17 August 2017
The crux of the merger arbitrage approach is to harness bond-like returns and behaviours from a market-neutral equity portfolio by harvesting the arbitrage spread of announced merger and acquisition (M&A) transactions worldwide. From this perspective, the strategy provides a solution to many investors who are looking for alternative sources of meaningful yield with low volatility. This is a particularly attractive proposition in an environment where low interest rates and credit-spread compression make it increasingly difficult to harness such attributes through traditional fixed income funds.
The rationale supporting the strategy is that the opportunity set benefits from permanent drivers associated with liquidity and behavioural logic. After a takeover is announced, existing investors in the target company are typically keen to crystallise the large paper profit relating to the initial share price movement. At this point, their pay-off becomes both binary and negatively asymmetric, with the short-term upside being restricted to the residual spread (perhaps low single digit) while the potential downside becomes the total takeover premium that has just been incorporated into the share price. Consequently, these ‘natural sellers’ exert some downward pressure on the share price, effectively keeping the spread open and ensuring the opportunity is structural in nature.
Intuitively, it makes sense to harvest as many arbitrage premiums as optimally possible, since a large number of positions provide greater diversification of idiosyncratic risk. In this respect, a portfolio comprising of 60-80 different M&A opportunities is not only diversified in its own right – which helps to limit the drawdown risk – but also constitutes a useful source of diversification in a portfolio context. The major driver of risk and return is the completion of M&A deals, which is not directly related to the direction of markets or the level of volatility. As such, the fund exhibits a low correlation to fixed income, equity and alternative strategies, which is one of its most compelling attributes.
In order to maximise potential risk-adjusted returns, it makes sense to focus on the small to mid-cap segment of the market as this is where the least crowded positions can be found, offering greater premiums for absorbing the same risk of the transaction failing to complete. In fact, such a bias also reduces the risk of any given deal being vetoed for antitrust reasons, since transactions involving lower-end caps do not tend to impact the competitive structure of the overall business case.
In terms of the prevailing environment, global M&A transactions remain resilient, with both volumes and transaction numbers remaining above the average for the last decade, albeit below those seen in 2015 and 2016, which were record years in this timeframe. We believe that current transaction levels are supported by low borrowing costs (cash deals), high equity valuations (stock transactions) and sub-par economic growth rates which make it easier to expand market share through acquisition-based expansion, rather than organic growth.
However, in terms of spreads, we are currently at the bottom end of the range. Nevertheless, by virtue of high portfolio turnover (between two and three times over the year), which reflects the short timespan between deal announcement and transaction completion, a merger arbitrage portfolio can (in fixed income terms) be described as ‘low duration’. Consequently, the strategy is able to adapt quickly to moves in risk free rates and arbitrage spreads. Indeed the potential to generate returns would be enhanced, over the year, by an increase in rates and/or spreads. The nimbleness of portfolio adjustment is also a distinct advantage in times of uncertainty and, with the valuation of many capital assets appearing stretched, the strategy’s potential as a powerful source of diversification should not be underestimated.
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The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.