Overlooked and unloved, merger arbitrage could generate returns in 2022

Merger arbitrage may be the hottest ticket for strong returns this year.

Kevin Russell, CIO of UBS O’Connor, the hedge fund, wrote in his annual letter Wednesday that the manager will increase its focus and allocations to the arb merger in 2022. The strategy, in which investors buy and sell the shares of two companies involved in a merger, is a central part of O’Connor’s approach since the hedge fund launched in 2000. In recent years, Russell wrote, the manager has not viewed the strategy as a fundamental driver of return, but now believes it deserves increased investor attention.

“I didn’t bring it to investors’ attention,” Russell said. Institutional investor. “The strategy’s returns were decent last year; they weren’t spectacular. [But] we see that the outlook for returns will be significantly higher in 2022.”

Russell said the record M&A deal activity the market saw last year is a strong indicator of the strategy’s potential in 2022. At the end of 2021, M&A deals set a all-time high when they topped $5.8 trillion, and few think activity will slow anytime soon. Like II previously reported, 92% of respondents to Deloitte’s 2022 M&A future trends survey expected deal volume to increase or stay the same over the next 12 months.

“We expect continued high levels of deal announcements and deal activity [to continue]”, said Russel. In addition to the large volumes in progress, there is a backlog of transactions that have not closed in 2021, which has created another opportunity to generate returns for investors. He added that the Investment banks that O’Connor partners with all expect robust M&A activity to continue this year.

Chris Pultz, portfolio manager at Kellner Capital, an alternative investment manager specializing in merger arbitrage, said rising interest rates would also boost the strategy’s performance. Merger arbitrage, Pultz said, is one of the few investment strategies that is positively correlated with interest rates. “As interest rates rise, spreads on transactions and yield rates also rise,” Pultz said. II.

For players like Kellner, who focus specifically on strategy, these factors provide an advantage. Pultz, who has been with the firm since 1999, said the investment strategy goes in and out of fashion largely based on the spread environment, trading environment and interest rates. interest. More than a decade ago, big hedge funds like Perry Capital, which closed in 2016 and became a family office, and Jamie Dinan’s York Capital, which closed in 2020, steered their assets under management largely towards arb fusion. While money is still flowing in and out of strategy, less money is explicitly dedicated to it, and overall fewer players are in the space, Pultz said.

While the arb merger has always been considered a cyclical strategy, Russell said he believes the strategy is pivoting to become a consistent, uncorrelated approach to investing. “The market [has] had a rough start to the year, unlike mergers and acquisitions,” he said.

The uncertainty of the transaction adds a certain level of risk. With funds typically taking a long position in the acquired company and shorting the acquiring company, a failed trade will leave a mark. If the merger or acquisition is not completed, as was the case in the collapse of the $30 billion deal between Aon and Willis Towers Watson in July 2021, participants stand to lose revenue. silver.

However, Pultz said, M&A deals have historically had a high success rate, and those failures are few and far between. Russell added that while some of the blame for potential failures and other challenges, such as increased regulatory scrutiny, may lie with investors and managers, all parties are aware of the potential pitfalls and are generally taking action. to avoid them.

“We and most other investors have already factored this higher approval risk into the assessment of deal-breakers and are demanding higher base yields,” Russell wrote in his letter. “Most importantly, the companies announcing the deals and their advisers also know that this regulatory landscape has changed, so we can expect them to be more measured in the forms of consolidation and market power being pursued.”