Opportunity Set From Increased Corporate Deal Activity

 

Corporate deal activity is finally on the rise. After years of lackluster deal volumes, corporations are getting more aggressive with strategic activities. The value of global mergers and acquisitions (M&A) rose to $1.77 trillion in the first half of 2014, a 73% increase from the same period in 2013 and the highest level since 2007. The number of megadeals has also surged, with 46 deals worth more than $5B announced in 1H 2014, up 130% from the previous year.1

Corporate Transaction Volume Should Remain High

We expect the elevated pace of corporate transactions to continue for a variety of reasons. The macro backdrop is benign, interest rates are low, market volatility is subdued and capital markets are eager to provide financing, if necessary. Companies with low organic growth prospects are looking externally to deliver top-line growth to shareholders. Cash levels on company balance sheets stand at all-time highs at around $1.6 trillion, according to Moody’s Investors Service.2 Even so, unlike the last market cycle leading into 2008, companies are increasingly using their stock as a currency to buy other companies.

Activist Shareholders Driving Deals

An area that deserves greater focus is the role of activist shareholders in driving deal flow. While return on capital has historically been the main message of activist campaigns, advocating for synergistic deals looks to be a major catalyst during this M&A cycle as evidenced by significant inflows into activist hedge funds. According to Hedge Fund Research, activist hedge funds held an estimated $100.5 billion as of March 31, 2014, up from $93.1 billion at the end of 2013 and nearly triple the $32.3 billion in assets at the end of 2008.3 Activists tend to use dedicated special purpose vehicles (SPV) to invest in specific positions, which increases their firepower to be able to influence company boards. During the first half of 2014, 148 activist campaigns were launched, the most since the financial crisis.4 Median activist targets exhibited 352 bps of equity outperformance versus their relevant comparable sector post the announcement date of the activist’s involvement, according to Goldman Sachs.5

Deals Abound in Healthcare . . .

Deal activity has been strong in multiple sectors, but the largest deals thus far this year have been in healthcare and telecommunications. The healthcare sector is experiencing record levels of consolidation with announced megadeals, most notably the Valeant/Allergan transaction. Big pharmaceutical companies are finding that mergers are a faster way of improving bottom-line earnings than relying on research and development-driven internal growth. Tax benefits from consolidating in jurisdictions with lower corporate tax rates than the acquirer’s home jurisdiction (tax inversions) are an important driver of transactions. However, it is possible that such tax advantages may be eliminated if the US tax code is changed, as Democratic Senate Finance Chairman Ron Wyden appears to favor.6 Another potential regulatory headwind is recent news related to the U.K. government tightening rules governing foreign takeovers of British companies to ensure acquirers are held to commitments such as maintaining jobs.7

. . . and Telecommunications

The telecommunications sector has also enjoyed increased deal activity this year. The Time Warner/Comcast and AT&T/DirecTV transactions were both convergence plays. Consolidations are underway in Europe as well, with recent deals such as SFR/Altice and BSkyB’s bids for Sky Deutschland and Sky Italia. Both of these situations have complexity associated with them. In SFR’s case, the company was in a bidding contest with Bouygues and Altice. Altice was attracted to the deal because of the prospect of offering bundled wireless, wireline, TV and internet packages, which has been an important trend in the European telecommunications sector. In BSkyB’s case, a large minority shareholder in Sky Deutschland publicly expressed opposition to the deal, which may lead to a revision in deal terms. Despite the surge in deals, the global healthcare and European telecommunication sectors are still very fragmented and may see continued activity as long as the macro environment remains benign.

Positioning to Take Advantage of Deal Flow

There are many hedge fund trading opportunities amid the current environment of active corporate deal activity. In a traditional merger arbitrage trade for a stock-for-stock transaction, the basic approach to trading at deal announcement is to go long the target company and short the acquiring firm. The aim is to capture the risk premium associated with the historical price gain of the target versus a decline in the acquirer (for various reasons including regulatory challenges, change in strategic direction by the acquiring firm, financing difficulties).

Plain vanilla, friendly deals may be trading at tight levels, but complex, hostile merger deals may offer attractive risk-adjusted returns and create trading opportunities depending on the volatility of spreads. Competitive bidding situations can create profitable trading opportunities by taking views on the target company’s fair value and whether another buyer might enter the picture.

Another trading opportunity can be created by taking a fundamental view on the consolidated entity post-merger. In this trade, an investor goes long both the acquirer and target company. This would require diligent financial analysis and taking views on a variety of catalysts that may unlock value. Catalysts can include required divestitures, cost reduction programs and eliminating company overlaps. This trade structure is supported by the recent favorable market treatment of acquirers. Over the past year, the market has rewarded acquirers with positive stock price performance the day of the deal and one month after the deal announcement.8 In the first six months of 2014, buyers experienced stock price appreciation in nearly 70% of announced US acquisitions worth $1B or more.9 Market sensitivity of the trade can be mitigated by shorting a fundamentally weaker comparable within the same sector or by using a broad sector or market index hedge.

Finally, one can “reverse” the traditional merger spread trade by going long the acquirer and short the target, which is essentially a bet on the deal breaking. If the deal spread is trading at a very tight level versus the risks the deal may not close, this creates an opportunity not just to generate returns on a standalone basis but also as a hedge against the rest of a portfolio of traditional long merger spread positions that may break for various reasons.

In conclusion, increased deal activity improves the opportunity set for event-driven equity managers and offers multiple ways to generate returns. Successful trading of these opportunities requires the use of a diverse set of trade structures as well as diligent analysis of a range of factors including company fundamentals, regulatory actions, activist involvement and, most importantly, whether the deal will go through.

 

1Thomson Reuters, “Mergers & Acquisitions Review”, June 30, 2014
2Moody’s Global Credit Research, “US Non-Financial Corporates’ Cash Pile Grows, Led by Technology”, March 31, 2014
3Hedge Fund Research, “HFR Global Hedge Fund Industry Report Q1 2014”, April 21, 2014
4The Wall Street Journal, “Returns from Activist Hedge Funds Are Causing a Stir”, July 7, 2014
5Goldman Sachs Research, “Where to Invest Now, Growing Pains”, March 4, 2014
6Wall Street Journal, “We Must Stop Driving Businesses Out of the Country”, May 8, 2014
7Bloomberg News, “U.K. to Tighten Rules for Foreign Bidders, Cable Says”, July 13, 2014
8Citi Research, “Global Equity Strategist, M&A Catch-Up”, May 2, 2014
9Thomson Reuters, “Global M&A at Seven-Year High as Big Corporate Deals Return”, June 30, 2014

For further developments, see Mayer Cherem​‘s September 2014 PAAMCO Viewpoint​.

Alper Ince, CFA, CAIA is a Managing Director and the Sector Specialist responsible for the management of long/short and event driven equity hedge fund managers in the various PAAMCO portfolios. As a member of the firm’s Investment Oversight Committee, he is involved in all stages of the investment process. In addition, Alper is responsible for managing relationships with certain institutional investors. Prior to joining PAAMCO, Alper was an Associate Director at BARRA RogersCasey, a major pension-consulting firm, where he led the firm’s hedge fund investment and manager research efforts. Alper received his MBA in Finance from the University of Hartford, and earned a BS in Economics from METU Ankara (Turkey). Alper has seventeen years of investment management and consulting experience with institutional investors.

Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Araştırma Hizmetleri A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively. 

This document contains the current, good-faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”).  The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type.  This document may contain forward-looking statements.  These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate.  Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements.  Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements.

Pacific Alternative Asset Management Company is a registered trademark in the United States, Canada, Japan, Singapore, Australia and Mexico. PAAMCO is a registered trademark in the United States, Canada, Europe, Japan, Australia and Mexico. Pacific Alternative Asset Management Company Europe and PAAMCO Europe are registered trademarks in Europe. Pacific Alternative Asset Management Company Asia and PAAMCO Asia are registered trademarks in Singapore. completeAlpha is a registered trademark in Singapore, Japan, the EU, the U.S. and Canada and it is a trademark of PAAMCO in Australia.