Merger arbitrage hedge funds bank on M&A resurgence

The resurgence in M&A volumes should be good news for merger arbitrage hedge funds. Though deal spreads remain tight, the growth in transactions in Q1 is fuelling expectations of higher returns.

A notable up-tick in corporate deal-making in the first quarter is fuelling expectations of better returns for merger arbitrage funds over the coming months.

Global mergers and acquisition (M&A) volume hit $809 billion in the first three months of 2011, up 28% from $634 billion a year ago, according to data from Dealogic.

US deal volume grew an astonishing 62% to $329 billion from $204 billion in the first quarter of 2010, while M&A activity in Asia-Pacific (excluding Japan) and Europe was up 31% and 22% respectively.

The surge in deal activity is an encouraging sign for merger arbitrage funds which struggled to meet return expectations in 2010 amid slower than expected M&A volumes and tightening deal spreads.

Merger arbitrage funds generate returns by capturing the spread between a target company’s share price once an M&A deal is announced and the price offered by the acquirer.

The arbitrage spread technically reflects the risk of a deal falling apart following the initial announcement and narrows as the transaction moves closer to completion.

But in practice arbitrage spreads are largely a function of supply and demand within the strategy.

“The ideal environment for merger arbitrage is when there is a mismatch between supply and demand, essentially a scarcity of capital in the strategy and plenty of deals,” says Lan Cai, a managing director at PineBridge Investments and head portfolio manager of its merger arbitrage strategy.

Merger arbitrage funds struggled in 2010 because capital flows into the strategy grew at a faster rate than deal activity, causing spreads to tighten, she says.

The average merger arbitrage fund returned around 6% for the year, according to data from BarclayHedge.

The environment for the strategy was better in 2009 despite a huge drop in deal activity because the impairment to capital in the aftermath of the financial crisis was so severe that supply still outstripped demand. Deal spreads widened dramatically and merger arbitrage funds finished 2009 with returns of around 12% on average.

Arbitrage spreads have remained tight through the first quarter of 2011 despite the increase in deal activity. The highest quality deals – those considered to have the best chance of completion – are currently trading at annualised spreads of around 4%.

Transactions with the same risk profile were yielding 6%-7% this time last year.

Fund managers expect arbitrage spreads to improve through 2011 as M&A activity heats up. “If we have more deals, that will certainly help arbitrage spreads to widen. It looks like we are at the beginning of an upturn in the M&A cycle which is positive for merger arbitrage,” Cai says.

Expectation is that deal volume will grow 10%-15% this year and pick up steam from there before peaking in 2014 or 2015.

The rise in deal volume in recent months has already provided a boost for some managers. “We were fully invested for the first time in three years in the first quarter,” says Christopher Pultz, a principal at Kellner DiLeo & Company (KDC) and the portfolio manager of its merger arbitrage strategy.

The bulk of deals announced in the first quarter involved mid-size companies with market capitalisations in the $250 million to $2 billion range. “We’re living on the middle market deals at the moment,” says Pultz. He expects to see more blockbuster deal announcements later this year and is also watching for increased M&A activity in Europe.

“The European funds probably have more exposure to US deals than they typically would do and that’s squeezing spreads here. Once deal volume picks up in Europe, this capital should repatriate and ease spreads in the US a little,” says Pultz.

Some believe the chances of a near-term resurgence in European deal volume are slim. “The macro environment is scary for European CEOs,” says Lionel Melka, a partner and head of research at Bernheim, Dreyfus & Co, a specialist asset manager which invests in announced and expected M&A deals.

M&A is a confidence game and the deep recessions in Portugal, Ireland and Greece coupled with the political turmoil in the Middle East and North Africa have made European boards apprehensive. Melka says spreads are more likely to widen if the macro uncertainty is reflected in stock market volatility.

“Volatility is the main driver of arbitrage spreads,” says Melka. “We are effectively in the business of writing insurance against failed merger attempts and insurance is always more expensive when the perception of risk is higher.”

Bernheim, Dreyfus differs from competitors as it also takes positions on companies that it believes will become takeover targets in a separate portfolio which is managed alongside its merger arbitrage book. The pre-event portfolio is hedged with futures contracts in order to be market neutral.

The pre-event and arbitrage portfolios are negatively correlated, says Amit Shabi, a partner at Bernheim, Dreyfus. “The arbitrage portfolio performs well in high-volatility markets like 2008 but when stock prices are steadily rising, we tend to make our returns on the pre-event trades,” he says.

The pre-event portfolio underperformed in the first quarter but Shabi believes it could be a strong contributor to overall returns in 2011 if volatility stays low and arbitrage spreads fail to widen.

There is some debate over whether arbitrage spreads can ever return to the levels seen in the 1990s and early 2000s.

Gaurav Jetley and Xinyu Ji of the Analysis Group, a consulting company, examined the decline of merger arbitrage spreads over the period from 1990 to 2007. The study, entitled ‘The shrinking merger arbitrage spread: reasons and implications’, was published in the March/April issue of the Financial Analysts Journal.

They found the median day one arbitrage spread for successful deals involving US companies fell from 6.39% in 1990-1995 to 4.62% in 1996-2001 and only 1.91% in the five years to the end of 2007.

The tighter spreads impacted the alpha generated by merger arbitrage funds which declined by 4.81% on an annualised basis in 2002-2007 relative to earlier periods, according to Jetley and Ji.

Jetley argues the decline in arbitrage spreads is a secular trend that he attributes to a number of factors, including changing deal characteristics, lower transaction costs and the growth in capital dedicated to merger arbitrage.

“Merger arbitrage is still a profitable strategy but it is just not as profitable as it used to be. Investors have to adjust their return expectations,” he says.

Fund managers have a few bones to pick with the study.

Cai says the findings may have been less dramatic if the data from 2009 had been included.

Jetley acknowledges deal spreads were wider in 2009 but says this was an anomaly and does not detract from the long-term trend. “Spreads widened in 2009 in response to a specific market event. They have since come down to pre-2008 levels and I don’t see them widening any time soon,” he says.

KDC’s Pultz says looking at arbitrage spreads on an absolute basis is misleading. “Most merger arbitrage funds aim to deliver a return to investors that is a multiple of the risk-free rate. You have to take the interest rate environment into account when assessing arbitrage spreads,” he says.

Relative to the risk-free rate, arbitrage spreads are currently more attractive than they have been through much of the past decade, says Pultz. “When interest rates were at comparable levels in the early 2000s arbitrage spreads were in the 2%-3% range. Now they are 5%-7% on average,” he says.

The strategy has been comparatively more attractive over the past 12 months than it was pre-crisis despite spreads being tighter on an absolute basis because the risk-free rate has fallen at a faster rate than the merger arbitrage spread, he adds.

Jetley counters that while interest rates have fluctuated over the past decade, arbitrage spreads and fund manager alphas have declined steadily. “We did not find any correlation to interest rates,” he says.

There is little doubt changes in the marketplace over the past decade have had some impact on how arbitrage spreads behave. Transaction costs have fallen, deal mechanics have evolved, information is more readily available and traders are armed with more sophisticated tools.

All this means arbitrageurs have to move more quickly to capture spreads. “Once a deal is announced, you need to do the research and be ready take a position in a matter of hours. If you delay the spreads will tighten and you lose a large portion of the potential return,” Cai says.

She believes this “day one phenomenon” partly explains the decline in arbitrage spreads recorded by Jetley and Ji. It is still possible to find attractive spreads, she says, but they tend to be more fleeting.

The arbitrage spread continues to evolve in response to structural changes in the market. Regulations requiring banks to close down proprietary trading desks mean trades are less crowded, though this comes at the price of less liquidity. At the same time capital is entering the strategy through new avenues.

The past 12 months have seen the emergence of passive index-based merger arbitrage products. These aim to capture at least part of the arbitrage spread at a lower cost to investors and with more liquidity than actively managed funds.

The Credit Suisse Merger Arbitrage Liquid Index ETN began trading in October 2010 and a leveraged version of the product was launched in March this year. Credit Suisse has raised around $100 million for the ETNs over the past six months.

Merger arbitrage managers say they are not overly concerned about index products eating into their spreads.

Nor should they be, says Michael Clark, head of the structured equity derivatives at Credit Suisse. “We see the merger arbitrage ETNs [exchange traded notes] as niche products. They are not designed to replace the large discretionary funds in the marketplace,” he says.

Credit Suisse is primarily offering the ETN as an option for retail and private wealth clients that want exposure to an alternative source of returns. They are also being used by some institutional investors as a tool to manage their exposure to the strategy while they search for an active manager.

The passive merger arbitrage products are currently too small to have a meaningful impact on spreads. If they become meaningful players in the marketplace, index funds could cause spreads to tighten further.

They may also create new trading opportunities for active managers. Because the indexes are programmed to purchase shares in acquisition targets at a certain point in time after the deal is announced, they could cause spreads to tighten irrespective of the completion risk.

“If you know how much demand is out there, who the players are and what their approach is, you can trade around that to maximise returns,” says Cai.

There is plenty of room for skilled managers to generate excess returns even if average spreads remain tight. The best managers distinguish themselves by avoiding “busted deals” and capitalising on transactions that offer ­outsize returns.

“Merger arbitrage funds really make money by trading around competitive bids and hostile takeovers. We have not seen a lot of those yet but there is still a long way to go in this M&A cycle,” says Jetley.