Felix Lo has been trading somewhat defensively in the first half of 2022, having rotated the portfolio towards higher quality deals and exited lower quality deals around the start of the year, and the strategy is up by a mid-single digit percentage in the first half. 

The opportunity set for the core strategy of merger arbitrage remains compelling. Abundant deal flow continues, while spreads are widening due to factors including higher interest rates and credit spreads in 2022, as well as regulatory complexity.

Lo has traded merger arbitrage for more than 15 years at single strategy hedge funds and multi-strategy multi-portfolio manager houses. His experience of co-founding Granite in Hong Kong encouraged him to partner with Trium Capital, which provides incubation, seeding and acceleration capital, as well as broad operational, regulatory and distribution support. “Managers at Trium Capital share compliance, risk, back office and marketing teams, so we got to year five on day one. This de-risks the offering for institutional investors. There was also a good cultural match with Trium being family office backed and taking a long-term view,” says Lo.

Lo’s former employers, multi-strategy firms Millennium Management and LMR Partners, are increasingly important players in merger arbitrage, and Lo found their culture, “very professional, transparent and robust in terms of risk management”. However, he missed direct dialogue building long term relationships with end investors, some of whom reached out shortly after March 2022 looking to deploy capital as the pandemic created rare opportunities in the market. 

Scouring the globe for small and mid-cap alpha

The larger part of his career was spent at Sandell, where founder Tom Sandell and others were important influences: “Tom Sandell always had a very international outlook, covering more interesting markets in Europe and Asia, which can require more work and complexity. I also learned from others at Sandell who now run risk arbitrage at Sculptor and HBK”.

Lo forages outside the well picked over US and UK markets and has a high weighting in small to mid-cap deals, which on average have lower deal break risk and tighter spreads. “However, there is also more dispersion in deal spreads, less broker coverage, and more potential to add value through proprietary research. At Sandell, we generated most alpha from more work and structuring on complex situations outside the US. We look at every deal but find these add most value.” Smaller cap deals (market cap below $2 billion) have averaged 40% of Lo’s book but are 54% in June 2022. 

Continental Europe, the Nordics, Eastern Europe and Asia Pacific countries can be more rewarding than the UK: “Our top three deals this year have been two in Singapore and one in Australia, where we had high conviction in lower-risk deals”. A more complex mid-cap merger in the Nordics last year proved the value of grassroots research: “Two liquor distributors wanted to merge but the market implied only a 50% probability of completion, due to antitrust concerns. We spoke to competitors, suppliers and others, and worked out that the deal could be done. In this geography, this sort of complex situation might only appear once every few years,” reflects Lo. Eastern European countries, such as Hungary and Poland, also demonstrate intermittent deal flow, perhaps one every five years – compared with one or more per week in the US or UK.

Hungary and Poland are unusual for Lo, who generally avoids emerging markets due to legal uncertainties around contracts, but both countries are in the EU with strong legal frameworks. In Asia he feels comfortable with countries such as Hong Kong, with a developed takeover code and enforceable contracts. 

High hit rates

Lo has been able to achieve over 99% completion rates, even including deals that eventually broke, but were exited prior to break. “We have a robust process to look at deals, decomposing risk factors to identify potential deal breaks and monitor milestones,” he says.

Deep data dives

Lo has worked with Neo Tsangarides for five years, building a customized database to track all the global universe of deals and risk factors. The universe is split between clean deals, with no deal specific issues, and complex deals, which require more research due to some complication, which is typically antitrust. “Given the level of work required, each of us can cover only about five to fifteen complex deals at any time,” says Lo. Data analysis combine public fundamental data with proprietary data such as expected proforma leverage, deal synergies and rationale, premiums versus peer groups, and deal multiples. “We have been tracking a rich dataset of deal characteristics to analyze its impact on completion rates and incremental returns for deals across sectors and geographies for a long time,” says Lo. 

Personalities and deals

The team maintain a huge database of deals, but the process is far from exclusively data driven: “We have the data but it is not prescriptive,” says Lo. Game theory and personality analysis can be germane: “We call as many people as possible to see how they sell the deal and how their motivations and intentions may change over time,” says Lo. He had first-hand experience of M&A joining Evercore straight out of university, working on big deals with “rainmakers” such as Michael Price and Eduardo Mestre who was chairman of Citi’s investment banking division. This provided insight into deal negotiations. 

Unusual deal structures and considerations

An attractive form of complexity is unusual considerations, which might include fixed, variable and contingent elements, akin to exotic options. Hedging some elements can isolate an asymmetric payoff and sometimes create free options. Various combinations of futures, ETFs and options can be used to hedge and trade unusual considerations. A recent example was an investment company consolidation in Australia with a variable exchange ratio based on the underlying NAVs of the two companies, among other quirky features, such as a ratchet mechanism for the ratio. “The NAVs could be hedged with an acceptable degree of tracking error to create an asymmetric payoff profile. Elections where investors have some choice over the mode of consideration can be another source of optionality,” says Lo. 

Benign and malign complexity 

Specialist event-driven brokers are useful for gauging consensus, which deals to do more work on, and which deals with no coverage should be prioritized because nobody else is looking at them. “In general, we love complexity, and are happy to do the legwork around antitrust, politics and litigation. We would avoid complexity where it cannot be worked around, such as emerging market risk, bad contracts, and natural catastrophes, which are harder to handicap,” says Lo.

Some more complex deals could even become short positions to wager on deal breaks, where the hit rate does not need to be as high because a failure can often generate many times more profit than completion. “A recent short in a Canadian telecoms company was trading at a 90% implied probability of completion, despite anti-trust issues, and the government sued to block the deal,” points out Lo. 

Actively varying turnover and leverage

Portfolio turnover could average 8-10 times but varies with the climate: “In a normal environment with steady spreads we do not trade so much. Currently with huge intraday and daily swings, we are trading around a lot more as spreads move but usually deal risk does not change that quickly”. 

Leverage is generally at overall portfolio rather than deal level though: “If any spread remained in unconditional deals for some technical reason, a position could be expanded to a size allowing for the estimated maximum 400 basis point loss,” says Lo. 

Historically, Lo has de-levered when spreads tighten to levels that no longer offer attractive risk/reward. “In 2014 we had a 6-year period when every deal had closed, and spreads were super tight. We held 40% cash at that stage, until the Shire deal broke, and spreads then blew out again. All spreads widened due to a change in tax rules that was not relevant to all deals. We rebuilt the book at wider spreads and ended 2014 with one of our best years for performance. Our discipline during that summer allowed us to take advantage of the mayhem. Recency bias is important in explaining how spreads move,” says Lo.

The GFC and Covid were different: “In 2008 and March 2020 the blowout in spreads was more about liquidity risk than single deal break risk. In the worst of times investors use merger arbitrage as an ATM. Implied probabilities go from 95% to 60% even though 90% deals actually still end up closing. It is very hard to identify the bottom of the market in these situations, but merger spreads tend to recover quickly as it is a relatively short duration strategy, and we will add to deals we expect to close”.

The strategy also has a tail risk overlay hedge, for a sudden black swan risk rather than a slow grinding bear market as seen in 2022: “We normally expect the hedge to have a cost and in 2022 it has roughly broken even,” says Lo.

Playing defence in 2022 

“In early 2022 we sold cyclical and private equity deals and took a 20-basis point hit to crystallize these losses. This has more than paid for itself now,” says Lo. In June 2022 long exposure sits at 185%, which is slightly below the average of 200%, and leaves dry powder to add risk on spread widening. It is well below the 230% level seen at the end of 2021. The LMV ranges between 150% and 250%. “Overall, this is a good environment with a high volume of deals – there has not been the hiatus in deal flow seen in 2008 or 2020. Deals are motivated partly by wide dispersion within sectors such as technology, creating winners who want to press their advantage, and losers who are more desperate to find a quick fix. With disruptions from supply chain, interest rates and political events, there are also real business reasons for doing deals. But fear and financial market conditions means that spreads stay wide even on higher quality deals.” 

Interest rates and credit spreads 

Higher short term interest rates in 2022 are contributing to wider spreads, in line with a historical relationship that Lo has modelled. “The widening of spreads has applied to both clean and complex deals, though deals with issues have widened a lot more. Yet deal break risks historically did not increase in a higher rate climate,” he says. 

Credit spreads have also blown out, and they correlated strongly with private equity deal spreads. “We are not sure if these deals will actually break, but at some stage banks may find an excuse to renege on financing,” warns Lo. 

Regulatory and antitrust risk and complexity

Another reason for wider merger arbitrage spreads, predating higher rates and credit spreads, is growing regulatory and antitrust risks in multiple jurisdictions as the political mood becomes more protectionist: “The UK has introduced a new national security law as its post-Brexit Competition & Markets Authority has re-asserted its power. In the US new leaders at the Department of Justice and Federal Trade Commission have made deeper scrutiny of mergers a centerpiece of their policymaking. In Australia the Australian Competition and Consumer Commission has been more aggressive for some time, including issuing a 600-page report on internet market dominance in 2019. All of this adds complexity and means we can get rewarded”.

Pinpointing the right types of hard catalysts

Beyond announced mergers, an opportunistic sleeve can trade other event driven situations. Hard catalysts could include a few broken deals that become oversold, but this is rare as Lo finds fundamental long/short equity managers have the real edge in such situations. The team also tend to be very selective in trades that have a lot of inherent market exposure, such as valuation arbitrages from sum of the parts discounts and spin offs: “Exceptions could include short-dated trades such as announced spinoffs with complexity around flow back mechanics and technicals,” says Lo.

Some other corporate events, such as rights issues or capital raisings, can spring from mergers, but they need a twist to pique Lo’s interest: “We would not do a plain vanilla capital raise where the edge is getting a large allocation. Our added value would come through a differentiated view on a more complex situation”.

Litigation situations will usually involve common law jurisdictions, where the US has the most precedents. “We recently invested in a US firm where 95% of its value resides in litigation. There is uncertainty around whether, how and when it gets paid, even though the settlement funds are held in escrow. We can capture a spread and have a free option on any remaining value.”

SPAC arbitrage is generally too long term: “It is like a two year lock up and a lottery ticket that rarely pays off outside the crazy 2020-2021 period. We might look at shorter term SPAC liquidation events however,” says Lo.