How to find the best merger-focused arbitrage funds as regulatory threats increase

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Perhaps the biggest sign that the environment has become more difficult for merger arbitrage funds has been the collapse of the $ 30 billion deal between the insurance brokerage giants.


Aon

and


Willis Towers Watson

in July, after the US Department of Justice filed an antitrust complaint against her. Attorney General Merrick Garland called the failure “a victory for the competition and for American businesses, and ultimately, for their customers, employees and retirees across the country.”

Regardless of the veracity of his statement, it is clear that the collapse was bad for merger funds, which depend on closing trades to generate returns. When a merger is announced, the shares of the acquisition target typically rise near the publicly disclosed acquisition price, but not quite, as investors are uncertain whether the deal will close. The arbitrators call the difference between the two prices the “spread”. They invest after the trade is announced, expecting to profit from it when the connection is terminated and the spread closes. This transaction-dependent return is largely independent of market movements, which makes alternative investment merger funds attractive.

But in July, President Joe Biden issued an executive order, dubbed Promote competition in the US economy– this worries the arbitrageurs. The order “reflected to some people that it was trying to create a less conducive environment for mergers and acquisitions,” said Roy Behren, co-manager of $ 4.2 billion.


(symbol: MERFX), the oldest mutual fund focused on corporate marriages. “Regulators were going to get tough and be more stringent on approvals. “

Worse, China is scrutinizing deals between US tech companies that do business there, like chipmakers.



Advanced micro-systems

(AMD) and


Xilinx

(XLNX), who recently encountered obstacles with that country’s regulator, the State Administration for Market Regulation, or SAMR. This has resulted in significant widening of spreads and arbitrage to lose money on some mergers.

“SAMR is widely viewed in the arbitral space as a black box,” says Eric Fritz, co-manager of the NexPoint Merger Arbitrage (HMEZX) fund. “We do not have great transparency in these [regulatory] merger reviews. He largely avoids agreements with exposure to China.

The average spread has been 6% to 7% recently, says Fritz. At the height of the pandemic market fall in March 2020, it was closer to 8%, he notes, with investors worried that many proposals would collapse. A more typical spread before Covid was 4%.

That’s not to say investors should avoid merger funds. Widening spreads presents opportunities for higher returns for anyone who can determine which trades will go through. Still, that means you should generally avoid fusion-arb index funds – there are a handful of exchange-traded stocks – which don’t distinguish between good deals and bad.

“Rules-based or index-based ETFs do not allow active management to quickly navigate issues like China, large contract terminations or changes in [political] administrations, ”says Greg Bassuk. Bassuk is CEO of AXS Investments, which offers an actively managed merger fund,


Fusion AXS

(GAKAX). He is also a co-founder of IndexIQ, the asset manager that launched the first merger ETF—


IQ Merger Arbitration

(MNA) – which New York Life Investments acquired in 2014.

Fund / Ticker Fund size in millions of dollars Total cumulative return for the current financial year Total return 3 years Total return 5 years Total return 10 years Volatility 5 years
Arbitration / ARBFX 1651 1.2 4.1 3.1 2.3 2.9
Fusion AXS / GAKAX 77 -1.1 1.3 1.6 N / A 4.2
BlackRock Event Driven Equity / BALPX 8454 1.3 5.3 5.7 9.4 4.3
Driehaus Event Driven / DEVDX 196 5.7 12.9 9.9 N / A 10.5
Gabelli ABC / GABCX 734 2.9 3.1 2.7 3.2 3.1
Merger / MERFX 4231 -0.6 4.1 4.3 3.3 3.1
NexPoint / HMEZX Merger Arbitration 290 4.2 7.5 6.8 N / A 3.8

Notes: Returns as of September 17, 2021. Three, five and ten year returns are annualized.

Source: Morning Star

Some arbitrageurs prefer the flexibility of investing in corporate events outside of mergers, such as spin-offs and balance sheet restructuring. “Funds that are only fusion arb only have one sandbox to play in,” says Yoav Sharon, co-manager of


Driehaus event

(DEVDX), a mutual fund that recently only had about 10% of its portfolio in arb merger. “If we were only doing merger arbitrations, we would probably be involved in every deal we make. Instead, Sharon currently favors the bonds of companies that refinance or repay their debts; these represent 20% of its portfolio.

Such flexibility can increase returns – and risk – by linking performance more closely to the volatility of securities markets. For example, in the second quarter of this year, the fund held stakes in four small banks, including


Bancorp blue foundry

(BLFY), which recently went public in a process called demutualization. Sharon and her co-managers see these banks as acquisition targets because they are cheap, and the big banks are gobbling up smaller ones. Yet being an unofficial target is not the same as an advertised target, so their stocks always behave more like the rest of the market. This helps explain why Driehaus Event Driven’s 9.9% five-year annualized return, as of September 22, beats 91% of its event category peers, but its 10.5% annualized volatility is significantly higher than the category average of 5.9%.

Still, for merger-oriented arbitrageurs doing their homework, positions concentrated in the best deals can produce strong risk-adjusted returns. As of June 30, NexPoint Merger Arbitrage held 62% of its assets in 10 potential transactions. Until September 22, it had beaten 89% of its peers in the past five years with an annualized return of 6.8%, but with only a volatility level of 3.8%.

“A big part of our success has been avoiding the explosion of the deal,” Fritz said. The fund has only experienced two months of decline in the past three years, a loss of 0.11% in June 2019 and a decline of 1.8% in March 2020, when the


S&P 500

the index slipped 16%.

Fritz generally avoids planned acquisitions involving larger companies, which are most likely to invite antitrust review. Instead, it favors those with a target market value of less than $ 10 billion. “Transactions above this level tend to have a failure rate almost twice that of transactions below this level,” he observes. His biggest bet recently was an 11% weight in the health insurer’s $ 2.2 billion acquisition


Centene

(CNC) of


Magellan Health

(MGLN) – fry much smaller than the


Aon

(AON) okay.

Larger arbitrary funds struggle to invest significantly in smaller mergers, which are less liquid than mega. The $ 8.4 billion


BlackRock Event Driven Actions

(BALPX) acknowledged in its Q2 commentary that issues with the Aon / Willis and AMD / Xilinx agreements were hurting performance. The fund’s $ 20 billion average market capitalization for its investments is well above NexPoint’s $ 5 billion. This year, through September 22, it was up 1.3%, compared to 4.2% for NexPoint, $ 279 million.

Other notable arbitrage managers have also been affected by Aon’s explosion. In their July commentary, senior manager John Oricco and his famous $ 1.6 billion co-managers


Arbitration

(ARBFX) indicated that he had exposure to Aon / Willis. But instead of selling, they said they were “looking to increase our exposure to [the deal] opportunistically, to take advantage of the dislocation of post-break spreads. As of September 22, the fund had only grown by 1.2% in 2021. Smallest, $ 736 million


Gabelli ABC

(GABCX), up 2.9% in the same period, had invested $ 8 million in Willis Towers Watson (WLTW) in June, but has yet to reveal whether it added to the deal broken or if it had been sold.

E-mail: [email protected]

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