Assets under management in merger arbitrage hedge funds have quadrupled to $85 billion from $22 billion in the last 10 years, according to data from Man Institute, the research arm of London-based $142 billion investment firm Man Group. Investors gravitate toward the strategy for its predictability and its diversification benefits. M&A happens in every sector of the economy and tends to be relatively cyclical.
In 2021, that changed a bit. The economy reopened from the pandemic, which increased M&A, but that wasn't the only factor.
"Historically, M&A would get done to grow the company, or take out a competitor, or to create synergies," said Scott Schefrin, New York-based portfolio manager of the AB Custom Alternative Solutions' merger arbitrage strategy at AllianceBernstein.
"But we saw in 2021 that COVID brought forward a lot of other issues like the need to improve technology or diversify manufacturing or shore up supply chains. There are a lot of new reasons now to pursue M&A."
Those new reasons upended the tight cyclicality of M&A and led to the biggest year ever for deal activity in 2021 with a total of $4 trillion of transaction value, topping totals from both 2020 and 2019, according to data from S&P Global.
In 2022, deal volume was lower at $3.63 trillion, according to data from Bloomberg. Tighter debt markets slowed overall deal activity. However, companies were still pursuing transactions to deal with new issues arising from the pandemic and to support overall growth, sources said. The cost of financing is also playing a bigger role in deal offers.
Global manager abrdn, which has £376 billion ($452.6 billion) in total assets under management and invests in merger arbitrage funds, said in its recent outlook that it anticipates these trends will help merger arbitrage outperform.
"The complex regulatory, macro and geopolitical environments have kept spreads wide," the abrdn report said. "This has also lengthened deal timelines and lowered the probability of completion. But it also created mispricing, and therefore, trading opportunities for merger arbitrage managers. Today, it is very much higher interest rates that drives our positive outlook for the strategy. The positive interest rate carry associated with a deal spread outweighs our concerns around reinvestment risk given our expectation for lower levels of deal activity in 2023 than we have seen in recent years. Increased deal volumes don't necessarily translate to better returns, but our research does suggest that higher interest rates lead to higher returns for the strategy. We continue to place great importance on individual deal analysis, selection and trading to generate excess returns over passive merger arbitrage strategies."
Actively managed merger arbitrage strategies can take advantage of mispricings by sizing their investment positions based on how they view the current price of the deal. If they do this well, they might have slightly higher returns than a passive approach that invests more or less the same amount in each deal.
With greater interest in merger arbitrage strategies and new reasons for companies to engage in M&A, it may be time to take a fresh look at how the strategy is being modeled from a risk perspective, managers say. Recent research from the Man Institute suggests that volatility may not always be fully understood or adequately forecast with traditional value-at-risk models.
"The question always is how accurate is your risk number? And is it correct? Is it appropriately modeled? That was the spirit of our research to look at some of the challenges or difficulties you may have within a merger arbitrage deal," said Darrel Yawitch, chief risk officer of Man Group investments, in an interview.
Typically, stocks in a merger arbitrage fund exhibit a certain level of volatility because a merger creates a new regime for both the target and the acquirer, causing the individual stocks to react. But fewer deals fall apart now than they have in the past and volatility may not be a direct indicator of increased risk. If, for example, deal participants are working on amending terms, the stock price might react during that process creating volatility. But that volatility may not be an accurate indicator that the deal is going to fall apart. Risk models that don't allow for changes in the trajectory to deal close may give inaccurate forecasts of potential risk, the paper noted.
Mr. Yawitch's paper suggests investors may want to assess whether it is necessary to update risk modeling to rely less on historical assumptions in an effort to get a clearer picture of current risks. In some cases, traditional models could overstate the probability of broken deals and therefore risk in a merger arbitrage portfolio.
