Merger arbitrage experiences resurgence

There is growing investor appetite for merger arbitrage in the context of rising M&A activity but also a structural decrease in deal spreads

After several years of underwhelming corporate activity, mergers and acquisitions (M&A) is predicted for a comeback in 2014, with new deals evidencing a resurgence in arbitrage opportunities as the year looks set to be a strong one for takeovers.

Arbitrageurs buy shares of the firm being acquired and short the shares of the acquirer. But a downturn in deals saw many hedge funds exit the strategy, and also witnessed large outflows from other merger arbitrage products. According to financial data company Markit, while assets managed by merger arbitrage exchange-traded products are still relatively low, at around $100 million, their returns can be used to gauge the efficacy of the strategy; outflows meant assets under management fell by nearly 40% from their peak at the end of 2011.

However, the cycle appears to be reversing. Globally, M&A deals announced in Q1 were up 54% on the same period last year, according to Thomson Reuters. That momentum continued in April, with global year-to-date deals announced topping $1.1 trillion.

In a persistently flat interest rate environment, and following rising confidence on improved recovery prospects and fading concerns over a eurozone break-up, cash being held on corporate balance sheets could represent reasons to herald an increase in M&A activity – at least from a buyer’s perspective, since relatively low corporate valuations may deter sellers.

So far, M&A activity is up especially strongly in the US, in particular in the communications and consumer non-cyclicals area where notable deals include the $68 billion offer for Time Warner Cable by Comcast, which would combine the largest and second-largest US cable companies. The US healthcare sector during Q1 had more than $56 billion in M&A deals alone, over 80% higher than Q1 2013, according to data provider S&P Capital IQ.

In Europe the cycle is also taking off, with large deals announced at the end of April in the pharmaceutical, materials, telecoms, media and technology sectors. Pfizer’s $106 billion bid for AstraZeneca is the latest mega-merger to be proposed.

However, while M&A opportunities are relatively plentiful, managers have been adapting to a structural decrease in deal spreads. Markit reports that the spread between Comcast’s offer and the current price of Time Warner is the same as on the day of the announcement.

Lyxor Asset Management agrees on spreads. In the merger arbitrage space it estimates the declining spread compression, taking place in the context of falling interest rates globally, to be in excess of 500 basis points over the last 10 years.

In a paper, The Shrinking Merger Arbitrage Spread: Reasons and Implications, Gaurav Jetley and Xinyu Ji say this decade-long trend corresponds to the decline in aggregate returns of merger arbitrage hedge funds, as well as increased inflows into funds employing the strategy. Part of the decline in the arbitrage spread may be explained by reduced transaction costs and changes in risk related to merger arbitrage. In addition, inflows into funds that invest in M&A deals have increased trading and narrowed spreads, while lower bid premiums and less hostile deals have exacerbated the compression effect.

But despite this, according to Lyxor, resultant performance has been in line with expectations and managers have maintained alpha generation intact. Lyxor says that event driven is by far the strategy that has received the largest inflows on its managed account platform over the last six months, with assets under management rising by 16%. Hedge Fund Research, meanwhile, says event driven has posted average returns close to 3% year-to-date, marking itself out as the best-performing strategy in Q1.

The way M&A is played has changed in order to achieve this. Lyxor says that due to the low yields offered by plain vanilla transactions, merger arbitrage managers on its platform are focusing instead on other areas where returns can be much higher.

Plain vanilla deals currently offer annualised returns in the 3–4% range. As a result, says Lyxor, risk arbitrageurs have had to climb up the scale of complexity to deliver returns, focusing their investment universe on deal structures where returns can be much higher, in the 5–10% range. This includes topping bids, hostile deals and transactions taking place in multiple jurisdictions or exposed to antitrust risk.

In particular, managers on the platform are emphasising investments in complex deal structures (Vodafone), competitive bids (Sprint/Softbank/Dish), hostile takeovers (Osisko/Goldcorp), accretive acquirers (Thermo Fisher, Actavis) and pre-announced deals (Life Technology/Thermo Fisher).