“S&P HITS A NEW HIGH!” It’s a headline investors have heard repeatedly in the last few years, but with equity valuations appearing ever more stretched, geopolitical concerns increasingly in focus and rate rises in the US imminent, one hedge fund strategy in particular stands out as compelling. Merger arbitrage typically exhibits low correlation to capital markets as well as other hedge fund strategies; it is a good diversifier in times of market stress, and tends to benefit from rising interest rates. So what is the downside? Some critics liken the risk/reward profile of merger arbitrage to “picking up nickels in front of a steam roller”. The risk/return characteristics of the strategy have not changed, but the current political environment has certainly created some strong tailwinds, US tax reform being a notable example.
The Trump administration has made corporate tax reform a priority, and while the exact details of the proposed reforms are unknown and unresolved, lower corporate taxes and favourable terms to repatriate foreign assets would build a sizeable pool of cash that could be used for M&A activity. It may be coincidental, but the last time the US enjoyed a tax holiday, in 2004, deal volume increased substantially in the years that followed. Current estimates of cash held overseas by large US corporations range between $1.6 trillion and $2.1 trillion; Apple alone is said to account for more than $200 billion of this.
Associated with the change in US administration is an anticipated relaxation in the approach to regulation. Antitrust laws are the biggest threat to deal completion, and regulator intervention has led to a number of high profile deal breaks. Historically, Republican administrations have tended to be more business-friendly and predictable when it comes to antitrust, and the current administration has signalled its intention to be less interventionist when it comes to M&A.
A third factor in the rise of merger arbitrage as a strategy is the fact that there are fewer players in the space. The Volcker rule has limited banks’ ability to engage in proprietary trading, leading to less competition amongst merger arbitrage buyers. In addition, a number of event driven hedge funds (a broader category that encompasses merger arbitrage) have suffered substantial withdrawals after a prolonged period of underperformance, and some have even closed down. The increased supply/demand mismatch in a period of healthy deal volume has led to some wider merger spreads and, as a result, a more rewarding opportunity.
On the other hand, there are some challenges faced by the strategy, the greatest of which is protectionism. The US government has expressed its displeasure at the proliferation of foreign buyers acquiring US companies, particularly bids coming from China. The Trump administration recently blocked a Chinese-backed private equity firm from acquiring US-based chipmaker, Lattice Semiconductor Corp, on the basis that it involved a technology that had a potential military application. At the same time, the Chinese government has increased regulation and scrutiny on outbound investments, which has exacerbated the negative impact on deal activity. So far, the Chinese government’s stance has been that scrutiny is required in order to control the quality of acquisitions, rather than to deter acquisitions altogether.
Another challenge is the uncertainty surrounding Brexit, which has been detrimental to cross-border deals involving British companies; however, a weaker Sterling provides foreign buyers with an opportunity to acquire UK assets cheaply if they can stomach the uncertainty.
Bull Points: Tax reform and less regulation in the US and also fewer players in the space.
Bear Points: Protectionist politics and Brexit.
