Charles Sweat was feeling pretty good at the beginning of July. As co-manager of a merger arbitrage portfolio for $209 billion Dutch fund manager Robeco Asset Management, he’d made a decent return in the first half of 2007 and had plenty of deals to play, including the $96 billion hostile takeover battle for Dutch bank ABN Amro.
But by the middle of August, things had changed drastically. Troubles in the U.S. subprime mortgage market had spilled over into the equity markets, sending stock prices tumbling. Spreads on merger deals widened, and arbitrageurs began to fear that banks might not honor their financing commitments or that buyers might walk away from deals.
An orderly retreat quickly became a rout. When a handful of investors were forced to sell sizable positions, others followed suit as deal spreads blew apart. But Sweat took it all in stride, using the opportunity to make a cheaper entrance into a handful of deals — a tack also taken at the time by many fund managers that don’t usually specialize in merger arbitrage.
“When you see spreads move out across the board, it is more reassuring than when one or two move out,” says Sweat. “It tells you it’s not deal-specific; it’s strategy- or market-specific.”
Though the market has rebounded somewhat since, the volume of M&A deals remains under pressure, as most of the big private equity transactions announced in the first half of 2007 have closed or are falling apart. With private equity firms effectively shut out by the soaring cost of leveraged credit, corporate buyers have come to the fore, though the market has fallen back from the record activity in the first half of 2007. Faced with fewer large deals, many merger arbitrageurs have begun turning to less-traditional event-driven transactions, such as buying companies up for sale at auction, those under siege by shareholder activists or ones simply seen as likely takeover candidates. Arbitrageurs are also casting a wider geographic net, looking for opportunities in Europe and Asia in addition to the U.S.
Traditionally, arbitrageurs make money by capturing the spread between a stock’s price at the time a deal is announced and its price when the deal is completed. To do that in all-cash deals, they typically buy shares in the target below the deal value. In a share-exchange transaction, they also short shares of the acquirer to lock in the spread. When deal volume is strong, the strategy tends to do well.
The first half of 2007 provided just such a scenario, as private equity firms launched a torrent of multibillion-dollar buyouts: Blackstone Group paid $39 billion for Equity Office Properties Trust; Kohlberg Kravis Roberts & Co. bid $44 billion for Texas power company TXU Corp. and $29 billion for credit card processor First Data Corp.; and J.C. Flowers & Co. made an ill-fated $26 billion offer for SLM Corp., the parent of student-loan provider Sallie Mae. Of the total $4.7 trillion in global M&A deals announced in 2007, a record $2.7 trillion took place in the first half of the year, according to London-based data provider Dealogic.
When the credit crunch hit last summer, merger arbs got caught in the backwash. The collapse of several hedge funds, as a result of losses in the credit markets, prompted prime brokers to tighten margin requirements as prices for structured debt tied to subprime mortgages plummeted. To meet margin calls, leveraged hedge funds and proprietary trading desks were forced to raise cash quickly — and merger arbitrage positions were among the first to be sold.
Sweat, who has worked in merger arbitrage since 1997, when he received his MBA from Nashville’s Vanderbilt University and immediately joined a team at privately held commodities conglomerate Koch Industries in Wichita, Kansas, knew that turbulent market conditions can often create investment opportunities. He invested in a handful of deals likely to close that had extremely wide spreads — such as the $6.9 billion merger between regional brokerage firm A.G. Edwards and Charlotte, North Carolina–based bank Wachovia Corp. But such opportunities were short-lived.
After the Federal Reserve Board cut the discount rate on August 17 — to 5.75 percent from 6.25 percent — the credit markets temporarily stabilized. Equities soared and merger spreads snapped back on deals where financing commitments were ironclad and agreements left little room for buyers to wriggle out.
“A lot of the potential was realized quickly,” says William Crerend, CEO of Norwalk, Connecticut–based fund-of-hedge-funds firm EACM Advisors. “For no-brainer deals like First Data and TXU, spreads yawned and then came back by early September.”
Despite the huge drop-off in LBOs — private equity M&A volume fell to $71.8 billion in the fourth quarter of 2007, from $378 billion in the second quarter, according to Dealogic — strategic buyers are still busy doing deals. Preliminary fourth-quarter data pegs corporate M&A activity at $911 billion, the second-highest quarterly figure ever.
But traditional merger arbitrageurs are not the only ones chasing those deals. The wide spreads this past summer attracted new participants — hedge funds that don’t specialize in merger arbitrage, along with several multistrategy managers that set up special-purpose funds to take advantage of the opportunity. Now all that new capital is looking for a place to go.
“Merger arbitrage is a very popular strategy,” says Sweat, who manages about $170 million in unleveraged capital at Robeco. “It is short duration, low volatility and one of the most liquid strategies.”
Hostile takeovers can offset the pressure on spreads that comes from lower deal volume. In volatile markets individual share prices can get beaten down to distressed levels that attract opportunistic buyers and generate more hostile acquisitions. EACM’s Crerend says his event-driven managers would not be surprised to see an uptick in unfriendly deals.
Jesse Ho, a merger arbitrage portfolio manager in the London office of Dallas-based hedge fund Carlson Capital, welcomes the shift away from LBOs because he says it lowers the risk of deals’ not closing. Corporate buyers, which have strategic objectives as well as a financial interest in proposed mergers, are less likely to walk away. Ho believes the weak dollar will attract non-U.S. companies.
“A corporate buyer is still able to get a bank to lend money,” says Ho. He expects to see more share-exchange deals if spreads for corporate credit over Treasuries widen enough to equalize the cost of debt and equity capital.
With banks no longer willing to fund buyouts, private equity firms have had to look for alternative sources of financing. Ho says some hedge funds have stepped forward to fill the gap by providing leveraged loans, much the way they began making direct loans several years ago to corporations too small to access the public debt markets. That’s good news for merger arbitrageurs, as it ensures LBO activity will not disappear.
Developments in financial technology give hedge funds more ways to play the arbitrage game. In the past it was difficult for arbitrageurs to hedge a cash merger. They could buy puts on the Standard & Poor’s 500 index, but there is generally little correlation between the index and the price of a takeover target when a deal blows up. Today, Ho says, arbitrageurs look at the entire capital structure — equity, debt and convertible securities, as well as credit derivatives.
Rather than buy stock in an LBO target, arbitrageurs may trade credit default swaps, expecting the credit spread over Treasuries to widen if a deal is completed. A credit default swap is a form of insurance against default — one party agrees to take delivery of bonds in the event of default in exchange for annual payments, calculated as a percentage of principal, that reflect interest rates on Treasuries plus a credit risk premium. The spread over Treasuries is fixed when the swap is initiated, so if the credit quality improves, the price of an existing swap will rise and new swaps will incorporate a lower spread. In the case of an LBO, which reduces the target company’s credit quality by piling debt on its balance sheet, existing credit default swaps typically tumble in price and new swaps must carry a wider spread.
Swap spreads can raise an early warning flag that a deal is in trouble. Although the proposed acquisition of San Antonio, Texas–based media conglomerate Clear Channel Communications by Boston-based private equity shops Thomas H. Lee Partners and Bain Capital is not contingent on selling the group’s television stations to Providence, Rhode Island’s Providence Equity Partners, the stock price dropped more than $2, to $35, after the early-November 2007 announcement that Providence might pull out. Investors feared the entire deal would fall apart.
Arbitrageurs who monitor credit default swaps had a chance to avoid damage, as swaps narrowed from 300 basis points over Treasuries to 200 basis points ahead of the news. The tighter spread signaled an improvement in Clear Channel’s perceived credit quality, indicating that the market thought the deal was less likely to be completed.
Ho also uses swaps as a hedge. “Sometimes we buy the stock and go long the credit through the credit default swaps,” he says. “If the deal doesn’t happen, the credit spread will revert to normal.” A gain on the trade helps offset any loss on the equity position in a busted deal. It’s a riskier trade now that credit spreads have become so volatile, so Ho has added another dimension: He offsets the single-name credit default swap with an opposite position in a credit default swap index.
Ho is currently hedging his portfolio with a combination of short equity indexes, short credit instruments and a short basket of financial stocks. “Takeover stocks are correlating more closely with financials than they are with industrials,” he says. “The health of financials is influencing deal completion risk.”
Judy Posnikoff, a co-founder and managing director at Irvine, California–based Pacific Alternative Asset Management Co., a $10.5 billion fund-of-hedge-funds manager, says the volatility of merger arbitrage returns has risen as mandates have broadened and managers hedge less. She says unlevered returns have averaged 300 to 400 basis points above LIBOR in the recent past, but she expects future returns to be lower. “Traditional merger arbitrage is not going to pay as well as it has the last couple of years,” says Posnikoff, adding that too much money is chasing fewer deals.
As a result, managers are scouring the world for opportunities. Even new funds headquartered in New York are setting up offices in London and in some cases Asia. Posnikoff expects corporate consolidation to continue to drive deal flow in Europe. And though the environment may not be strong, she still expects decent returns from merger arbitrage funds.
“If the equity markets sell off hard, that could throw a spanner into it,” she says. “But barring that, in the U.S. the weak dollar will make cross-border deals more attractive.”
EACM’s Crerend expects to see fewer large-capitalization LBOs in the coming months, but he too is optimistic about the prospects for merger arbitrage. He says strategic motivations for corporate buyers haven’t disappeared. Private equity funds also have plenty of dry powder, although Crerend foresees a shift toward middle-market targets while the credit crunch persists.
In normal market conditions, the returns on classic merger arbitrage trades have become so tight that it has all but vanished as a stand-alone strategy. Crerend says event-driven merger arbitrage mandates can still deliver returns of 500 basis points over LIBOR, but those returns will come with higher volatility — a conflict most investors haven’t acknowledged.
“People want higher returns, but they really like the low historical annualized standard deviation,” says Crerend. “That’s not going to be the environment going forward.”
Even a traditional merger arbitrageur like Robeco’s Sweat expects to eke out acceptable returns in the current market. He too has written off the big $15 billion–plus private equity club deals for now. But he predicts a flow of smaller transactions subject to financing in which the banks fund the senior debt, the high-yield market takes the junior debt, and interest coverage ratios drop back to where they were a couple of years ago.
“You won’t see the merger premiums you have seen in the past in the LBOs,” says Sweat. “The strategic buyers can now come back into the game, and from a capital structure standpoint, you should see more stock transactions.” Like many arbitrageurs, Sweat prefers all-share deals because they offer a natural hedge against market movements. As long as there is some merger activity, he and his fellow arbitrageurs will find ways to make money.
