As published in Finance et Investissement on 8 January 2023 (in French).
After a year when many buyers and sellers were waiting on the sidelines for improved visibility and a better environment to make deals, 2024 could be the year the trillions of dollars in ‘dry powder’ are deployed. Should that happen, certain previously unloved sectors, such as small-to-mid cap companies, could experience a rush of investor attention.
Comments from various bankers and dealmakers have indicated that there is a ‘huge backlog’ of M&A activity with deal pipelines at many firms at their highest levels ever. While rate cuts will certainly be a driver to stimulate M&A activity, stability in rates could be enough to get deals over the line, given the backlog of activity which has been put on hold in what has been a tightening cycle with the fastest increase in interest rates making it challenging for M&A. As deal making conditions improve, we are seeing catalysts form within our small-cap universe with considerable pent-up M&A potential. Greater visibility on the path of rate hikes, improving market sentiment, trillions in ‘dry powder’ at PE firms and corporations, wide dispersion in equity valuations, motivated target shareholders and trends like electrification, AI, reshoring as well as hostile geopolitics provide the right incentives and a strong environment to do deals.
Indicative of a changing M&A environment, back in November, the Pender Alternative Arbitrage Fund closed several deals including many of the largest positions in the Fund. These included Avantax Inc. (NASDAQ: AVTA), Avid Technology Inc. (NASDAQ: AVID), Polymet Mining Corp. (TSX: POM), Hersha Hospitality Trust (NYSE: HT) and Sculptor Capital Management Inc. (NYSE: SCU), were among the 19 merger deals held by the Fund that closed. We harvested the returns from the closed deals and are actively redeploying that capital into new merger deals with a focus on high-quality small-cap merger deals trading at wide spreads and positioned to deliver attractive returns. We also initiated positions in 11 new deals during that month.
Unlike bond markets, which have been pricing in lower yields on expectations of rate cuts in 2024, merger arbitrage spreads remain wide providing an attractive relative and absolute opportunity. The spread gap between small-cap merger deals and larger or mega-cap mergers has narrowed as several large- and mega-cap merger deals closed in past few months. This development represents a favourable environment for a small- and mid-cap focused strategy allowing investors to benefit from a wider spread environment while avoiding the higher deal and duration risk of larger merger deals.
There is a material shift in market sentiment driving a large move in markets. Equity markets saw a strong rebound in November and December. As the BoC and Fed signaled that rate hikes had likely peaked for this cycle and inflation data suggesting rates could move down further than expected in 2024, investors have found new confidence which is driving the market rally.
As investor sentiment shifts from fear to greed, and rate cuts get priced into markets, the path forward for markets and interest rates is difficult to predict with elevated expectations priced in. With the potential for stock and bond correlation to increase, as was the case in 2022 where both asset classes experienced steep declines in value, a non-correlated event-driven alternative strategy like merger arbitrage can be a good diversifier within a portfolio.
The broad-based positive inflection in small-cap equity prices seen at the end of last year could be the catalyst to spark a wave of small-cap M&A, given the months of underperformance and the valuation gap relative to large-cap companies reaching historic peaks in October, 2023.
We have discussed the compelling environment for M&A with ample capital on the side along with motivated and incentivized boards, management and shareholders at target companies who are highly receptive to a deal. Market uncertainty, tighter lending conditions, higher interest rates and a large gap between the bid and the ask have been some key considerations which have held down M&A activity throughout this year. As market conditions improve, interest rate expectations trend lower and equity market valuations increase, buyers are likely to pay up, not wanting to miss out on a compelling acquisition opportunity while still getting a great deal as many small-cap companies trade at deep discounts to intrinsic value. Feedback from companies, bankers, and dealmakers who we follow and speak with suggest considerable pent-up M&A potential. Investors should consider how to take advantage of an increase in small and mid-cap merger deals in 2024.
