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M&A arbitrage: how to make a hedge fund strategy as safe as bonds

M&A arbitrage: how to make a hedge fund strategy as safe as bonds

This article first appeared on Modern Investor magazine

At the end of November, Pfizer announced the largest merger of the year so far. The US-based pharmaceutical giant bought Irish firm Allergan for $160 billion – more than the GDP of Hungary and half that of Malaysia.

If the deal goes through, it will become the third-largest merger ever, topped only by Vodafone’s $171 billion takeover of German company Mannesmann in 2000 and AOL’s disastrous purchase of Time Warner for $165 billion in the same year.

However, the Pfizer-Allergan merger is just one of hundreds of deals struck in the M&A market this year, which has seen a record-high level of activity. According to financial software company Dealogic, global M&A volume from January to October surpassed $4 trillion for the first time – and this number doesn’t include the gargantuan Pfizer-Allergan merger.

However, the booming M&A market doesn’t have a decisive effect on event-driven funds such as the Allianz Merger Arbitrage Strategy. There are more important factors for the strategy, says the fund’s manager, Roberto Bottoli.

‘High M&A activity doesn’t have a direct impact on returns. Of course, it’s an advantage, because it helps with diversifying my portfolio. But, going forward, rising volatility in equity markets will produce higher arbitrage spreads, rather than a larger number of deals.’

A bond Substitute 

Although the level of activity in the M&A market doesn’t affect returns directly, the $373 million fund benefits from a target-rich environment.

Diversification plays a key risk-containing role. So far this year, the fund has acted on 60 deals – twice the minimum number deemed safe by their investment strategy, says Allianz’s alternative investments global business manager, Spencer Rhodes.

‘We are trying to create a portfolio of as many low-risk deals as possible. What we’re giving clients is a pure exposure to deal risk, and we make sure to hedge out any other kinds of risk. It’s a fundamentally different source of risk and returns for a portfolio.’

This low-risk, low-return strategy distinguishes the strategy from other funds in the sector, he says.

‘Merger arbitrage funds can be doing very different things. There are high‑risk and potentially high-return hedge funds that try capture a big, juicy part of return by trying to anticipate a deal or by shorting it.

‘There are also merger arbitrage funds that are well diversified and very low-risk and low-return. We are in the second camp.’

The strategy has proved popular among institutional investors, who currently make up all of Bottoli’s clients. ‘Institutions look at the general merger arbitrage strategy as a kind of bond substitute or absolute return, low-risk strategy,’ he says.

The fund’s results might also be encouraging for investors. Launched in October 2012, it returned 1.75% in 2013 and 1.12% last year, while its benchmark – the EONIA – returned 0.09% and 0.1% respectively. The fund’s performance has improved recently, too: over the 12 months ending in October 2015, it returned 3.94%, whereas the average return of 27 event-driven Ucits funds was -1.89%, according to Citywire data.

Moving Cautiously

Rhodes says the fund has a very systematic strategy to contain risk. ‘We take all deals in the market and filter out the ones which are in the 2% to 5% return target. A deal has to be friendly, not hostile, and have a market cap of more than $200 million.

If all of those things are true, we invest in it – up to a limited position size, of course.’

The fund also acts cautiously when a deal is going exceptionally well. Several rounds of counter bids for chipmaker PMC-Sierra was an example of that, says Bottoli.

‘In the case of PCM-Sierra, we’ve already come to a third round of counter bidding. We gradually decreased our exposure to this company, because the last round of counter bids especially is a bit stretched.

‘Since we’re going for a low-risk, low-return strategy, once we start to get crazily above (our goal) we back out and take profits when some others may play along,’ Rhodes says.

In some cases, the fund is also able to pocket expectations of a counter bid ex ante through the options market, Bottoli says.

Given the vigorous M&A market, the manager will have a lot of work analysing deals that might fit their profile and trying to figure out how to make them as safe as possible.

‘I don’t see M&A activity decreasing substantially in the next two or three years, because monetary conditions will stay relatively loose.

‘When we look at the whole investable universe, there are hundreds of deals that are potentially interesting to us.’

Merging positions to contain risk

Theoretically, the deals selected for Allianz Merger Arbitrage Strategy are uncorrelated with one another.

But sometimes a risk from one source may hamper several deals. When this happens, the fund treats these deals as one, says Rhodes.

 

‘In summer 2014, there were lots of deals in the US where US-based companies were buying foreign companies to get around the US tax regime. The risk emerged that Congress was going to act against this tax inversion, and various deals might have fallen apart for the same reason. So, all of a sudden, they’re not separate deals – they share a risk factor.’

The Pfizer-Allergan merger is also an example of a deal that might face similar regulatory or political pressure, as many commentators suggest the main goal of the merger for Pfizer is moving to Ireland, which has a substantially lower level of corporate tax than the US.

The fund had to contain risk by treating several firms as one position when a trend emerged in China by which stakeholders were bidding to take private Chinese companies listed in the US in order to relist them back in China due to the higher profitability of the market there.

‘It was a compelling deal for stakeholders, but then the Chinese crisis came and all of a sudden it slowed down,’ says Rhodes.

Merging Positions to contain risk

Theoretically, the deals selected for Allianz Merger Arbitrage Strategy are uncorrelated with one another.

But sometimes a risk from one source may hamper several deals. When this happens, the fund treats these deals as one, says Rhodes.

‘In summer 2014, there were lots of deals in the US where US-based companies were buying foreign companies to get around the US tax regime. The risk emerged that Congress was going to act against this tax inversion, and various deals might have fallen apart for the same reason. So, all of a sudden, they’re not separate deals – they share a risk factor.’

The Pfizer-Allergan merger is also an example of a deal that might face similar regulatory or political pressure, as many commentators suggest the main goal of the merger for Pfizer is moving to Ireland, which has a substantially lower level of corporate tax than the US.

The fund had to contain risk by treating several firms as one position when a trend emerged in China by which stakeholders were bidding to take private Chinese companies listed in the US in order to relist them back in China due to the higher profitability of the market there.

‘It was a compelling deal for stakeholders, but then the Chinese crisis came and all of a sudden it slowed down,’ says Rhodes.

The buyer

Raluca Cata - VP of Asset Allocation Strategies, Risklab

Wolfgang Mader - Director of Asset Allocation Strategies, Risklab

The merger arbitrage strategy may work as a substitute for a fixed-income investment because there’s not too much standalone risk.

There are two main reasons why it appeals to institutional investors. First, it offers an attractive alternative risk premium, in the long term uncorrelated to markets.

Second, this strategy has a very clear way of capturing this premium: investing in announced deals, not speculative deals, means the risk is low, as well as volatility. The Sharpe Ratio is above one, and therefore it generates a very attractive performance.

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