Magazine Issues » April 2016

HEDGE FUNDS: The resurrection of merger arbitrage

ProppingMerger arbitrage, an original darling of hedge fund strategies, has gone through some tough times. With Ucits versions of the strategy liquidating, David Stevenson asks if there is still any interest.

Last year, Hillary Clinton made a public plea for pharmaceutical companies to keep their costs down amid a scandal involving US pharma giant Valeant, in which she singled out a drug produced by the company that had increased in price by 356% over the year. Whether this was political brinksmanship or a deeply held conviction regarding social equality didn’t matter to the dons of the hedge fund world – that announcement lost them billions. 

Healthcare is a hotbed of merger activity and any fund worth its salt involved in merger arbitrage will have a strong holding of deals in this sector. But the Valeant scandal, involving a firm known for acquiring others, came hot on the heels of the failure of the Abbvie-Shire deal at the end of 2014.

“I’m not a big fan of merger arbitrage - small gains, large losses. Everybody was bullish on merger arbitrage due to volumes, but it doesn’t matter for the strategy. What matters is deal spreads,” says Nicolas Rousselet, head of hedge funds at Unigestion.

He says spreads were not great even before the Abbvie-Shire deal fell through and, in the end, that’s what makes this strategy attractive.

Merger arbitrage is essentially quite a simple strategy. If a deal is announced and it’s a stock-for-stock deal, a manager will go long on the target and short the acquirer. If it’s cash-only, the manager can only go long on the target, but managers may also overlay a portfolio-level hedge using an option to reduce the volatility as, unlike with the short position in a stock deal, there’s no hedge in a cash deal. Rather, you just wait for the deal to close and collect the premium on completion.

But to really guarantee a return with no risk, the key is to invest in a deal that is close to completion and practically a certainty. This is where Rousselet believes Ucits can be a hindrance as it limits the holding a fund can have in the target firm to 10%, which limits any upside the completed deal will have on returns.

Yet Andrew Dreaneen, head of GAIA (Global Alternatives Investor Access) business development and product at Schroders, sees this as just a difference between models. He says that if the stock did well, it would be a big return driver for the hedge fund, although if it went down, then Ucits funds – such as Schroders’ Paulson GAIA Merger Arbitrage Fund – would lose less due to limited exposure.

Other proponents of using the Ucits umbrella for merger arbitrage include Jan Tille, a researcher at German financial information firm Absolut Research. He says merger arbitrage “fits quite well into the Ucits framework”, but adds there might be distortions due to ‘5/10/40’ diversification rules.

These rules are one of the most commonly known restrictions in Ucits. A maximum of 10% of a fund’s net assets may be invested in securities from a single issuer; investments of more than 5% with a single issuer may not make up more than 40% of the whole portfolio.

But many firms replicating hedge fund strategies under a Ucits umbrella have not performed well, despite the fact that the Ucits rules should have protected funds from going ‘all in’ on deals. In the past year, Westchester, PineBridge Investments and Sandell Castlerigg Investments have all liquidated their merger arbitrage funds.

When contacted, Westchester simply said there was no investor demand for the strategy under Ucits. Westchester follows more or less the basic merger arbitrage strategy within a global equity universe and has typical position sizes in the range of 3% – not a problem under the Ucits framework. But as the firm suggests, the Westchester fund did not gain traction – despite a relative stable performance until 2015, when it lost about 4.4%.

Castlerigg’s Ucits fund, on the other hand, incurred heavy losses in 2015, losing 30% between February and November. However, the fund was quite large and started with $200 million (€176 million) on the Merrill Lynch platform. The assets quickly dropped after October 2014, perhaps falling prey to the failure of the Abbvie-Shire deal.

PineBridge Investments’ merger arbitrage funds never really gained any traction: the fund moved sideways, with 2.5 % cumulative growth in five years.

However, it was not a complete washout for merger arbitrage Ucits funds. Laffitte Capital Management’s Risk Arbitrage fund is up 5.3% over the 12 months to February this year. The fund focuses on merger arbitrage in Europe and North America. Another merger arbitrage Ucits product to perform well is Lutetia Capital’s Patrimoine fund, up 3.2% over the year and 18.8% since inception.

The factors these funds must take into account when investing in deals include competition issues, financing, shareholder votes and regulatory issues that may lead to a deal break. Under Ucits, spreading investments across a variety of deals and not going in too heavy on one can produce steady bond-like returns – as opposed to a high-conviction bid for a company that may be rumoured for a hostile takeover, that offshore equivalents can take part in and reap the rewards from the greater risks. 

One of the strongest-performing merger arbitrage Ucits vehicles is Schroder’s Paulson fund, managed by  John Paulson, the head of US hedge fund giant Paulson & Co. Starting with only $250 million in 2014, it has grown to over $800 million today. However, the fund lost 15% between March 2015 and February 2016, one the largest losses among all Ucits merger arbitrage funds. A representative of Paulson & Co. told Funds Europe that this was largely due to holdings in Valeant.

The deal went bad as Paulson & Co held roughly 6 million shares of one of Valeant’s targets, Allergan, making the firm’s stake roughly $1 billion. Paulson predicted Allergan’s share price would soar using Valeant’s chief executive officer’s cost savings, which had made the company such a success until political intervention scuppered the deal.

Paulson was not alone in suffering at the hands of Valeant’s alleged dubious drug-pricing policies. Bill Ackman’s Pershing Square, in 2014 one of the world’s best-performing hedge funds, lost more than a fifth of its value up to the end of last year after its outsized position in the US drug company tumbled.

Philippe Ferreira, senior cross-asset strategist at Lyxor Asset Management, says: “The consolidation in pharma has been happening for a few years, with lots of M&A, there’s interest from merger arbitrageurs. But then Hillary Clinton said they would investigate price increases, which led to fears of price controls, so the entire sector was impacted beyond the specific companies targeted by the political players.”

While drug companies have been the choice names for merger arbitrage funds for some time, given the amount of consolidation among companies in the sector, there are other opportunities. 

“There’s a healthy amount of consolidation among hotel groups, there are some interesting elements with competitive bidding situations,” says Alper Ince, a sector specialist who heads the management of event-driven strategies at hedge fund investment manager Paamco.

Away from sector selection, merger arbitrage has additional benefits compared to other strategies. The large event-driven firms are tending to shift their capital into merger arbitrage at the moment, as it’s considered more attractive than other sub-strategies of the event-driven category.

As Rousselet at Unigestion says, one reason the strategy is currently so popular may be the various fund liquidations, and other managers tiring of getting burned after a two-year pharma shock, traditionally the sector with the most M&A action.

“There is a lot of fatigue in the event-driven space so merger arbitrage spreads are wider, there’s less capital chasing fewer deals,” he says.

While Rousselett is unsure how long this is going to last, Ince of Paamco is not worried due to the nature of the strategy. Ince says when there’s an issue like a deal break, firms tend to liquidate merger arbitrage first because it’s a very liquid strategy. This creates trading opportunities for investors who can take advantage of those dislocations and attractive spreads.

Compared to other event-driven sub-strategies, current market conditions make merger arbitrage a clear winner. For example, Lyxor’s Ferreira says special situation funds tend to be more concentrated and market directional than merger arbitrage, and with exposure to credit. He says this strategy also has the biggest drawdowns, which is why Ferreira continues to be positive on merger arbitrage.

Also, it is difficult for a special situation funds to be used in a Ucits format, according to Ferreira. Some special situation funds were down between 15%-20% last year and as this strategy deals with credit, it can’t fit in with the Ucits rules that ban credit-type funds. 

But with heightened market volatility, a healthy line of M&A activity and a reduced number of firms using the strategy, especially under Ucits, then – after two years of misery – the foundations seems be laid for a merger arbitrage renaissance.

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