By Joseph Marren
Things are looking up for arbitrageurs as a host of positive
factors are clearly evident in the M&A marketplace.
Corporate balance sheets are flush with cash, private equity
firms have raised significant funds that need to be put to
work, credit is readily available for deals that make sense,
interest rates remain low and valuations are reasonable.
Furthermore, the political environment is more certain in 2013
than it was in the 2012 election year. Most importantly, the
economy is growing at a slow but steady rate. These economic
conditions have spurred many CEOs to seek to acquire growth as
strong organic growth is very difficult to achieve.
There have been a number of headline grabbing deals
announced early in 2013 including the proposed
leveraged buyout of Dell for $25 billion by
Michael Dell and Silver Lake, Virgin Media agreeing to be
acquired by Liberty Global for $24 billion and HJ Heinz
agreeing to be acquired by Berkshire Hathaway in conjunction
with private equity firm 3G Capital for $28 billion. However,
for most arbitrageurs, returns are generated by investing in a
reasonable number of more modestly sized transactions.
Globally, while the number of deals declined by 11.1% in the
first half of 2013 to 5,854, according to Mergermarket, the
outlook is promising.
The most critical factor impacting M&A volume is CEO
confidence. Surveys indicate that most market participants
expect the volume of transactions in 2013 to exceed the level
of activity in 2012. In addition, the Federal Reserve announced
on July 31 that economic activity expanded at a modest pace
during the first half of 2013 and that labor markets have
improved but the unemployment rate remains elevated. It
reaffirmed its view that a highly accommodative stance of
monetary policy will remain appropriate for a considerable time
after the asset purchase program ends and the economic recovery
strengthens. This approach will likely bolster CEO
Other important factors affecting M&A volume are the
sheer size and activity level of the private equity industry.
The Financial Times reported in 2012 that the value of assets
managed by the private equity industry exceeded $3 trillion. By
definition, private equity firms are not long-term investors
and are always contemplating exiting their investments.
Generally, they look to own businesses for a maximum of five to
seven years. However, with equity market values surging they
are more than willing to opportunistically exit their
investments. Furthermore, if interest rates rise many stressed
and distressed companies, which are often found in private
equity portfolios, may be forced to seek buyers.
The bottom line is that the factors described above have
translated into a mergers and acquisitions environment that is
producing a steady stream of attractive investment
opportunities for hedge funds. One of the hallmarks of this
environment is that agreed deals are getting completed. Most
believe that today's deals are higher quality deals. This
environment is also likely to produce a reasonable number of
topping bids for deals, which can create very attractive
returns for arbitrageurs.
The case for M&A volume stagnating at current levels
relates to CEO confidence and actions by central banks and
political leaders around the world. Actions that make CEOs more
nervous about tax policy and broader economic issues will
result in the deferral of M&A activity. The most obvious
impediment to be overcome this fall is the looming debt ceiling
battle in the U.S.
The normal risks that the merger arbitrageur faces in the
market have not changed or diminished. The parties to an
announced transaction may decide to terminate or delay a
transaction for a variety of reasons including a competing bid,
antitrust concerns, shareholder dissent, sharp changes in the
prices of either the acquirer's or target's stock price,
regulatory issues or personality compatibility concerns. For
example, in January 2013 EU antitrust regulators blocked a $7
billion bid by United Parcel Service for TNT Express.
One of the closely-related investment areas that
arbitrageurs typically exploit is transformational
reorganizations and spin-offs. The number of these investment
opportunities has risen in 2013 as equity markets have surged
and company boards have sought to unlock shareholder value.
This trend is likely to continue if equity values stay at or
near current valuation levels.
In June 2013 most arbitrageurs experienced classic deal
spread widening causing mark-to-market losses. However, no
significant number of deals broke apart during the month. As a
result, most hedge funds investing in merger arbitrage
experienced a bounce-back in July as merger spreads tightened.
And many firms took advantage of the market dislocation in June
to increase their positions in high conviction deals.
One of the most attractive features of investing in merger
arbitrage is that, generally, the strategy will benefit from a
rise in interest rates. If rates rise, merger spreads will
widen. Results in June and July support this notion. An
increase in the number of deals being announced may lead, as it
has in the past, to risk premiums widening.
The only market environment that would be difficult for
hedge funds that pursue merger arbitrage would be one in which
an interest rate rise is caused or accompanied by significant
distress in the financial markets. This scenario would likely
cause financial institutions to restrict credit for deals and
lead to a number of deals falling through. One factor that
would mitigate the reduction in deal flow in this scenario is
that the number of distressed company deals would rise markedly
as companies' ability to refinance their debt would be taken
away by market conditions.
It is not surprising that most investors looking in the
rearview mirror are not focused on merger arbitrage. In 2011
many merger arbitrageurs experienced slightly negative returns.
Returns for the strategy in 2012 and so far this year have been
only modest. Thus, flows into merger arbitrage funds have been
modest. But for the reasons outlined above, the smart investor
should be thinking about an increased allocation to merger
Joseph Marren is the president and chief executive
officer of KStone
Partners, which manages absolute return funds of
hedge funds for institutions and high-net-worth