The Omni Event Fund (the “Fund”), managed by Omni Partners LLP, is a hard catalyst focused event driven fund, trading mainly M&A and related corporate events. John Melsom, Chief Investment Officer, has the freedom to identify the trades he perceives as having the best risk/reward characteristics globally, selecting from liquid large-cap and mid-cap stocks listed on North American, European and Asia Pacific equity markets. Geographic weights are the consequence of bottom-up trade selection and not predetermined. “We are agnostic as to where capital should be allocated at any one time,” he says. “We look at the globe holistically and pick the best trades regardless of geography”. The US always has a reasonable weighting owing to its abundance of corporate activity. Europe has picked up since the crisis years of 2011-2012 as corporates have regained confidence, while Asia Pacific, which includes Australia, might make up one sixth of the P&L this year.
Above all, says Melsom, who has managed money through several economic and market cycles, “it is a true absolute return strategy, aiming to compound absolute returns regardless of the climate for event-driven investing and for broader equity markets.” The Fund has historically exhibited markedly lower correlation to equity markets when compared to indices of other hedge funds managing merger arbitrage, event driven or special situations strategies. The Fund’s performance also has a low correlation to the hedge funds’ returns themselves, as tracked by those indices.
Melsom partly ascribes the modest correlation to Omni’s strict risk framework. The strategy is distinguished by a dynamic approach to risk management, “we can swiftly adjust positions and trade around them as situations and news evolve, and we can cover all time zones from our trading desks in London and West Coast US,” he says. Omni is authorised and regulated in the UK and US.
The focus on “hard catalysts” — principally mergers — which have been announced by companies and often have established timeframes, also helps to reduce equity market correlation. Melsom is of the opinion that strategies trading “soft catalysts”, which include rumoured or potential events, tend to have higher equity beta. Nearly all of Melsom’s trades revolve around mergers or takeovers in one way or another. Even so, he judges that, “my strategy is probably somewhere in between a merger arbitrage and an event-driven strategy, being more concentrated than a traditional merger arbitrage fund and pursuing some other trade types, but avoiding the soft catalyst trades that are pursued by some event driven funds”.
Some 75% of the book is typically invested in announced and agreed merger deals or minority squeezeouts, with 15% in M&A situations that may not be agreed, including those involving competitive bidding, hostile approaches or activist involvement. Approximately 10% might be invested in non-merger trades such as spin-offs, share-class collapses, index events, “Dutch auction” tender offers and rights offerings.
One reason why merger deals can offer attractive spreads is market segmentation: between the arbitrage and long only communities, and between global and regional arbitrageurs.
“Long-only managers understand corporate events better than they did 15 years ago, but the fact that they have different objectives, and face different constraints, segments the market and leads to inefficiencies that can be exploited by unconstrained investors. Most simply, if a long only investor has already made a 40-50% profit from a takeover bid, they may be inclined to bank the profit, whereas we would be focused on the deal spread, having probably only entered the trade after the bid,” explains Melsom.
A global perspective can let the investment team construct trades with wider spreads in cross-border deals, a core trade type. Investors that are restricted to one market or currency might need to use US-listed ADRs for both legs of a trade involving a cross-border merger. The Fund could for example short an acquirer’s Asia listing and buy the target in the US or UK, which might allow them to capture a wider spread. Similarly, in cross-border deals, the holders of a local stock might not be able to accept the stock of an overseas acquirer as payment for a takeover, which creates interesting flows particularly around the consummation of deals. These can often be seen in index rebalances, when a target will exit one index and effectively enter another one, subsumed into its new parent or partner. The associated trading activity can produce imbalances caused by benchmark-conscious or index-tracking investors who need to sell or buy particular listings.
Melsom, who makes the final decision on position sizing, does not accept the conventional wisdom that diversifying into more deals necessarily reduces risk and argues that, “a broader range of deals produces more deal break risks”. As such he runs a concentrated book, with his top ten usually making up some 70-80% of the portfolio, and is highly selective, both in choosing which situations to invest in and at what point to get involved. Whilst his team monitors a broad universe of potential opportunities across the globe, he may only choose a small number that make it into the portfolio. He does not necessarily invest over the entirety of a deal timeline — typically from announcement until completion or break — and instead may only get involved after a particular risk has passed, or will trade around critical deal milestones.
Melsom can run positions as large as 30% of NAV for example, if it is consistent with the strategy’s tolerance for a maximum estimated downside risk of a 5% loss to NAV overnight, but in reality a deal is likely to be largely de-risked by the time positions grow to this size. Their downside estimates are updated daily, taking account of market and peer moves as well as company specific news. In stock-for-stock deals, the risk that the acquirer itself is bid for, which could result in losses on both the short acquirer and long target legs of the trade, is considered.
Though the portfolio can be highly concentrated there are some limits on its overall sensitivities to potentially correlated risk factors. Deals are selected on a bottom-up basis, however a top-down screen aims to cap exposure to common risk factors, such as hostile deals, activist deals, LBOs, those vulnerable to legal changes or even natural disasters such as hurricanes, any of which might trigger deal breaks for the same reason. For instance, a credit crisis as seen in 2008 could see multiple leveraged buyouts fall through.
Occasionally, Melsom has “reversed” merger arbitrage trades, or shorted cash bids, that could profit from spread widening or deal breaks, but these typically do not form a large part of his book or his profits, and are usually short-term in duration.
Mergers can contain more than two moving parts, which can lead to different trade types that may provide “complexity premia”. For example, “stub” trades can arise while investors await the creation of a new corporate entity. As part of the Disney bid, the spin-off of 21st Century Fox’s core assets should result in Fox shareholders receiving both Disney shares and shares in New Fox, containing the spun-off assets. Melsom points out, “it is possible to buy Fox and short Disney, in an appropriate ratio, in order to isolate the New Fox stub synthetically at an effective price of USD 20 a share. This compares with a “grey market” price of USD 35”. In absolute terms, the spread on this stub is much larger than on the overall deal.
Exchange-listed options can also be used to structure trades with better risk/reward, mainly in the US and sometimes in Europe, but less so in Asia where option markets are not liquid enough. Melsom also “keeps a close eye on options markets as a signalling mechanism of risk and implied downside. We do not always agree with the options market assessment of risk, which may lead us to believe some options are mispriced”.
An understanding of option trading also informs other trade types, such as those thrown up by some deals that vary the consideration between cash and shares, and vary share ratios, according to the share price. This is another facet of the Fox/Disney deal, where the stock portion of the deal is set according to a floating ratio with a cap and collar mechanism. “The deal pays a fixed ratio of Disney shares above the top end of the collar, and a floating ratio below that price to give you a certain cash value in shares, which throws up opportunities for ‘gamma trading’ around Disney share price volatility. There is effectively positive gamma at the top end of the spread,” says Melsom. This is analogous to gamma trading in convertible bond arbitrage strategies. However, he points out that the very end of the deal could have a very different profile “as we approach the close and hedge it out over the averaging period, there will be negative gamma”. Investors who feel uncomfortable with these nuances might shy away from the trade, but Melsom relishes the complexity.
Since inception in September 2013, the Omni event strategy has annualised at around 10%.
Melsom has been trading corporate events for nearly 17 years. He has worked with Omni founder, Steve Clark, since 2001, and was co-managing a similar event strategy with Gavin Simpson from 2004. Upon Simpson’s retirement in 2013, Melsom decided to establish a US office and manage a new fund from there, this time under a single-CIO structure. The current Omni Event investment team of four includes Head of Research, Rahul Patel, who has worked with Melsom for 12 years, and two analysts. Omni also has strong infrastructure in terms of operations, legal and risk departments, that was built around the event strategy — Omni’s first and flagship strategy. Omni’s operational team have experience of handling corporate actions across multiple jurisdictions and geographies.
The team’s proprietary research and resources are complemented by external expertise where helpful. Omni can seek opinions from law firms, including antitrust and competition lawyers, and tax counsel for some deals. Omni has recently retained a corporate governance expert on Japan to help gauge the likely voting actions of an acquirer’s Japanese shareholder base. Counterparties include a mix of niche, boutique brokers who specialise in researching the event space, larger special situations and merger arbitrage desks at leading banks and financial institutions, as well as relationships with global prime brokers that can provide additional services such as access to stock lending.
Though Melsom trades deals from many more angles than some investors, and can thus be rewarded for a wider range of risk factors and quirks of individual deals, merger arbitrageurs still get paid primarily for taking on the risk that deals break. Assessing this risk can include weighing up regulatory and legal factors, as well as keeping abreast of equity and credit market conditions.
Melsom has recently had a preference for strategic cross border deals that help companies find new revenues or increase market share, but he is selective and there are certainly exceptions. “We would not go anywhere near deals involving Chinese buyers of US technology at the moment, because regulatory risk is rising in those situations,” he explains. “CFIUS (The Committee on Foreign Investment in the United States) is constantly evolving and we do not rely too heavily on precedents. That particular agency is more influenced by the White House. We are also wary of deals where foreign governments are stakeholders in the acquiring company”.
China’s regulatory process can also slow down deal approvals, which in extreme cases may scupper them. “Qualcomm/NXPI dragged out for so long that the companies walked away,” says Melsom, who believes that deal approvals are getting caught up in the politics of trade wars.
He points out that domestic US deals can also be politicised. “The US President is political and unpredictable, and has also seemingly tried to influence a domestic US deal, AT&T/Time Warner”. US antitrust policy and EU competition policy have developed over decades, influenced by shifting paradigms in industrial economics, and by political priorities. “Historically, the US focused more on horizontal deals that have structural remedies, but the DoJ is now starting to look at vertical deals, that tend to have behavioural remedies,” observes Melsom. Though AT&T/Time Warner ultimately closed, the concerns raised by the DoJ took some observers by surprise. The jury is still out on whether the DoJ might veto another vertical deal. Melsom notes that, “the Head of the DoJ has said he does not want to enforce and monitor behavioural remedies”.
We would not go anywhere near deals involving Chinese buyers of US technology at the moment, because regulatory risk is rising in those situations.
Melsom closely scrutinises legal agreements around mergers, in particular focusing on the Material Adverse Change (MAC) clause, which sets out conditions that may allow bidders to walk away. Geopolitics is rarely a concern here. “Agreements are generally worded tightly, with wars and conflicts generally not included,” he observes. Melsom is however becoming cautious on those deals that have a cash or EBITDA test, as he feels that, “this signals some concern about the fundamentals of a business. We want a very committed buyer to have conviction”. There is also growing controversy around how to define EBITDA itself, and about the proliferation of adjusted EBITDA measures, which are sometimes increased to allow for anticipated merger synergies. In addition, Melsom closely researches those MACs that might allow mandated divestitures as a reason for bidders to renege.
The good news is that this legal and regulatory uncertainty is contributing to wider spreads across the board, increasing potential rewards. And Melsom is less worried about political vetoes in Europe and the UK, where deals, such as Fox buying Sky, have generally gone through.
Omni’s process is wholly discretionary. Melsom studied computer science 20 years ago, but does not use AI for analytics, and is sceptical about using rules-based approaches for event investing. For example, some merger arbitrage rules avoid all LBOs, but Melsom can demonstrate that he has consistently profited from his LBO investments. “Rules are a lazy way to invest. Ruling out a particular deal type throws the baby out with the bathwater, and leaves opportunities on the table,” he says. As for systematic and quantitative strategies investing in merger arbitrage, which are available in some ETFs, “the returns speak for themselves”.
(THFJ is aware of two merger arbitrage ETFs. The IQ Merger Arbitrage ETF (ticker: MNA) has delivered a total return of about 26% between inception in November 2009, and October 2018, working out at an annualised return of around 2.6%, offering a small spread above cash over this period of predominantly near zero interest rates. In contrast, the Proshares Merger ETF (ticker: MRGR) has lost nearly 10% since inception in December 2012, equating to an annualised return of close to minus 2%).
Over the past five years, the Omni event strategy has annualised at around 10% since inception in September 2013. Its worst year – and the only down year of Melsom’s career – was 2014, when he was invested in a large deal break (Shire/AbbVie), and incurred some other smaller losses. The best year was 2015, when Melsom was distinguished by continuing to perform in the second half of the year, during which the event driven indices lost money. Such episodes, he says, arguably “separate the sheep from the goats”.
Looking back further, 2007 was a very strong year, up over 20%, partly because higher interest rates then contributed to wider deal spreads, and also as higher interest rates encourage companies to engage in the stock-for-stock deals that Melsom likes to trade. “My returns have tended to peak when interest rates have peaked,” he declares. “Recent increases in USD interest rates have helped to increase spreads on plain vanilla deals to a typical level of 6% annualised, though they can trade tighter if counterbids are expected,” he continues.
Melsom has made some use of leverage, which tends to expand when he finds more stock-for-stock deals as they require both long and short legs. He may also employ leverage for shorter-dated lower risk situations. Deals that have gone unconditional may offer a slender spread in absolute terms, but an astronomical one in annualised terms. Conversely, leverage has been reined in when trading longer duration, higher risk deals, or during stressed markets.
In turbulent markets like 2008 Melsom has also played defence and increased his emphasis on stock-for-stock deals. These can be hedged by shorting the acquirer, as opposed to cash deals like leveraged buyouts, which can see their beta increase as markets implode. 2008 was a strong year for Melsom, partly because most strategic deals actually closed, but also due to market volatility blowing out spreads fairly indiscriminately and providing good entry points into higher quality situations. Melsom’s approach to event driven investing recently provided some more strong data points supporting its lack of correlation to equity markets by posting a positive +0.57% net return in October and +3.82% net (estimate) in November, when the S&P 500 lost over 5% in the last two months, leaving Melsom’s fund up over +13.35% YTD.
Though liquidity matters more to Melsom than a company’s market cap per se, most of his investments are in companies above $1 billion in market cap, and the vast majority are over $2 billion. There is no upper bound and he has done mega-cap deals, where spreads can be wider, possibly because insufficient arbitrage capital exists to digest them.
Melsom could probably manage $2-3 billion in the strategy but is remaining patient when it comes to marketing, putting a priority on performance. That’s why he can declare with confidence that “we are not capacity constrained at our current size”.
Omni Partners LLP is authorised and regulated by the Financial Conduct Authority and registered with the Securities Exchange Commission.