A ‘full house’ for dealmakers?
2018 has seen a continuation of an M&A boom fuelled by an environment of cash-rich balance sheets, low borrowing costs, robust global growth and strong corporate confidence. Technological disruption also is a key driver of M&A, as advances in the technology space force companies to be more innovative and forge more strategic partnerships[1]. Add to the mix the effect of Trump’s tax cuts and cash repatriation and the equivalent of a ‘full house’ for deal-making is dealt.
Set against this, however, are rising geopolitical tension, a sharp increase in protectionist policies and the prospect of rate hikes, all of which are casting a shadow on the space. One need look no further than the recent demise of Qualcomm’s bid for NXP as an example which will undoubtedly have further ramifications for the M&A space and those looking to benefit.
Here we examine what stage we have reached in this game (the M&A cycle); the nature of the hedge fund players; the high-rollers and their winnings to date (hedge fund performance); and finally, how much money is in the pot (the opportunity set) and how the deck is stacked (risk and reward).
Cards on the table
Where are we in the cycle?
M&A activity has been accelerating to record levels, with H1 volumes up 65% from the same time a year ago, reaching $2.5 trillion[2]. For the year to September, it has exceeded $3.3 trillion, a 39% jump from 2017[3]. The landscape for M&A has ratcheted up in intensity, with cross border activity at a post-financial crisis high, in spite of geopolitical tensions and protectionist squabbling. The US has led the way in terms of deal volume, with over 10,000 deals valued at over $900bn; from a regional perspective, however, Europe has been a material contributor to M&A growth, with deal volume over $1 trillion and approximately 14,000 deals[4].
The boom shows no signs of abating, as the recent Comcast/Sky deal demonstrated. In what has been an epic battle, the American cable giant outbid Fox on 22nd September, valuing Sky at well over $40bn, over twice as much as Fox’s initial bid back in December 2016.
Source: Financial Times: Global M&A activity hits record level – 28th September, 2018
Big is beautiful
Interestingly, the number of M&A deals has actually dropped by 10% year-on-year. The average deal size is getting bigger[5] and we have seen a resurgence of the ‘megadeal’[6], the primary engine that is generating this activity. We have seen this in the US, particularly in the telecoms and media sectors, including such examples as T-Mobile’s $26bn acquisition of Sprint, Disney’s recent $71bn bid for Fox, and Comcast’s $40bn winning bid for Sky.
According to an article in the FT, there have been 79 deals above $5bn, “surpassing the previous year-to-date record set in 2007”, and a record 35 deals above $10bn.[7]
Counting the chips
How have hedge funds performed?
With all the euphoria surrounding deal activity, money must be flooding into event driven strategies and it must be a boom time for hedge funds, right? Well, as it turns out, this record-breaking opportunity set has not been reflected in hedge fund performance. Year to date the HFRX Merger Arbitrage Index is down 0.5% to the end of July, moderately outperforming the broader hedge fund universe, with the HFRX Equal Weighted Strategies down 1.3% over the same period. At the same time equity markets have continued to rise, with the MSCI World up 2.4% and the S&P 500 up 5.3%. Continuing my poker analogy, going to the poker table and ending up with less money than you started with is not unusual, but hardly the stuff investors’ dreams are made of, especially if you thought you had been dealt a strong hand!
Does this record deal flow correspond to the hedge fund industry increasing the percentage allocation to event driven strategies? Aurum Research Limited tracks industry flows, performance and dollar P&L generated across strategies, monitoring well over six thousand funds and approximately $3.2 trillion of AUM in the hedge fund space. Our data actually shows that, since January 2013, the relative proportion of the event driven share of total hedge fund assets has been on a downward trajectory, currently 5-6% of total hedge fund AUM. This figure does not include multi-strategy funds, which may have a meaningful allocation to the space, but is interesting nonetheless in the context of this record-breaking year.
Source: Aurum Research Limited
Drilling down further into the data in the chart below, we can see the cyclical nature of the strategy, as well as the ‘performance chasing’ behaviour of allocators. The left axis shows the rolling 12 month dollar P&L generated by the strategy and the corresponding rolling 12 month dollar flows. One can clearly see that the upturn in performance starting in 2016 is followed by increased flow into the space. Incidentally, we observe the same phenomenon across most hedge fund strategies – but that will be the subject of a future article. What is interesting about the last few months is that rolling dollar returns have been on a downtrend but it is only in the last few months that we have started to see some positive net flow back into the space.
Source: Aurum Research Limited
The chart below shows monthly dollar P&L generation from the event driven funds that we track relative to the total AUM in the space. Again, we observe that asset flows do not reflect the record deal flow and rhetoric around the opportunity set. Total event driven AUM is still well below the peak reached in 2015, when it exceeded $200bn. This contrasts starkly with the overall industry growth as shown in the first chart, where hedge fund assets are close to their all-time highs.
Source: Aurum Research Limited
There are some interesting details under the surface, which we explore in the next chart. There have been several high profile event driven fund closures in the last few years, including Eton Park Capital and Perry Capital, as well as some large high profile funds (in the $4-10bn range) that have seen a significant decline in assets, accounting for the bulk of the total outflows in the event driven space. The chart below clearly shows the very big funds (>$10bn) getting proportionally bigger and a significant shrinking of the relative proportion taken up by funds in the $4-10bn range. Perhaps the most interesting thing to note about the chart below, however, is that the relative share of funds in the sub-$1bn range has steadily increased over the last few years.
Source: Aurum Research Limited
Headline returns do not tell the whole story. For example, in the last 12 months February was one of the more challenging periods, with the HFRX Merger Arbitrage index losing 1.3%, driven by the market downturn and spread widening. Across the M&A space, however, some hedge funds significantly outperformed, as they were exposed to the Sky and NXP deals (prior to the NXP deal going sour later in the year, which we discuss below). March was a similar story, as many deal-spreads widened, driven by a negative macroeconomic environment, regulatory uncertainty and problems in the semiconductor sector.
A manager’s relative success – as typically is the case with merger arbitrage – depended upon avoiding those few deals that failed, as there is typically asymmetry to the downside when deals break. On the flip side, the top performers tended to be exposed to one or two key deals, where there was optionality to the upside, such as the Sky deal, where merger arbitrageurs became beneficiaries of a bidding war between Comcast and Fox. The final winning bid from Comcast was £17.28 per share, a significant increase from the previous offer of £14.75. When markets opened on the Monday after the winning bid was announced at the weekend, Sky jumped 8.6% to £17.22, a great result for hedge fund shareholders.
Another interesting aspect to track is how dominated the event driven space is by a small number of very large funds, as shown in the chart below. For example, the top 10 largest funds we have classified as event driven account for 58% of the total AUM in the space, at just over $100bn.
Source: Aurum Research Limited
In a similar vein, the top 10 dollar generating funds accounted for over 80% of the net P&L generated by the space, or over $5.5bn in the 12 months to July. Whilst not all of this P&L relates to M&A, it is certainly the case that nearly all of these big names are significant players in the megadeals. There is also a clear link between a deal like NXP going sour and the associated challenges in the space, which we will discuss later.
Is bigger better?
Questions often raised in the hedge fund space are ‘Do larger funds typically perform better or worse than smaller ones? How does that vary by strategy?’ Using data collected on the event driven space we have been able to explore these, and associated, questions.
We have considered this by looking at the relative proportion of the event driven industry represented by each fund and comparing it to the relative proportion of dollars generated. For example, the largest fund in our dataset has represented (on average) approximately 16% of the event driven space since January 2013, but by our calculations has produced 26% of the dollar profits over that time period. This can be translated to a simple ratio, which we will refer to as the power ratio, of ~1.6.
The chart below shows the cumulative assets in the event driven space from January 2013 to July 2018, going from largest funds to smallest by average AUM, left to right on the X axis in a dataset of 160 funds, and the corresponding percentage of total dollars generated in the event driven space since January 2013. What is it telling us? Where the blue line is above the red line this essentially tells us that the larger funds are responsible for generating proportionally greater P&L from the space relative to their size. For example, in the dataset of 160 funds, the three largest funds, representing approximately 32% of the event driven sector, are responsible for producing over 50% of the dollar P&L. The areas of the sector generating the greatest P&L are those areas of the blue line where the slope has the steepest positive gradient. For example, area A shows the largest fund sitting well above the red line. The next largest funds also slightly outperform on average (the gradient is slightly steeper than 1:1 represented by the red line). Area B shows the next largest funds, at 32-45% of strategy AUM, significantly underperforming the average. These three funds ranged from approximately $8-12bn (average AUM over the period). In Area C we see a steep drop caused by a single large fund that lost a significant amount of dollars through poor performance; this was followed by subsequent outflows, with the fund shrinking from $4.5bn to $1bn. Further up the chart we see occasional sharp increases in gradient, representing smaller outperforming funds, particularly area D; although even at this point the AUM range is between $2bn and $4bn representing eight funds. It’s also interesting to note that that area of the chart represented by the blue arrow is comprised of just 16 funds, making up nearly 70% of the AUM and P&L in the space. By contrast the green arrow represents 144 funds and the remaining 30% of AUM and dollar P&L in the space.
While the largest funds are, on average, producing better-than-average returns, there are also number of big names that have made significant losses, or flat-lined, over the period as well as some smaller funds that are able to extract significantly above average returns relative to their size.
Source: Aurum Research Limited
The chart above does not give any insights into which funds are outperforming, or whether there is a ‘sweet spot’ one should aim for as an allocator. So how have funds performed at different sizes and what is the dispersion like?
Source: Aurum Research Limited
The chart above illustrates that the large funds have done a reasonable job on a relative basis. One should keep in mind that, moving from left to right in the chart above, the sample size in each bucket increases dramatically; as we’ve already seen, the total strategy AUM is dominated by a few big players. For example there are four funds that averaged over $10bn in our dataset over the period, but 17 funds between $1.0bn and $2.5bn and 50 funds under $100m. It is unsurprising that as the sample size increases so does the dispersion of performance. There are, however, some interesting observations to make. Once you start looking at funds $2.5bn or smaller, the range of dispersion of results increases significantly relative to funds in the larger asset bracket.
Both the median and mean average returns decrease as you move away from the few behemoth funds, with both the median and mean average returns highest in the group of funds over $10bn. Is this evidence that ‘bigger is better’, contradicting the theory that smaller funds are more dynamic and should therefore be more successful than large funds? Not necessarily. Allocators typically are not looking for the average, they are looking for outperformance. To significantly outperform one should move away from the very large. For example, if you are looking for funds with power ratios over 2, then, based purely on the data above, you should probably focus your efforts on funds running less than $2.5bn. As can be seen from the ranges to the downside, however, you would also be exposing yourself to the greater possibility of significant underperformance – which is not surprising given the dramatic increase in available funds when including smaller funds in the investible universe.
The dispersion of fund performance serves to highlight the importance of fund selection skill and a rigorous due diligence process. Allocators to merger arbitrage funds must ensure there is a robust risk framework and portfolio construction process in place at the manager, identify where there is a repeatable edge and ensure that they are not overly exposed to a particular risk factor without adequate compensating expected returns. Liquidity is another critical factor in fund selection which is not covered in the charts above. Many of the largest funds have very broad exposure to the event space, including illiquid transactions that fall well outside bread and butter merger arbitrage; they also have fund redemption terms that may be much more onerous than smaller funds.
Tipping the dealer
So apart from a select group of hedge funds, who else has been a beneficiary of this record deal flow? Others ‘making hay while the sun shines’ include banks, which have already generated fees at record levels so far in 2018 through their lending activities. According to Reuters[8], banks that arranged nearly $36bn of loans to support the Disney/Fox bid stood to pocket an estimated $200m in fees. Even prior to this bid, banks had earned nearly $9bn year to date from US M&A alone. According to the FT, “Morgan Stanley topped Goldman Sachs as the most active adviser on mergers and acquisitions. The two Wall Street investment banks were followed by JPMorgan, Citigroup and Bank of America, according to Thomson Reuters data.”[9]
High stakes and a full pot, but is it a loaded deck?
What is the outlook for M&A and the current risk/reward environment for event driven funds?
In June 2018 we saw a resolution to one of the two pressing questions overhanging the space: ‘would the AT&T and Time Warner merger be allowed to pass?’ At the end of July we also got our answer to the other question as to whether the Chinese regulators would give their approval for Qualcomm’s $44bn pursuit of NXP Semiconductors. Both of the outcomes have significant ramifications for the future pipeline of deal flow, as well as ‘shifting the odds’ or to use investor terminology, the ‘risk/reward’ ratio of the event driven space.
More money in the pot?
The significance of the AT&T / Time Warner ruling
In this case, the court ruled in decisive fashion in the defendants’ favour, and in so doing dealt a blow to the Antitrust Division of the US Department of Justice. It was also a stark illustration of how difficult it is to successfully challenge a vertical merger in court. To quote the ruling in the case:
“the Government’s evidence, as “undermined” and “discredit[ed]” by the defendants’ attacks, is insufficient to “show[ ] a probability of substantially lessened competition,” and thus that the Government has “failed to carry its ultimate burden of persuasion.””[10]
“…as my 170-plus page opinion makes clear – I do not believe that the Government has a likelihood of success on the merits of an appeal.” [11]
The ruling was a landmark decision and set a legal precedent. PwC US Acquisition partner, Curt Moldenhauer, said it was “the first time in 20 years that the DoJ has evaluated a vertical type of deal” and “[as a result] we might see a lot more verticals go through, such as deals between healthcare companies and pharmacies.”[12]
The aftermath of the decision saw material spread-narrowing on a variety of pending vertical deals. For example, the Aetna/CVS premium narrowed by 3.1% and Express Scripts/Cigna narrowed 4.5%.[13] We also saw an escalation in the bidding war between Comcast and Disney for Fox that lifted its share price significantly, with Comcast’s competing proposal quickly topped by the $71bn bid from Disney that was 34% higher than its initial $53bn deal.
The sucker at the table
Who has lost out as a result of the collapse of Qualcomm’s bid for NXP?
The world – and particularly event driven hedge funds – watched the unfolding drama surrounding the proposed merger of US firm Qualcomm and Dutch chip-maker NXP, which was agreed back in 2016 when Obama was still resident in the White House.
Both firms are huge semiconductor companies with significant operational overlap. With questions over the potential impact of the deal on consumers and competition, the deal had been subject to scrutiny from global regulators. Over the last two years, the deal received approval from eight jurisdictions, including the EU and South Korea. China was the lone holdout.
As the clock continued to tick away, the deal saw repeated extensions, with the associated price of the acquisition of NXP by Qualcomm changing repeatedly – and set around $44bn.
During this period the tech industry became a focal point in the trade battle between the US and China. In March, Trump blocked a $117bn takeover of Qualcomm by rival Broadcom, using the argument that it could significantly tip the balance in favour of China in the development of 5G technology. The following month, the Trump administration went on to impose a seven year ban on Chinese smartphone company ZTE, preventing it from buying critical parts of US companies. This however, was not without ramifications for Qualcomm; as a major supplier of chips for the smartphones ZTE produces it lost a significant amount of business. Trump then intervened after three months and lifted the ban – seen by many as a prerequisite for the Qualcomm/NXP deal to get Chinese approval.
Hope that the deal might get passed was further boosted after the US government came to an agreement with ZTE that allowed it to resume business in the US. However, relations between the US and China were dampened further after the US pressed ahead with plans to impose tariffs on Chinese goods worth $34bn in June, citing alleged theft of US intellectual property as justification for its actions. In what appeared to be a case of ‘tit-for-tat’, China responded in kind and Trump threatened to target an additional $200bn of Chinese products.
While the continuing tensions between the US and China appear to be the primary reason that China’s State Administration for Market Regulation (SAMR) dragged its feet in granting approval, it has been suggested that China has other motives for its (in)action. China is highly dependent upon foreign chip-makers[14] and should international relations continue to worsen, this could significantly threaten Chinese manufacturing ambitions and goals relating to semiconductor production. Qualcomm ultimately walked away from the deal in July 2018.
The aftermath
The Qualcomm/NXP deal was one of the largest seen this year. It was an all-cash deal, strategic in nature and had been passed by eight regulators. In the event driven community, the deal became increasingly crowded and a ‘no-brainer’. A review of 13F filings indicated that some very large, high-profile hedge funds held NXP, including Elliott, Pentwater, Soroban, Farallon and Arrowgrass. Prior to the deadline date towards the end of July, the share price had fallen well below the $127.50 offer price as it became increasingly likely that the deal was not going to get the approval it required, with many hedge funds exiting the trade, some having suffered significant losses.
Conclusion - Look around the poker table; if you can’t see the sucker, it’s you.
This is proving to be a bumper year for corporate activity and there is an opportunity for event driven money managers and merger arbitrageurs to capitalise. The reason is simple: this huge amount of flow represents potential capacity in this tried and tested hedge fund strategy and gives funds the opportunity to put significant capital to work.
But, of course, life is never so easy, and along with this opportunity comes heightened risks. There are numerically fewer deals, with megadeals representing a significant portion of the deal flow. Hand in hand with this we have seen a number of very large deal-breaks, heightened regulatory uncertainty and other risk factors at play that have been less prevalent in previous M&A cycles.
Taking the above factors into account, when one looks at event driven hedge fund performance, we have seen some significant dispersion between top and bottom quartile performers, with much of the relative success or failure resting on whether funds were in or out of a few key deals; commentators on this strategy would point out it has ever been thus when it comes to merger arbitrage. One could also highlight potentially increased concentration and crowding risk, as capital becomes concentrated in a few key mega-deals.
This space continues to provide significant raw material for hedge fund specialists, but as the section on performance analysis shows, skilful fund selection is key, particularly if you want to outperform the few ‘behemoth’ funds that operate in the space. As an allocator to the space, Aurum Fund Management Ltd. focuses on those managers who are specialists in their field and are therefore best positioned to assess likelihood of deal completion, placing a premium on those funds that run highly liquid books and do not have overly restrictive fund redemption terms in place. The analysis performed above does not include a consideration of the liquidity of fund redemption terms, or underlying portfolio liquidity. Allocators should demand to earn a significant premium if they are increasing their illiquidity risk.
One should also ensure that the funds are not overly concentrated or aggressive, such that a single deal-break would represent a catastrophic loss. Anyone considering allocating to the space should ask questions about how managers diversify their book with respect to certain types of deal risk, e.g. proportion relating to LBOs, tax-inversions or involving US/China cross-border transactions, etc.
The market environment is creating opportunities and providing the fuel that is the life blood of the event driven portfolio manager. Being based in London we also see the opportunities presented by funds managed by European managers, relative to the US ‘mega-managers’, something we consider ‘the road less travelled’.
If one is looking to diversify then the event driven space potentially provides a rich source of non-correlated returns. However, one must look beyond the headlines and be prepared to really get into the weeds of the funds investing in the space. Deep work is required to ensure you don’t find yourself the sucker at the table.