The last merger cycle was typified by companies using their inflated equity prices to acquire ‘strategically’; helping to build mega-cap telecom, media and technology groups. Interestingly, this merger cycle has been somewhat different from the last. Post Enron, WorldCom and Adelphia, company management has focused efforts on cleaning up their balance sheets and refocusing their core businesses. As the economy has recovered and companies have repaired balance sheets, they have become increasingly cash-generative and this cash has accrued to the balance sheet. Company management is faced with the dilemma of either spending this money or returning it to shareholders, in the form of share buybacks or special dividends.
There is additional pressure on companies to continue to improve earnings in an environment where many sectors have limited pricing power. The most obvious option available to management is to look for strategic acquisitions, which would allow them to ‘use rather than lose’ the cash – and look for synergistic savings or opportunities in new markets to boost earnings. We believe this factor will continue to underpin deal activity during 2007.
Connected to this, and another demand-side pull, is the increasing role that private equity funds are playing in deal activity. Private equity funds have raised a large amount of money in the last couple of years and are obliged to invest this money or return it to clients. Financial buyers in Europe raised a record €170bn ($226.1bn) in 2006, up from €44bn ($58.5bn) in 2005.
Moreover, a new development in this space has been the propensity of private equity funds to club together on deals, allowing them to take on larger targets. The HCA deal, which occurred last year, was the largest LBO of all time. 2007 is likely to be the year of the jumbo LBO deal. This is the second main demand factor which should drive deal activity through 2007 and beyond.
Outside M&A activity we continue to see other types of corporate activity that provide further opportunities to profit. Company management remains intently focused on shareholder value, which is a significant shift in behaviour in continental Europe and Asia. Often, this is encouraged by a more active shareholder base, which can include activists and hedge funds as well as traditional money managers. This is leading to spin-offs and divestitures of non-core businesses alongside changes to capital structures. Other event-driven trades relating to share class arbitrage, (eg index inclusions/deletions and minority interests) also generate opportunities.
Finally, there are credit event-driven situations, which are most commonly associated with bankruptcies and liquidations, but increasingly arise as part of a corporate transaction. These events are often linked to a downturn in economic activity, which places certain companies and sectors under financial stress. At present, the low default rate has limited opportunities in this area; however innovative managers are taking advantage of other credit-orientated situations, both long and short, surrounding corporate events. We would expect to see a pick-up in defaults towards the end of 2007, which will increase the opportunity set for distressed investors.
Merger arbitrage is one of the oldest hedge funds strategies and when executed successfully, provides steady returns with a low correlation to equity markets. In its simplest form, merger arbitrage involves exploiting the difference between the bid price for and the prevailing market price of the target company. In the case of a stock-for-stock deal, the arbitrage profit can be locked in by going long the target company and short the acquirer in the ratio of the merger deal. The key risk to your profit is deal break. However, should the deal be consummated, the arbitrageur has locked in their profit regardless of market moves. The skill of the event-driven manager is to identify and price the likelihood of deal break and constructing attractive risk return trades.
Merger arbitrage spreads are a function of deal activity, prevailing interest rates (as risk is priced relative to the prevailing interest rate), the amount of capital allocated to the space and more generally the market’s appetite for risk. In recent years, information flow has improved and more money gravitated to the space, resulting in ‘plain vanilla’ deal spreads compressing.
Over the past two years, the market has seen a significant pick-up in corporate activity as well as a steady rise in interest rates globally. Both these factors have contributed to a general widening of spreads, as the available capital is allocated across a wider number of positions. Spreads have moved out to Libor plus 3-4% on more straightforward transactions.
However, where there is some complexity in the structure of the deal or uncertainty surrounding completion, mid-teens spreads are available. In fact, most merger arbitrage funds have increasingly focused their attentions on the complex situations and also broadened the remit of their funds, both in terms of event-driven trades and geographic coverage. Additionally, there is a rise in the more activist approach to event-driven investing; again, instead of passively holding a spread, managers are engaging with management to optimise the return for shareholders.
Ermitage launched its Event-Driven Fund back in September 1997, which has meant we have developed our approach to running the portfolio through several cycles and a variety of different environments. One of the interesting features of the fund has been the low correlation of returns to those of traditional equity and bond markets, particularly in periods of stress. 2006 was the Event-Driven Fund’s best ever year, both in absolute terms and relative to Libor, with the US$ share class up 16.4% – equivalent to approximately Libor plus 11.2%.
With regards to the longer term trends, we have been increasing our exposure to Europe and more recently Asia, including Japan. The Japanese market in particular is offering some interesting opportunities created by cross shareholder unwinding, a burgeoning market for corporate control and a change in attitude amongst company management towards shareholder value.
Overall, we are confident the high level of merger activity is set to persist in 2007 and this should feed through to strong returns for event-driven hedge funds. Coupled with this, we are encouraged by the fact that we are finding plenty of opportunities to deploy capital with talented managers.
Michael Howard is Vice President – Hedge Fund Research covering event-driven and long/short strategies.