Merger arbitrage: spreading the love

Hedge funds had one of their worst quarters on record in the first three months of the year, with an average return of -10%, according to financial data provider Preqin. Performance was hit by the impact of the COVID-19 outbreak and oil price war.

Having protected capital in the first leg of the sell-off in February, most of the negative performance for hedge funds occurred in March (-9%). March’s losses were greater than any monthly loss during the 2008 Global Financial Crisis. That said, hedge funds performed much better than public markets, with the S&P 500, for example, falling by 20% in the first-quarter of the year.

Strategy selection is key

Like private capital investment, it is important to think of hedge funds as a collection of distinct strategies rather than a homogeneous asset class. The dispersion of performance between hedge fund strategies, and managers, is much wider than is usually found in public market investment strategies and funds, adjusting for volatility.

While certain strategies will likely suffer as the economic crisis unfolds, other strategies should benefit from dislocations in financial markets. More precisely, with the economy suffering from quarantine measures, we see opportunities in a strategy called “merger arbitrage”.

What is merger arbitrage?

A merger is the process by which one company attempts to purchase the shares of another company to acquire a controlling stake. The acquiring entity usually offers a premium to the current share price, hoping to motivate enough investors into selling their shares in the target business.

While the target company share prices tend to jump when the acquisition is announced, the price may then fall to reflect the uncertainty over whether the merger takes place. For instance large shareholders might fight the acquisition, financing might fall through, regulators could prevent the deal or significantly worse performance by either party could derail the deal.

Merger arbitrage is a strategy that became well known in the late 1960s and early 1970’s. The strategy aims to capture the aforementioned spread that exists between the share price of the target company and the acquisition price on announced transactions, while also potentially profiting from other deal-related opportunities.

Historically high spreads to capture

This year’s sell-off in equities has affected announced merger transactions, increasing the spread between the acquisition price and the share price of targets. While risks exist of certain transactions failing, we think that selective opportunities provide hedge funds with experienced and seasoned investment teams focusing on merger arbitrage with good prospects. Risks around financing and motivations to complete deals certainly increase in periods of stress.

Furthermore, the longer the coming recession lasts, the more that puts some merger transactions at risk. While the recession is likely to be very severe, we expect the conjunction of government and central bank support and a lifting of confinement measures to lift the global economy out of recession relatively quickly.

Diversification opportunity

Where the acquirer pays with shares, a merger arbitrage strategy focuses on relative value between two stocks. As such, it is partially uncorrelated with the performance of stock markets and provides diversification to an equity portfolio.

After the dislocation in risk markets and the subsequent rally, merger arbitrage, with the current levels of spreads, offers an attractive risk/reward while also providing diversification benefits.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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