by It’s been a big year for mergers and acquisitions. The combined value of worldwide transactions is on track to hit .6 trillion in 2015, an increase of almost 25 percent over last year’s .1 trillion. All signs point to the deal frenzy continuing, too. So how can a savvy investor take advantage of the increased appetite for deals? By investing with even savvier ones. Credit Suisse’s Private Banking & Wealth Management Division thinks the time is right to invest in hedge funds that specialize in merger arbitrage. In the typical M&A deal, merger arbitrage is a pretty straightforward strategy. It all starts with an acquiring company making a bid for a target company, at some premium to the target’s current stock price. While the price of the target tends to rise when a bid is announced, it usually doesn’t rise all the way to the level of the bid, and it’s in that gap that the arbitrage opportunity can be found. When news of the deal breaks, the arbitrageur simultaneously buys stock in the target and shorts stock in the acquirer. If the deal pans out, those shares of the target will eventually be converted into shares of the acquirer — but at a higher price – and the arbitrageur delivers those shares to close out the short position, keeping the difference as profit.
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It’s been a big year for mergers and acquisitions. The combined value of worldwide transactions is on track to hit $2.6 trillion in 2015, an increase of almost 25 percent over last year’s $2.1 trillion. All signs point to the deal frenzy continuing, too. So how can a savvy investor take advantage of the increased appetite for deals? By investing with even savvier ones. Credit Suisse’s Private Banking & Wealth Management Division thinks the time is right to invest in hedge funds that specialize in merger arbitrage.
In the typical M&A deal, merger arbitrage is a pretty straightforward strategy. It all starts with an acquiring company making a bid for a target company, at some premium to the target’s current stock price. While the price of the target tends to rise when a bid is announced, it usually doesn’t rise all the way to the level of the bid, and it’s in that gap that the arbitrage opportunity can be found. When news of the deal breaks, the arbitrageur simultaneously buys stock in the target and shorts stock in the acquirer. If the deal pans out, those shares of the target will eventually be converted into shares of the acquirer — but at a higher price – and the arbitrageur delivers those shares to close out the short position, keeping the difference as profit. The risk, of course, is that the deal doesn’t pan out, in which case the potential returns move into reverse, leaving the arbitrageur exposed to losses.
A Credit Suisse index that tracks merger arbitrage performance shows that the strategy has delivered average annual returns of 6 percent a year since 1994, lower than the bank’s broad hedge fund index, which returned 8.4 percent over the same time period. At the same time, however, it has experienced less volatility – 4 percent on an annualized basis compared to 7.1 percent for the overall hedge fund index. Because merger arbitrage profits hinge on the fate of specific deals, they are also less correlated to the stock market overall than other hedge fund strategies. During the severe selloffs of 2008 and October 2014, the merger arbitrage index suffered smaller drawdowns than the overall hedge funds index. Both the lower volatility and the lack of correlation make the strategy a useful addition to an overall portfolio.
Merger arbitrage funds perform best when both deal volumes and premiums – the difference between the buyer’s offer and the seller’s stock price – are rising. That’s been the case since 2014, as better financing conditions, improving business confidence, and higher corporate profits have pushed deal volumes and premiums higher. And the strategy will keep working until premiums, pushed higher by competitive bidders and confident sellers, reach their peak.
There is ample historical evidence that M&A activity has not reached that overheated point yet. According to Datastream, both the number (884) and value ($1.5 trillion) of global equity M&A deals so far this year is well below the approximately 1,500 deals worth some $3 trillion completed in 2007. Deal values are also low relative to 2007 as a percentage of market capitalization – 4.6 percent compared to more than 7 percent eight years ago. Though they have been rising for the last few quarters, at 25.4 percent in the first half of 2015, the premiums that acquirers are paying for target companies are below their 12-year historical average of 27.1 percent as well as the 2009 peak of 33 percent. Private equity firms have been relatively quiet during the M&A recovery, backing just 5 percent of deals to date in 2015, compared to 9 percent in 2014, according to the Wall Street Journal. Buyout firms could yet drive a wave of new deals.
The overall market environment is also supportive for further M&A. U.S. companies have plenty of cash, very little debt, low financing costs, and an abundance of CEO confidence. At the same time, there’s a revenue recession going on, which Credit Suisse thinks will encourage further consolidation. There’s always a risk that a deal doesn’t go through, but for now, Credit Suisse believes the potential reward from using merger arbitrage to tap into an accelerating M&A cycle outweighs those risks.