As published in Conseiller on 29 May 2023.
The torrid pace of global M&A appears to be playing catch up, especially in the mega cap universe where we have seen elevated regulatory scrutiny on high profile deals such as Microsoft/Activision Blizzard Inc., Black Knight Inc./ Intercontinental Exchange, Inc. and Broadcom/VMware. Adding to the less hospitable regulatory environment is a backdrop of macroeconomic pressure from higher interest rates and potential recession. However, just beyond the klieg lights of the mega caps and macro factors, there are attractive price dislocations and significant pent-up demand in the small-to-mid-cap size space which could fuel accelerated deal activity later this year.
Some investors wonder, given higher interest rates, if they shouldn’t just park their money in a high-interest-savings-account or a GIC, a passive long-duration bond index fund, or even a stack of high-dividend-paying stocks until the markets demonstrate a clearer direction. The trouble is, these assets are correlated to the market and short-term interest rates. In this uncertain and challenging market environment where inflation remains elevated above target, there are pockets of economic distress—in the banking sector, commercial real estate, retailers and consumers. Traditionally, this would be a time to lean into bonds, yet there is still great uncertainty on interest rates. And, as we saw in 2022, bonds are not always guaranteed to provide low-correlated returns. In fact, in 2022, bond holdings increased, not decreased losses.
This is one reason why, increasingly, financial advisors are recommending their clients include a sleeve of alternative assets, such as merger arbitrage, which can offer diversification to a portfolio and provide low-correlated absolute returns. Merger arbitrage seeks to generate returns from the discount between the market price and the deal price in announced, legally binding merger events.
These strategies on not dependent on the direction or level of the market. Thus, they can reduce portfolio volatility and improve portfolio stability. For example, since 1990 the HFRI Merger Arbitrage Index has only exhibited two years of negative returns.
One of the advantages of merger arbitrage strategies is the low correlation (beta) to equities and to bonds which we believe can result in lower drawdowns, lower risk, and better overall performance when added to a traditional 60/40 portfolio. During periods of high volatility, unhedged portfolios can experience dramatic drawdowns which interrupt the pace of wealth compounding in a portfolio. Merger arbitrage strategies are idiosyncratic in nature—the factors that influence and determine the success of a merger closing differ from each other and from the market as a whole. In addition, when a merger arbitrage fund contains anywhere from 35-45 different deals with no deal having a weighting greater than 3 per cent, it provides further diversification benefits. In this way, the risk of any one deal break is mitigated and the downside in the fund is limited. Having an optimal number of deals also allows the manager to shift to sectors where the opportunity set is more attractive and where spreads are widening. Levered merger arbitrage strategies provide higher-risk premia over the non-levered strategies. There is also the tax efficiency factor to consider, as returns are primarily taxed as capital gains, not interest income. For example, when held in a taxable account and at a 50% marginal tax rate, a 4% return in the form of capital gains is the equivalent of a 6% interest paying return from bonds.
Today, there appear to be compelling opportunities in several sectors including technology, industrials and biotech where the deals are of a high quality, short duration, and with a high probability of closing. With a typical merger deal taking three to five months to close, a short duration allows funds from closed deals to be redeployed into a new set of opportunities. It is likely that markets will continue to be more volatile than some investors have become accustomed to, which makes a strong case for including non-correlated, alternative strategies such as merger arbitrage to ensure a more resilient and sustainable balanced portfolio.