Hedge Fund Investors Have Fallen in Love With Merger Arb (Again)

  • Outperformance may be short-lived as deal flow slows
  • Paulson & Co., Manikay have raised new funds to bet on deals

With hedge funds losing money and bleeding assets, a handful of firms and clients are pinning their hopes on corporate marriages -- just as the best returns might be behind them.

Billionaire John Paulson’s Paulson & Co., Manikay Partners, a $1.9 billion firm led by Shane Finemore, and Arrowgrass Capital Partners have all raised new funds to speculate on corporate mergers, saying the return expectations are higher than they’ve been for years, according to people familiar with the firms. Multistrategy firms like Taconic Capital Advisors, Farallon Capital Management and Och-Ziff Capital Management LLC have also increased their allocation to mergers.

Merger arbitrage strategies, which generally bet that a target company’s shares will climb toward the offer price and the bidder’s will fall, are among the best performers this year, returning 1.3 percent in the first quarter, while the industry overall is slightly down. Yet returns may falter if merger activity slows.

“The opportunity set is good, but it’s not this massive, juicy pile of money waiting to be scooped up," said Paul Glazer, whose nearly $1 billion Glazer Capital Management has been investing in the strategy since 1999. His main fund rose almost 3 percent this year through April 14 after gaining almost 12 percent last year. “Most strategies have done so poorly, and merger arbitrage really shines in comparison in times of distress like we’ve been experiencing," Glazer said.

Spokespeople for the firms declined to comment for this story.

The number of announced mergers jumped last year by about 50 percent, and that’s a big reason the returns have been higher than normal. There is currently $50 billion to $60 billion of “spread” -- the difference between where stocks of companies in announced mergers are trading now and the final transaction price -- in deals globally, one merger-arb trader estimates. That compares with historical levels of $10 billion to $15 billion.

Deal Slowdown

There also have been fewer traders trying to make money off them. Investment bank proprietary trading desks that used to invest in the strategy are gone. Some event-driven hedge funds that once engaged in these wagers have also stepped back because of poor performance and client withdrawals.

Deal flow has been slowing this year just as hedge funds pour in. After a record year for global M&A in 2015, activity dropped 11 percent in the first quarter from a year earlier to $621.5 billion, according to Bloomberg data. That could eventually lead to lower returns.

Wide spreads have allowed traders to generate higher returns without piling on leverage, Och-Ziff Capital founder Daniel Och said at a conference in March, hosted by the University of Texas Investment Management Co. It’s a “very robust strategy” compared with a year ago, he said.

Other investors agree. "For the first time in probably a decade we’re seeing returns on relatively safe merger deals in the high single digits and low double digits," said Jeff Majit, a managing director at Neuberger Berman Group, whose $38.6 billion alternative investment management unit is raising its exposure to merger-arb funds this year.

Narrowing Spreads

The opportunity might be short-lived, he said. Most of the announced mergers are scheduled to close within the next six months, and spreads will start narrowing during the second and third quarters of this year. If new deals don’t materialize with sufficient spreads, he’ll cut exposure again, a sentiment echoed by the multistrategy firms that have recently increased their positions.

Andrew Spokes, Farallon’s managing partner, said at the Utimco conference that the firm had ramped up merger-arbitrage positions to be the majority of its capital coming into the year, up from 5 percent of assets at the beginning of 2014. While spreads on some of the safest deals have narrowed, there are still opportunities with more complex transactions “that have really attractive spreads if you can analyze your way through it.”

A few broken deals may have already chased away some investors. Earlier this month, Pfizer Inc. decided to terminate its $160 billion merger with Allergan Plc, ending the largest-ever health-care acquisition as Washington cracks down on inversions -- when companies shift their tax address overseas, often via a merger, to lower their tax bills. Allergan shares tumbled 15 percent in a day.

“People get desperate and they stretch for what seems to be relatively riskless returns,” said Brad Balter, head of Balter Capital Management. “They often end up with exactly the opposite result.”

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