Is Merger Arbitrage Going the Way of the Dodo?

by: Christopher Holt

Hedge funds are a diverse lot. Over time, the success of various hedge fund strategies can diverge significantly. Just check out the last 12 months when the HFR Energy hedge fund index was down nearly 40% while “Systematic Diversified”, (a global macro strategy) was up over 6%.

It seems that every strategy eventually has its day in the sun. With many hedge fund strategies showing a healthy dose of cyclicality, it can sometimes be difficult to identify long-term secular changes that could spell doom. Between 2000 and 2004, many prognosticators said that convertible arbitrage was extinct since valuing converts - once rocket science - could now be done on a high school calculator (you know…using the “covert arb” button on your old Casio calculator-watch…admit it, you had one.) Yet the strategy got up off the mat in 2004 and resumed growing until recently being sideswiped by short-bans.

Now two researchers are suggesting that a secular shift is heralding the gradual downfall of another traditional hedge fund strategy: merger arbitrage. In a paper called “Merger Arbitrage Spread: Reasons and Implications“, Gaurav Jetley and Xinyu Ji of Analysis Group find that merger arb returns may be suffering from a fundamental and irreversible decline.

They examine the arbitrage spread (the difference between the acquiree’s stock price and the offer price one would expect on closing day). As the closing day get’s closer, this spread generally falls as investors become more and more confident that the deal will be consummated. The larger the spread, the more can be made by merger arbitrage managers who buy the acquiree and often, but not always, short the acquirer.

The problem is, the arbitrage spread has been falling recently. In fact, when Jetley and Ji examine 3 successive 6 year periods they find the arbitrage spread has fallen by more than two thirds since the turn of the century: [ charts]

As a result, says their report, aggregate alpha of merger arb funds has fallen by 41 bps a month (4.81% per year) in recent years…

Worse still, they point to fundamental changes in financial markets as a reason the alpha won’t be returning any time soon…

The decline in arbitrage spread corresponds with the decline in aggregate returns of M&A hedge funds as well as increased inflows into M&A hedge funds…Our findings suggest some of the decline in arbitrage spread is likely to be permanent and thus investors seeking to invest in M&A hedge funds should focus on returns of the prospective funds since 2002 rather than returns over a longer period of time.

So what are these “permanent” shifts anyway? One is a usual suspect in cases of declining hedge fund alpha: too many assets. This is especially acute for merger arbitrage since the number of mergers at any given time is limited. The authors show that the acquiree’s trading volume (in relation to its average volume) was two to three times higher in the ‘02-’07 period than it was back in the early 1990’s.

Other reasons for a declining arbitrage spread are the popularity of cash deals in the leverage-crazy ‘02 to ‘07 period (cash deals have a lower arbitrage spread than stock-based transactions) and a drop in hostile takeovers (which have a higher risk and therefore a higher arbitrage spread).

Okay, so how “permanent” are these changes? With less cash floating around the economy, all-cash deals may take a back seat to all-stock deals for a few years; opportunistic activist investors could reignite the hostile takeover rage, and let’s face it, overcrowding has quickly become a non-issue for almost all hedge fund strategies.

Stripping away various betas may indicate that merger arb alpha is indeed declining. But merger arb managers would likely take issue with the choice of betas that yielded such a conclusion. They would likely point to the chart below from HFR showing that despite the contraction of the arbitrage spread, merger arb returns are looking awfully tasting right now…