Merger arb has been a popular strategy among hedge funds for a decade now, and recently more and more individual investors have been getting in on the act.
Essentially merger arb involves taking a long position in the target of an announced acquisition deal, a short position in the acquiring firm, and then waiting for the deal to close. The strategy has generally worked reasonably well for years now, providing a safe and mostly uncorrelated return stream relative to the broader market. Those returns are at risk going forward.
It’s highly likely that merger arb is headed for a terrible couple of years, but that’s actually good for the strategy in the long term. Let me explain.
Merger prospects are facing a very difficult few years. The DOJ and FTC are going to become the worst enemies of merger targets and merger arb investors alike. This reality carries two implications – investors need to be a lot more careful in selecting merger arb investments, and companies need to become quicker and more risk averse when doing deals.
One example is the Walgreens acquisition of Rite Aid. Both sides recently agreed to extend the end date of their merger agreement from October 27, 2016 to January 27, 2017. This strategic deal for the buyer has a solid merger agreement on antitrust if it can resolve its divestiture package soon. For investors, the $2 WBA-RAD arb spread offers a 95% IRR if the deal closes by February. Whether you are a Republican or Democrat though, it is hard to deny the fact that Hillary Clinton is almost certain to be the next President. As soon as that happens, deals like WBA/RAD are going to be MUCH harder to close. Investors and companies alike should look out.
Abbott and Alere are another example of a deal that is getting riskier by the day. Virgin Air and Alaska Air are a third example. The Bayer/Monsanto deal is basically a bad joke at this point. Given Democratic pressure from the hard left, it is almost inconceivable that deal will pass. It goes without saying the massive AT&T and Time Warner deal is in similar jeopardy. Bernie Sanders is already out in force against the deal, and the biggest pressure for Clinton will come from the need to keep Sander’s supporters in-line. AT&T is going to need all the luck and lawyers they can muster.
The broader point though is not that these type of deals are any harder to close than those that they were a few years ago – they are not - it's that the regulatory environment is changing right now. The FTC of tomorrow is going to look like the already testy activist DOJ of today. The FTC is shorthanded. Like the Supreme Court, vacancies are sitting open awaiting the new administration. Currently, the commission has a Republican, a moderate chairman, and a hard left progressive skeptical of the free enterprise system. Guess what current member is going to find a lot more support under Clinton?
In the long term, merger arb should benefit from the coming catastrophe. As investors see the first couple of deals collapse, they will likely flee the space. That in turn will produce wider deal discounts and better merger arb spreads. Over time, that shakeout will generate strong profits for investors who stick with the strategy in a prudent and patient manner.
The mechanics of the shakeout are likely to play out very much like the cyclical boom and bust process that occurs in the reinsurance space – those reinsurance firms that have the wherewithal to stay in the strategy after a major hurricane tend to be the ones generating alpha over time. The same thing will probably occur in the merger arb space. Investors should decide whether to bail or ride out the storm now while the waters are not too choppy.
Mike McDonald is a PhD in finance and a university professor in the subject. He also runs a consulting company doing work on quantitative investing, big data, and machine learning for a variety of financial firms, asset managers, institutional investors, and government regulators. Prior to getting his PhD, Mike worked for a major Wall Street bank and one of the top hedge funds. Comments, questions, and concerns are always welcome – email Mike at M.McDonald@MorningInvestmentsCT.com or visit his firm’s website.