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 confidence.
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 arbitrage.
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 investors.