by Scott Schefrin and Eugene Smit, AllianceBernstein
Is an M&A boom brewing?
Thereās a shift underway in the mergers and acquisitions (M&A) market. The headwinds of rising rates, price volatility and increased global regulatory scrutiny appear to be fadingāand market sentiment is getting brighter.
We see this as a welcome development for investors in merger-arbitrage strategies, which generally benefit from greater deal activity. A ramp-up in deals in the near term may have the potential to drive a new, longer wave of activity.
Investors saw a similar dynamic at work in 2021, when acquisitions surged as interest rates plunged. The prior year, the pandemic essentially shut down M&A activity. The year 2021 was also a strong one for merger-arbitrage performance: the HFRI Merger Index returned 10.6%. But activity declined thereafter.
A Strategy with Attractive Potential
In merger arbitrage, arbitrageurs purchase a target companyās stock at a discountāor spreadāto the merger consideration thatās being offered. If the merger closes as expected, the arbitrageur realizes the spread as profit.
Returns from merger-arbitrage approaches have been consistently attractive over time, with high Sharpe ratios (a measure of the excess return potential per unit of risk). Merger strategies have also been characterized by shallow drawdowns and low correlations with both conventional assets and style premia such as value, size, quality, momentum and low volatility. We think that makes merger arbitrage a strong portfolio diversifier.
Encouraging Signs
The new leaders of antitrust regulatory agencies in the US and UK recently said that the merger vetting process in the last few years has been overly burdensome. Both agencies have indicated a shift toward a lighter, more business-friendly regulatory approach.
Business leaders have also started to express interest in mergers and buyouts in their quarterly earnings calls with investors and analysts. Economic conditions have been adding further support, with equity markets rising and interest rates stable or declining.
Whatās more, leading indicators of M&A health, including increased IPO and spin-off activity, and hostile takeover attempts, have all been increasing.
The change in sentiment over the last few months has sparked a broad-based narrowing of spreads in existing deals. Deals that once appeared at a higher risk of regulatory denial now look more likely to get approved, and timelines for deal completions have started to shorten.
Next, we expect an increase in deal activity. But because deals take some time to plan and execute, and new regulators take time to settle in, we think there is likely to be a short window of opportunity before the market reaches full steam.
Playing by the RulesāA Systematic Approach
There are a few ways to potentially capitalize on that opportunity. In our view, the current landscape favors a systematic, rules-based approach for several reasons.
First, the merger environment is attractive when deals are plentiful, sentiment is strong, and competition between buyers is high. This is becauseĀ deals tend to complete more often, deal breaks tend to be less painful, and competitive bidding creates opportunities for significant upside. We believe the most effective way to take advantage of such an environment is through a systematic implementation, which offers broad-based exposure to deal activity.
Second, the primary risk merger arbitrageurs face is a deal break. A systematic approach benefits from greater diversification of this idiosyncratic risk compared to a fundamental approach that holds fewer deals. The scale of this benefit increases with the number of active deals. This is because a systematic approach isnāt limited by analyst and research capacity and can hold all eligible deals.
Finally, cost is an important consideration. The systematic approach offers a cost-effective way to gain exposure to the merger environment without paying the sort of high base and performance fees that hedge funds typically charge.
Managing RisksāIncluding Volatility and Trade Tensions
While we expect deal volumes to increase over the next two to four years, we are monitoring potential risks to this view. These include an increase in market volatility and another spike in rates.
Another risk is tied to global trade: if global tensions increaseāparticularly between the US and Chinaāforeign regulators may be more likely to withhold approval for deals. The market witnessed a few cases of this sort during the first Trump administration.
But if rates continue to trend lower, we wouldnāt be surprised to see leveraged buyouts increase, given the ample dry powder at private equity firms and the prevalence of private credit financing options.
Overall, we think the more business-friendly posture of regulators and the sunnier sentiment being expressed by investment bankers and corporate boardrooms are cause for optimism.
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About the Authors
Scott Schefrin is the Portfolio Manager of the AB Hedge Fund Solutionsā Systematic Merger Arbitrage strategy. From 2011 to 2015, Scott worked at Magnetar Capital, where he served as a portfolio manager for the firmās event-driven business and was a member of its investment committee. Prior to joining Magnetar, Schefrin was a senior managing director and head of merger arbitrage at Cantor Fitzgerald. From 1993 to 2008, he worked at Bear Stearns, where he was global head of the firmās risk arbitrage, event-driven and capital structure arbitrage businesses from 2003. In this capacity, he served as portfolio manager of the firmās $2.5 billion global proprietary portfolio and manager of its 35+ member professional team. From 2000 to 2005, Schefrin was also president and general partner of North Creek Partners, the investment advisor to the Bear Stearns Global Equity Arbitrage Funds ($675 million in AUM). He was also a senior managing director and a member of the Presidentās Advisory Council at Bear Stearns. Schefrin holds a BS from the University of Michigan and an MBA from Columbia Business School.
Eugene Smit is a Portfolio Analyst and Manager on the AB Hedge Fund Solutions (HFS) team within Multi-Asset. In this role, he conducts research on alpha and portfolio construction, and builds systems for portfolio management and monitoring. Smit has been the primary quantitative analyst for Merger Arbitrage and a member of the portfolio management team since its inception in 2018. Prior to that, he worked on the Equity Factor team, managing multiple global mandates. Smit joined AB as a member of the Technology Group in 2010, responsible for supporting equity quantitative research and the firmās Investment Risk Oversight Group. He joined Multi-Asset in 2013 as the lead technologist supporting the Equity Factor team. Smit transitioned to quant research and portfolio management shortly thereafter. Prior to joining AB, he ran an e-learning start-up. Smit holds a BS in business from the University of Cape Town and is a CFA charterholder. Location: New York
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