decisions of the company and has a superior view of the changing market environment and ARW’s future prospects. The fact that he approves the offer signals both the higher chances of eventual board approval as well as shareholder’s support.
• Despite rejecting the previous offers rather quickly (2-8 days), the board has been silent for almost a month now. I think negotiations are clearly ongoing and there is also some chance of another bump in the price.
• The buyer seems credible (Europe-focused PE firm with 8bn EUR AUM) and knowledgeable. Given the number of attempts made, it is clear that their intentions are real. TDR runs a very concentrated portfolio (14 active investments at the moment) and has some experience with businesses investing in non-performing consumer debt portfolios (see Lowell Group investment case study).
• The timing is opportunistic. Due to the impact of COVID-19, a significant increase in the NPL supply is expected this year, especially in Europe. The distressed debt purchasers are getting ready to jump on the new opportunities as soon as consumers are deprived of the government support programs and banks are forced to sell the NPL portfolios. ARW has commented on this opportunity both for their debt purchase business and payment servicing business as well (see the quote below). The servicing business (AMS) has already started to experience the positive impact of this situation with the record-breaking 16 third-party contracts signed in Q3’20 (more details on this are provided in the section below).

As we exit the crisis, European banks will be under significant pressure to provision for non-performing loans. With €1.1 billion of discretionary undeployed fund management capital, we are extremely well placed to be a leading investor in this huge market with increasingly attractive returns. […] Given the anticipated increase in non-performing assets due to the COVID-19 economic impact, we expect to see an increased demand for our servicing capabilities. […] IRRs have already increased to highest level since aftermath of GFC.

• Moreover, ARW has recently pivoted its business model adding an asset management segment. The company has been very successful with the capital raises so far. In H1 FUM (funds under management) stood at £2.6bn, while at the end of Q3 FUM reached £4.3bn. This compares to management target of £2bn for the end of 2020 set at the beginning of the year and vs £1bn of the company’s own debt portfolio size. This clearly marks a positive investor sentiment towards the industry. Moreover, the new capital-light business model will allow the company to slowly reduce leverage from Debt/EBITDA of 4x in Q3’20 to 3.0-3.5x by 2023 and at the same time scale margins and improve profitability. The company now expects to generate 25%+ through-the-cycle ROE during the next 4 years vs 16%-18% over the last few years.
• The offer comes at 5.2x BV, which is a significantly higher multiple compared to the previous trading levels of the company (2.4x in 2019 and 1.8x in 2018). However, the premium has been visually impacted by ARW write-offs during H1’20. The company wrote-off 13% (£134m) of the portfolio, which cut the BV nearly in half due to high leverage. However, it seems that those write-offs were mostly accounting-based and overall too conservative – the actual impact of the COVID-19 on the business is lower than might have seemed at the time of the write-offs. The impairment made based on a scenario between the ‘base case’ and the ‘downside case’ (see graph below) with the ‘base case’ scenario presenting a further £43m upside to BV at the time (potentially fr high currently). The idea is also illustrated with the Q4 collections apparently being at 111% above the H2 forecasts (January update). Thus, the actual acquisition price is not as high as it might seem at a quick glance, especially when considering high forward ROE forecasts.

Arrow Global

ARW is a European investor and asset manager, which buys defaulted customer portfolios from retail banks and credit card companies. It operates in five geographical markets: UK, Italy, Portugal, NL, and Ireland.

The segments are:

• Balance Sheet – generates revenues from own capital investments in NPL portfolios.
• Asset Management & Servicing – asset management and collections payment servicing to ARW balance sheet business assets (internal revenue), ARW funds (external revenue), and other third-party clients.
• Fund and Investment Management – management and performance fees from Group’s managed funds and internal revenues from portfolio management to the Balance Sheet business.

The business was negatively impacted by COVID outbreak with deterioration in debt payment collections (partly due to court and real estate market closures), new investments, and overall profitability. However, in Q3’20 the company returned to profitability, while the general outlook for 2021 seems positive:

H1 2020:

• Made significant non-cash impairments to debt portfolios (13% or £134m);
• Cash collections fell 13%;
• Losses of £0.62/share vs £0.13/share income in the same period the year before;
• FCF fell 28% YoY to £82.5m.

Q3:

• No further impairments were made;
• EPS bounced back to positive – £0.05/share vs £0.04/share the year before.
• FCF fell 30% YoY.

January update:

• The company has noted that it has seen a strong recovery in collections during with Q4 figures running at 111% of H2 expected remaining collections forecasts.
• NPL market opportunities are continuing to increase:

Our investment pipeline moving into 2021 is very promising and early indications are that available returns are continuing to increase.

Shareholders: