The daily dealing funds, reporting under SFDR 8, are managed by the duo of Fabienne Cretin-Fumeron and Stéphane Dieudonné, who were hired from Candriam. April 2024 marked their twentieth anniversary of working together, which is also longer than their respective marriages, or indeed the average 13-year length of a marriage in France. “We have lived and worked through good, bad and indifferent cycles for merger arbitrage and have grown to recognize our strengths and improve on our weaknesses,” says Cretin-Fumeron, who featured in The Hedge Fund Journal’s 2018 edition of 50 Leading Women in Hedge Funds, published in association with EY.

Carmignac, which has 64 fund managers and analysts running 24 strategies, provides a synergistic environment for the merger experts to share ideas with equity and credit sector specialists: “Senior Healthcare Analyst, Rosie Turner, has recently been helpful on pharmaceutical deals. It is also useful to sit near the credit team, who have been insightful on financial deals, such as one in Norway,” says Cretin-Fumeron. Additionally, Carmignac’s credit team invests the strategy’s cash in highly rated short term corporate debt.

The managers’ previous strategies beat cash nearly every year and Carmignac now offers a choice between low and medium risk target funds. CPMA is amongst a group of UCITS hedge funds, often managed by French firms, targeting a very conservative return profile of about cash plus 1%, with volatility of 1-2%. Meanwhile, the CPMA Plus strategy aims at cash plus 4% with volatility of 4-6%. “CPMA Plus currently owns all the same positions but sizes them between two and four times larger. In April 2024, the low volatility fund was 33% invested in 35 merger arbitrage deals and the CPMA Plus fund was 110% invested in the same deals,” says Dieudonné.  

Quantifying and pricing deal break risk

The managers have a proprietary database tracking over 6,000 deals since 1998, of which 7% failed. All these deal breaks have been documented and four broad reasons have been identified to explain a deal failure: hostility (31% hostile deal breaks); relative size 19%; antitrust vetoes killed 18%, and financial offers 12% failing.

Hostile deals refer to target management opposition to the deal, and not necessarily shareholders’ opposition. “Though shareholder opposition can occasionally break a deal, as Origin Energy in Australia recently showed, it can also lead to increased premiums being paid, and therefore is not a clear deal break risk factor,” explains Cretin-Fumeron, who is excited about more competitive bidding wars in 2024.

The “antitrust” category also includes various other sorts of political and regulatory approvals, such as foreign investment related ones that are not necessarily antitrust per se and may be the province of regulators other than competition authorities.

Controlling exposure to – and ideally avoiding – risky deals that break is vital for any merger arbitrageur. “Spirit Airlines is a good example of a deal break that was relatively easy to avoid. From the start we could see a high risk of the FTC bringing a case, and we could also see the downside was large,” points out Cretin-Fumeron.

Equally, trading only the safest deals may not always generate enough return. Carmignac carefully chooses higher risk deals that offer an attractive risk reward and takes a calculated risk on them. The low risk fund can risk up to 0.30% on riskier deals or between 0.50% and 1% on lower risk deals, whereas the Plus fund can risk as much as 2.50% on either sort of deal. Capital at risk is based on the team’s downside estimates.

Beyond valuation estimates, a delicate interplay of qualitative analysis is needed to assess the political, regulatory, economic, psychological and legal nuances behind deal break risks, including strategic reasons for a deal, financing conditions, and material adverse change clauses in offering documents.

ESG related deal breaks

The team also assess if deals could fall through due to ESG flashpoints. They may include environmental issues such as legacy clean up liabilities, social issues around local communities, employees and consumer harm, and of course the governance aspect that was analysed long before ESG even became an acronym namely poison pills, staggered boards, golden shares and other sorts of corporate governance that could make it easier for management or perhaps governments to block a deal.

Carmignac’s ESG exclusion list, based on a mix of MSCI ratings and some proprietary scores, is much less important from an investment perspective. “Typically, Carmignac’s ESG exclusions have only ruled out two merger deals per year. They do not exclude energy, which is an important source of dealflow and some recent mega deals,” confirms Dieudonné.

Hit rates and active trading

All hedge fund managers work on improving their hit rate, but the issue is much more acute for merger arbitrage. Whereas an equity market neutral manager might be happy with a 55% positive alpha hit rate on stock-picks, a merger arbitrage manager will often expect over 95% of their portfolio of deals to close, because one break can wipe out multiple profits. Historically, the Carmignac team have had a deal break rate around 3.5%, or 50% below that of the market’s 7%, and importantly it has been 60% lower on the subset of higher risk deals, which can also pay higher returns, especially recently.

Some positions are held until they close (or break) but others are more actively traded. The managers have avoided some losses by getting out before deals break. The Amazon offer for iRobot, which Cretin-Fumeron discussed at the Sohn Conference Foundation London event in December 2023, did break, but the managers had already exited this very small position.

In contrast, the Microsoft/Activision deal was actively traded around newsflow including the temporary blocking by the UK CMA. “We sized it smaller, took some profits, and were able to manage the downside risk,” says Dieudonné. Similarly, they traded around the regulatory milestones impacting the MoneyGram/Madison deal. “This was not a huge position after the FTC review, but we took the view that the company would successfully sue the FTC and win,” recalls Cretin-Fumeron, who sums up: “There is no single trading strategy for a deal. Sometimes we fully exit and sometimes we may add or reduce or do both at different times”.

Bidding wars including small and mid-caps

The bid for alternative asset manager Sculptor was one where they had confidence in potential upside because a third party had entered the fray and downside was limited based on proprietary valuation analysis. “With Sweden’s Pagero, two additional bidders were vying for the firm, which created a situation akin to buying a call option. The firm was eventually bought by Thomson Reuters,” says Dieudonne. Sculptor’s market cap below $1 billion was “small cap” in the US, Pagero’s around $2 billion was “mid cap” in Sweden, and there are also large cap and mega cap bidding wars.

Go east

The strategy is global but has historically been dominated by the US and Europe, which have most dealflow.

European dealflow has been gathering momentum not seen for at least 4 years. “Some 15-20 years ago, you could see 3-4 deals a day. Some deals in the Eurozone are however too small to be interesting, such as some in Spain and Italy below our thresholds,” says Cretin-Fumeron.

The Western dominance of the strategy might be starting to change, with up to 10-15% of the strategy now in Asia, mainly Australia and Japan. New Japanese takeover guidelines make it easier to do takeovers and there have since been many more deals in multiple sectors, even including private equity buyers,” says Dieudonné.

The managers are confident about the runway in Japan, but not so sure in China. Though it was welcome to see China waiving the need for approval of Japan Investment Corp’s bid for JSR, this decision cannot be used to extrapolate future Chinese decisions. “China is a black box. You can put some data in and do not know what you will get out. Overall, China is more pro-business than it used to be in wanting to attract more capital, but they will block some deals in strategic sectors, such as an Israeli semiconductor firm that Intel wanted to acquire,” observes Dieudonné.

Geopolitics may also affect deals outside mainland China. Though some investors were surprised by the German regulator’s refusal to give a reason for not approving Taiwan’s Global Wafers bid for Siltronic, Dieudonné did not find this very unusual: “We have also seen China’s regulator not approve deals, without any reason being given. The portfolio’s geographic footprint is growing, but subject to comfort with regulatory risks”.

Higher spread rewards for lower deal break risk

Historically most of the time the deal break percentage is much higher than the gross deal spread percentage, but recently these two variables have unusually almost converged.

In April 2024, gross deal spreads averaged 6.5% and this is not an annualized figure. It is not easy to annualize on a forward-looking basis because the timing of deal closing cannot be precisely predicted. But since most deals close in less than a year, the annualized spread is almost certainly higher than the raw gross 6.5% figure.

It is not straightforward to attribute the increased spread between the impacts of higher interest rates, and possibly more complexity or uncertainty risk premiums, on a forward-looking basis. But this exercise can to some extent be done on a backward-looking basis. “Spreads are much higher for more complex deals. The realized excess return on more complex deals has gone up to 10% from between 0 and 2% just two years ago,” according to Dieudonné.

This is an unusual configuration for any kind of risk premium. For instance, in credit markets it would be odd to see credit spreads widen while default rates decline. In government bonds it would be strange to see long-term bond yields, or inflation linked break-evens, go up when inflation goes down.

Capital exodus

The higher “deal break-adjusted spreads” might be partly explained by capital exiting the space, creating a void when non-specialist managers and shareholders who are not confident about predicting deal break probabilities will often exit upon an offer rather than wait for the deal to close.

Dieudonné judges that capital deployed in merger arbitrage has diminished, “Partly because the multi-strategy giants are doing less in the space, but also because some UCITS funds have shuttered. Mega size deals over USD 50 billion, including two oil industry deals at present, can have above average spreads”.

The overall opportunity set is amongst the best the managers have witnessed in 20 years.