AAIC - Ellington Financial And Arlington Asset Investment To Merge M&A Arbitrage Play

2023-05-31 07:54:21 ET

Summary

• Ellington Financial announced a definitive stock and cash merger agreement with Arlington Asset Investment Corp., offering numerous benefits to both companies.
• The merger is anticipated to be accretive to Ellington Financial's earnings in 2023 and book value within one year of closing, with enhanced long-term growth potential.
• There may still be some arbitrage opportunity in buying Arlington common post-announcement, with the potential for trading gains for those willing to take the risk.

• Ellington Financial on May 30 ^th announced a definitive stock and cash merger agreement with Arlington Asset Investment Corp.
• There are many winners in this mutually accretive combination.
• Market dynamics hint that there may still be some arbitrage opportunity in buying Arlington common, post-announcement.

In a pre-market press release on May 30 ^th , Ellington Financial ( EFC ) announced a stock and cash merger with Arlington Asset Investment Corp. (AAIC). Based on last Friday’s closing prices, if the merger is completed today, the terms provide AAIC common shareholders with a price premium north of 70%. The passage of time and payment of EFC’s dividends can alter that premium and in this article we will break out the moving parts.

Ellington Financial

In announcing the merger, Ellington management described their motivations in proposing the combination.

We are extremely excited about the opportunity to add a significant portfolio of assets – particularly low-coupon mortgage servicing rights – that align very well with our expertise and existing management platform,” stated Laurence Penn, Ellington Financial’s Chief Executive Officer. “We believe that the benefits of this acquisition include greater operating efficiencies, a larger market capitalization, and attractive long-term unsecured debt and preferred equity capital. Upon closing, we believe that we will be positioned well to drive accretive earnings growth and provide strategic and financial benefits to our stockholders.

Itemized, the potential benefits to both companies are numerous:

* Capital to Fund Growth Going Forward: Increased scale and liquidity to further capitalize on opportunistic investment environment.

*Strategically Compelling: Arlington’s investment portfolio aligns well with Ellington Financial’s portfolio, and its relatively low leverage should provide meaningful opportunity to enhance returns by deploying additional capital in EFC’s targeted assets classes.

*Accretive to Earnings and Long-Term Growth: Anticipated to be accretive to Ellington Financial’s earnings in 2023 and accretive to Ellington Financial’s book value within one year of closing, with enhanced long-term growth potential.

*Increases in Operational Efficiency: Anticipated increase in operating expense efficiencies as a result of fixed expenses spread over a larger equity base.

*Desirable Target Capital Structure: Arlington’s capital structure includes unsecured debt and preferred equity with attractive costs of capital.

*Increased Market Capitalization and Liquidity: Estimated pro forma market capitalization of approximately $1 billion (based on the closing price of EFC common stock on May 26, 2023) expected to enhance liquidity of EFC common stock and provide more efficient access to capital markets.

Arlington Asset Investment Corporation

In the press release, Arlington management described the benefits the merger brings to AAIC stakeholders.

We are thrilled to combine AAIC with the Ellington Financial team to make a combined company that we believe will be positioned to take advantage of opportunities into the future,” said J. Rock Tonkel, Jr., Arlington’s Chief Executive Officer. “This transaction combines two complementary portfolios, and we look forward to working closely with the Ellington Financial team to complete the acquisition and deliver value for our stockholders.

The “deliver value to our stockholders” statement has sort of been Rock Tonkel’s mantra since the start of the pandemic. During that time AAIC’s portfolio has been profitably recycled more than once, rapidly building book value per share. In lieu of reinstating a dividend, the company further enhanced book value through aggressive repurchase of discounted shares.

To the casual observer, it looked like AAIC was up for sale.

Potential Arbitrage

Under the terms of the proposed merger, each AAIC common share will be converted into 0.3619 shares of EFC. Additionally, each AAIC common share will receive $0.09 in cash. Portfolio Income Solutions Arbitrage Tracker maps out the arbitrage spread on a continuous basis as follows:

Arbitrage tracker: Outstanding arbitrage spreads

*Priced as of market close 05/30/2023

If you consider buying AAIC common today as an avenue to owning EFC through the merger, the nominal discount is a whopping 12%. However, since the merger is expected to close in the 4 ^th quarter, your AAIC position does not attach any dividends EFC shares pay in the interim until the merger’s close.

While both companies are structured as m-REITs, EFC pays a $0.15/share monthly dividend while AAIC common suspended dividend payments at the start of the COVID pandemic in March 2020. Foregoing those dividends could be seen as reducing the arbitrage spread to 4.7%.

In light of this difference, the timing of the merger’s completion is a material consideration and that is why Portfolio Income Solutions tracks the spread continuously.

Other Minor Players

Under the terms of the proposed merger, Ellington Financial will assume Arlington’s outstanding preferred equity, not redeem it.

Possibly due to its obscurity, the nano-cap Arlington Asset Investment 7.0% Series B preferred (AAIC.PB) shares jumped to close at $19.60 (+13.6% on the merger announcement). Investors, previously oblivious to AAIC.PB’s existence, must have liked the huge discount to par.

The still small, but larger Arlington Asset Investment 8.25%, Fixed-to-Floating Series C (AAIC.PC) got a more tepid response, rising just +0.63% to close at $22.53. We first noticed AAIC.PC when we were scouting for fixed-to-floating preferreds at the start of the Fed’s rate hiking cycle last year. Today’s price translates to a current yield of 9.21%, but at today’s LIBOR equates to a yield of 12.44% on conversion to floating rate in March 2024.

In the press release, EFC described AAIC’s preferreds as having an “attractive cost of capital”. If EFC has access to cheaper sources of capital when AAIC.PC converts to floating rate, EFC may elect to redeem the callable shares. On redemption at par, AAIC.PC shareholders would net an 11% premium to today’s price.

In Summary

In the merger of these two small m-REITs there are many winners. AAIC common shareholders are being offered a huge premium to last week’s market price. EFC gets to buy an attractive portfolio at 75% of book value. AAIC preferred shareholders enjoy the support of a larger capital base in the equity stack. And, if they have the courage to play, arbitrageurs can clip some trading gains.

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