Deal-driven hedge funds struggle as mergers hit regulatory roadblocks
Receive free Hedge funds updates
We’ll send you a myFT Daily Digest email rounding up the latest Hedge funds news every morning.
Hedge funds that bet on the outcome of mergers and acquisitions have suffered losses this year as big deals hit regulatory roadblocks and the pipeline for transactions dries up.
So-called merger arbitrage traders, who buy stakes in companies that are being acquired in expectation that shares will successfully be sold for a higher price, have lost 2 per cent on average in 2023, according to data from Hedge Fund Research. This return leaves the sector among the worst-performing hedge fund strategies.
Such funds, which typically aim to turn a profit regardless of the performance of underlying stock markets, say a drought in dealmaking has seen the number of opportunities traders can bet on dry up. But they also blame unpredictable interventions by regulators, which led to the scrapping of the $13.4bn acquisition of US lender First Horizon by Canada’s TD Bank and held up Amgen’s $28.3bn deal to acquire Horizon Therapeutics.
“This is the craziest environment I think anyone has ever gone through,” said one merger arbitrage specialist. “It’s not just hostile to deals but it’s particularly unpredictable.”
Shares in merger arb funds managed by firms such as Kite Lake and Alpine have declined this year by roughly 6-8 per cent.
Meanwhile, the S&P 500 posted a total return of 17 per cent in the first half of this year and the US Federal Reserve funds rate, a proxy for risk-free returns for investors, is 5.25 per cent.
The 2 per cent loss marks a reversal for the strategy — which was a rare bright spot last year as markets tumbled — and is indicative of how dealmaking has become increasingly unpredictable as transaction volumes decline to multiyear lows and competition watchdogs take a more aggressive approach to challenging deals.
Another trader described it as one of the most difficult years of their career. “The regulatory environment has been so tricky and the deals have taken a turn. It hasn’t been very pretty.”
One person close to the market was not quite so pessimistic, saying the lack of deals had led to merger arb funds chasing the same few opportunities but they added that “it hasn’t been a true arb-aggedon”.
In May, TD Bank scrapped its planned acquisition of First Horizon, blaming uncertainty over whether regulators would approve the deal. Investors had initially expressed a high degree of confidence that the deal would go through, sending First Horizon’s stock up from less than $18 per share to $24.9 per share, nearly equivalent to TD’s $25-a-share offer. It subsequently plummeted to almost $10 a share.
Later that month, the US Federal Trade Commission sued to block Amgen’s deal to acquire Horizon Therapeutics, a development that also took investors by surprise and sent Horizon Therapeutics’ shares tumbling.
In Europe, other deals that attracted arbitrage traders’ interest such as private equity group Apollo Global’s offer for the UK oil engineering company Wood Group, and UnitedHealth Group’s takeover agreement for health technology company EMIS, also have not gone to plan. Apollo said it would not follow through with its offer, while UnitedHealth’s deal has faced scrutiny from the UK competition regulator.
At least one bright spot has emerged after a US court victory last week for Microsoft in its effort to close a $75bn acquisition of video game maker Activision Blizzard. The revival of that deal, which many in the market had assumed was dead after regulators in the US and the UK raised objections, has led to gains for some merger arbitrage funds.
Felix Lo, who manages a $300mn fund betting on deals for London-based manager Trium Capital, said he sold his shares in Activision Blizzard in February when the takeover looked in doubt.
However, he recently bought options in a renewed bet on the deal closing and has now made gains after a San Francisco court refused a request from the FTC for an injunction to prevent the deal from closing.
Despite this year’s meagre returns, some traders said the regulatory uncertainty had a silver lining: with fewer investors willing to bet on deals closing, there are richer pickings available for those still brave enough to do so.
While in the past a given deal may have offered a 5 per cent discount, they say they are now able to buy shares at about double that spread, if not more.
“We have been quite bullish in the market since May, because a lot of spreads really widened as a lot of deals were not going through,” said Lo. “When regulators take a tough stance on mergers which previously would not have been blocked, more trading skill is required. Hurdles create opportunities when markets overpredict that a deal is already dead.”
This article has been amended to clarify that it is shares in merger arb funds managed by firms such as Kite Lake and Alpine which have declined this year by roughly 6-8 per cent.
