Fund Selector: Merger arbitrage worth a look
Recent headlines about low levels of merger and acquisition (M&A) activity have made me consider if any exposure to merger arbitrage funds is appropriate.
Essentially such funds go long the stockmarket listed firm being bought and short the acquiring firm in announced deals to remove any market risk.
Because there is always a risk that a deal falls apart, a gap – called the deal premium – tends to persist between the current price and the offered price until complete. Merger arbitrage funds seek to harvest this premium steadily over time.
A handful of such funds, traditionally the domain of hedge funds, have for the first time been launched as Ucits structures in recent months. They have historically offered a very stable and steady source of returns that are uncorrelated to the wider market. Their addition to the retail fund space, given that it is easy for investors to move in and out of them, is welcome to many.
From the negative perspective, the level of announced corporate deals globally in the first quarter of 2012 was 35 per cent lower than that in the first quarter of 2011 and volumes have been falling for several quarters now.
This is against a backdrop where company managements are still uncertain about the future, especially in Europe, and are often opting for share buybacks and special dividends over acquisitions.
On the plus side, though, companies continue to hold very large levels of cash on their balance sheets and shareholders are agitating for its deployment. Volatility measures are calmer and equity markets have been rising steadily so far this year. The Vix (the Chicago Board Options Exchange Market Volatility index – a market volatility gauge which is used by most investors), for example, is back to below 17, a level more familiar to the pre-credit crisis period.
These conditions help instil confidence and lead to a revival in deal-making. In fact there are already signs of recovery in European mergers and acquisitions (M&A), which had been the weakest geographic area, with volumes up 14 per cent in the first quarter of this year compared with the previous one as the continent’s sovereign debt crisis subsides.
In addition, a recent survey we conducted reveals that more than half of the global fund managers we asked said they either see M&A activity remaining similar to the 2011 levels or think it will slightly increase. Aside from market conditions, key metrics to consider include the number of current deals, average duration and, as with any strategy, valuations (in this case the average deal premium).
The number of announced deals worldwide (currently at approximately 80) is, while hardly booming, comfortably above the lows seen a few years ago. Major examples include Xstrata/Glencore, TNT/UPS and Pentair/Tyco.
Deals are being completed, on average, within a not unreasonable time frame of four months and the average deal premium, that is, the difference between the current price and the acquisition price, at the moment is more than 2.5 per cent. As always, the key risk is that a bidder walks away from a deal and the share prices move in the undesired direction – the target falls and the acquirer rises – but there is always the upside of the chance of a higher counterbid. Deals normally collapse in less than 20 per cent of cases.