Record M&A activity helps drive merger arbitrage strategies
Blake Hiltabrand, Head of Merger Arbitrage Research and Senior Portfolio Manager
Investors continue to face a number of risks in markets that were not front-and-center during the post-2008 financial crisis recovery. Many are turning to the world of alternatives, and in particular, market neutral and arbitrage strategies, as a source of diversification and alpha in an environment that has become increasingly unpredictable.
Merger Arbitrage is a strategy that seeks to capture the risk premia associated with announced transactions. In a world of increasing risk premia and transaction volumes, this traditional hedge fund strategy has begun to regain the attention of asset allocators across all regions, as they seek absolute returns with low correlation to the broader markets. We believe there are both structural and cyclical forces at play that add to the attractiveness of the space.
Record M&A deal volumes paired with wide spreads
To say the least, 2018 has been a truly unprecedented year for those that invest in merger arbitrage. Merger arbitrage returns are typically a derivation of either a robust deal environment or wide spread levels – though it’s unusual to experience both at the same time. High corporate confidence and low risk premiums typically go hand in hand with greater transaction volumes. So why now, when we look at the global M&A opportunity set, do we see record deal volumes coupled with substantially wider spreads?
If you turn to the front page of any newspaper, you would be hard-pressed not to find mention of significant deal activity in the headlines. Whether it is a rebound in deal activity in Europe after a decade of lacklustre corporate confidence or transactions in the US on the back of recently enacted corporate tax reform – it is obvious to even the most casual observer that the impetus for M&A is growing. As seen below in Exhibit 1, the first half of 2018 has reached record heights in terms of deal volume and size.
So then we turn to the other driver of returns in merger arbitrage: risk premia, or the spread. After a deal is announced, the security of the target company generally trades at a discount to the consideration the acquirer has offered to pay. That discount can vary substantially from situation to situation based on the risks inherent in the completion of the transaction. This is where the hand-off occurs from the traditional owners of the security, who likely were invested based on their views around the sustainability of the business, cash flows, value or potential catalysts such as an acquisition. These investors do not specialize in evaluating legal, regulatory, financing or political risk – and thus most public companies involved in mergers experience a massive redistribution of the shareholder base post announcement. Arbitrage investors look to profit from the over-estimation of risk by those who do not specialize in analyzing these risks consistently across situations, regions and over time. This type of market neutral investing was historically very common amongst bank proprietary trading desks, but with the Volcker Rule, we have seen the amount of capital dedicated to this strategy substantially shrink, creating the environment for wider spreads and a structural opportunity for investors.
The US administration has injected immense uncertainty into that market, particularly with regard to trade policy, resulting in wider spread levels. There have been surprising challenges from the Department of Justice, which have also elevated the perception of risk in the M&A space. Once again, merger arbitrage investors who have the experience in evaluating the various risks involved in these transactions have the potential to reap the benefits.
That brings us to today and where we believe the opportunity is headed in the coming years. It is our belief that uncertainty from political/policy actions emanating out of the current administration is the "new normal". These risks are real, but often significantly over-dramatized by the market, creating a target rich environment for those who specialize in evaluating these situations and risks. That, coupled with the continued "animal spirits" from the corporate board rooms to grow via acquisition, presents us with what we think is a truly attractive M&A landscape for the foreseeable future.