Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Tara Lachapelle is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Poor, poor hedge funds.

Returns have plummeted and investors are fleeing. Pensions headed for the exits, and now endowments are close behind.

No hedge fund seems to be immune from the fallout. Brevan Howard and Tudor Investment are just the latest marquee funds suffering an exodus of investors.

But hope for some hedge funds and their hangers-on is springing up in a seemingly unusual place: abandoned mergers and acquisitions.

It’s been a tough year for corporate nuptials. Close to $500 billion worth of proposed mergers and acquisitions have gone belly-up this year, the largest such tally in nearly a decade. Some of the biggest broken transactions include those between Pfizer and Allergan, Honeywell International and United Technologies, and Halliburton and Baker Hughes.

Booms & Busts
The heightened risk of busted deals has created opportunities for discerning arbitrageurs.
Source: Bloomberg

That’s bad news for the bankers who marry companies and charge a fortune for their blessing, but it’s potentially great news for merger arbitrage hedge funds and their investors.

Merger arbitrage is one of the oldest -- and historically one of the most profitable -- games on Wall Street. The HFRI Merger Arbitrage Index has returned 7.8 percent annually from January 1990 to July 2016 (the longest period for which data is available), with a standard deviation of 3.9 percent.

Those numbers may not seem impressive at first, but they're spectacular. The Merger Arbitrage Index had a Sharpe Ratio of 1.25 during that period, nearly triple that of the S&P 500 (0.45) and well above that of the Barclays U.S. Aggregate Bond Index (0.95) over the same time -- no small feat in a period that saw an epic drop in interest rates. (The Sharpe Ratio measures risk-adjusted returns; a higher ratio indicates that investors are more adequately compensated for risk.)

Mining Mergers
Merger arbitrage posted spectacular risk-adjusted returns from January 1990 to July 2016.
Source: Bloomberg

There's an added bonus in all of this -- merger arbitrage is exceedingly simple. Here’s how it works: An acquirer announces how much it plans to pay for a target, which usually is more than the target’s current share price. Hearing the news, investors gobble up shares of the target, driving the target’s share price closer to but short of the acquirer’s offer.

The reason investors pay less than the offer is because there’s no guarantee that the transaction will ultimately be consummated -- and if it isn’t, the target’s share price is obviously likely to take a dive.

This is where merger arbitrage funds come in. The arbitrageurs are effectively betting that the merger or acquisition will cross the finish line. If the arbitrageurs are right, their payoff is the difference -- or spread -- between the offer and what they paid for the target’s shares.

All of this sounds great, except that merger arbitrage funds have performed horribly in recent years. The Merger Arbitrage Index returned a measly 2.5 percent annually over the last five years through July 2016 due to a confluence of headwinds.

Like hedge funds generally, merger arbitrage has been a victim of its own success. According to HFR, a research group in Chicago that tracks hedge fund performance, merger arbitrage funds managed a paltry $100 million in 1990. That number ballooned to over $21 billion by June of this year. And unlike many other hedge fund strategies, the money is still flowing to merger arbitrage -- assets in the strategy have grown by 4 percent so far this year.

ma-arbitrage

Also, the environment that followed the 2008 financial crisis was no friend to merger arbitrage. There were too few deals and many of them were completed, while interest rates remained low -- all of which, together with the piles of money chasing deals, translated into thin spreads.  

Tight spreads are kryptonite for returns. A 2010 study of merger arbitrage by Gaurav Jetley and Xinyu Ji looked at spreads and returns from 1990 to 2007 and found -- no surprise -- that lower spreads resulted in lower returns.  

This brings us back to our recent round of deals left at the altar. In 2014, deal flow picked up after U.S. drug-makers sparked a global takeover frenzy. More deals meant more opportunity for busts, and all of a sudden arbitrageurs confronted a minefield. They began demanding higher payoffs for their trouble. Average spreads soon crept above 5 percent -- a mark prized by arbitrageurs -- and remain a lofty 5.9 percent today.

There's already evidence that higher spreads are translating into higher returns. The HFRX Merger Arbitrage Index has returned 6.8 percent over the last year through July 2016, while the HFRX Aggregate Index -- a broader measure of hedge funds -- has returned just 0.3 percent over the same period.

Of course, there’s no guarantee that merger arb specialists will successfully sidestep all abandoned deals. But the opportunity to do so gives them and their investors a glimmer of hope in what is otherwise a brutal environment for hedge funds.

-- Rani Molla contributed graphics to this column.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net
Tara Lachapelle in New York at tlachapelle@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net