Merger arbitrage as a low-volatility strategy
Four reasons for positive future returns
If you type the search term “analogy for volatility,” the results will include comparing volatility with riding an elevator while simultaneously playing with a yo-yo – the toy goes up and down (like the market), but you still reach the next level. There’s also a comparison with driving along a bumpy road, wet with rain, with lots of tricky curves. Riding a rollercoaster is another go-to analogy. But where are the analogies for avoiding volatility? Head in the sand? Bills stuffed under the mattress?
Today’s investors are seeking the perfectly-seasoned dish of low volatility, predictable long-term returns to support buying power, a low correlation to equities and bonds, and preferably, tax efficiency. Merger arbitrage strategies check all these boxes. In this article, I will focus on merger arbitrage as a low volatility investment strategy.
We’ve experienced more volatility to start this year but, historically merger arbitrage is a low-volatility strategy with amongst the highest Sharpe Ratios compared with traditional and alternative investment strategies.
One reason for this is that each merger arbitrage deal has idiosyncratic factors that have little or nothing to do with the general market or with other deals, for that matter. When you have a portfolio composed of 40 different deals, with no deal having a greater than 3% weighting, the portfolio is sufficiently diversified to reduce specific deal-risk in any one name or sector, and it potentially smooths volatility. Keeping some cash on the sidelines as deals close allows investors to wait for spreads to widen to take advantage of attractive yields.
Admittedly, it’s been a challenging year for merger arbitrage strategies. This is mostly due to a perfect storm of big-name deal breaks, widening spreads due to volatility, de-grossing impacts, and deal extensions. Yet despite the current challenges, the HFRI Merger Arb Index has only had two years of negative performance since 1990 and delivered 4.6% during the past decade.
Over a cycle, merger arbitrage has historically returned 200-300 bps over the risk-free rate. Today that spread is wider as investors are demanding a larger premium. Practicing a little second-order thinking to look beyond the immediate and short-term issues, we see a solid runway for future positive returns for four reasons:
1. Deal vintage
All of these riskier deals are either large-caps or of an older vintage (more than 12 months’ duration). The risk profile of more recent deals is lower as they were negotiated and priced in an environment of higher interest rates, greater volatility, and more recent valuations.
2. De-grossing impact
The regional bank crisis and major deal-breaks have had a de-grossing impact on the arbitrage space. They result in arbitrage funds and investors in the industry having to raise cash, reduce leverage, and reallocate positions. This results in widening spreads. A wider spread without a change in deal-risk or extension-risk simply pushes out the return to the close date so you eventually make up for the short-term impact with higher potential returns. For example, new, high-quality deals announced in the last few weeks are trading at much higher implied yields (8%-11%).
3. Pent up demand
After a spike of activity in the small-cap universe in late 2022, deals have lagged. These types of organic M&A deals have historically been strong contributors to performance. Within our universe of companies, we see a significant number where there is either an offer already in hand, an expression of interest, or a strategic review seeking a sale. When the right conditions materialize, they should provide future high-quality deal-flows for arbitrage funds. Biotech, tech, and infrastructure are some of the key sectors currently exhibiting more, high-quality deal flow at higher implied yields.
4. Short duration
An advantage of merger arbitrage is its short duration, which gives investors the ability to be nimble and react to more difficult conditions by demanding a higher return on new deals. We see this happening today with new, high-quality deals trading at wider spreads. As the interest rate cycle remains uncertain and arbitrage deals are trading at wider spreads until final deal approval, we believe it is prudent to practice patience and get involved later in the deal process.
This is a time to practice patience and prudence in merger arbitrage. Pent-up demand is there, however, and ready for a catalyst to get the deal flow moving at its customary and historical pace.
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Amar Pandya, CFA, is Portfolio Manager of the Pender Alternative Arbitrage Fund and the Pender Alternative Special Situations Fund at PenderFund Capital Management.
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