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No Shortage Of Opportunities For Merger Arbitrageurs

No Shortage Of Opportunities For Merger Arbitrageurs

Posted December 15, 2022
Lyxor Asset Management

By Amundi Institute

Greater premium from rates, less from idiosyncrasy. Days when merger spreads hovered around 5% last year seem long gone. After reaching a peak near 14% in July, they compressed back to 10%+. Since the summer, spreads were mainly impacted by rising rates and worsening funding conditions, while idiosyncratic risk receded.

Regulation risk, crucial for months, may have eased and contributed to reduce idiosyncratic risk. The U.S. DOJ Antitrust Department lost two legal cases (vs. Change Healthcare and U.S. Sugar Corp) that could result in a less strict rule enforcement, while giving acquirers more means to challenge antitrust decisions. Similarly, in Europe, the CMA eventually validated the Avast and Microsoft acquisitions, which were under heavy antitrust scrutiny.

Contracting M&A activity but richer opportunities. M&A volumes have declined after the record year of 2021, in sympathy with eroding corporate executives’ sentiment and worsening funding conditions. In particular, global liquidity is drying out, corporate savings have melted, and banks’ credit standards tightened (other funding platform remain accessible, though with greater cost and delays). Furthermore, private equity, a key source of funding and sponsorship for M&A, is under more pressure. Markdowns in private assets are yet to come and their own financing conditions have tightened. Increased discrimination from private equity players is thus likely going forward.

Yet, M&A activity remains ample (led by tech and telcos) with few deal breakups, significant hostile transactions, and limited redemption in the merger space. Tighter liquidity suggests fewer cash-funded deals and more stocks-deals, which may be good news for arbitrageurs. Stock-deals imply shorting the acquirer, which offer a natural and cheaper hedge. In contrast, cash-deals tend to be hedged with crowded 6 to 9 months maturing puts, with a costly implied volatility and mobilizing greater capital. Also, cash exposure is greater with stock-deals, a growing source of return.

Moreover, tighter funding conditions and milder private equity involvement also means fewer deals backed by financial sponsors which tend to result in higher deal volatility – a trend already showing in deal spreads. Instead, improving equity valuations are opening more strategic opportunities. Specifically in the U.S., a surging dollar is providing greater buying power abroad. Cross-border acquisitions tend to be more complex and riskier, but can also be juicier. Fewer financial sponsors and more strategic and US-driven cross-border acquisitions sets a favorable combo for arbitrageurs.

Conservative deal pricing. At 10%, spreads remain conservative. Higher compensation required by higher rates and higher corporate credit yields look factored in. Yet, intense hostile acquisitions and potential bidding wars seem poorly priced in. Implied deal probabilities remain low considering the low rate of deal breakups. Moderating deal spread volatility might also not be fully accounted for yet.

The animal spirt in M&A hasn't disappeared

Merger arbitrageurs are not short of ideas. Unlike most other hedge fund strategies, merger managers have fully redeployed capital. Spreads are volatile, but are also high and highly dispersed, which means both greater risk and reward. Cash deals still account for a majority of their positions. Ahead of year-end, they seasonally tend to focus on deals close to completion that offer attractive premium. These deals bear lesser idiosyncratic risk, are usually less volatile and are less correlated to markets (because stocks’ fundamentals are less likely to shift in a few months and alter deal terms). Rate sensitivity is usually lower, as investors hold long-duration positions (acquisitions are funded on a 5 to 10Y+ horizon, an advantage when the yield-curve is inverted) for a short time.

For all these reasons, we believe conditions have once more become much more supportive for merger arbitrageurs despite challenging broader market conditions.

More premium from rates and funding, less from idosyncrasy
More US driven cross-border acquisitions
Fewer financial sponsor usually reduce spread volatility

Originally Posted September 28, 2022 – NO SHORTAGE OF OPPORTUNITIES

Disclosure: Lyxor Asset Management

Lyxor Asset Management S.A.S. (“Lyxor S.A.S.”) is a French investment management company authorized by the Autorité des Marchés Financiers and registered as a commodity trading advisor and commodity pool operator with the CFTC.

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