Hedge funds aiming to profit from the uncertainty over whether corporate takeovers that have been agreed will ultimately be completed say the US stock market now offers more compelling targets than when the eruption of the coronavirus pandemic threatened to torpedo every deal.
So-called merger arbitrage funds typically place bets in the period between a deal being struck and when it is due to complete, a high-stakes strategy that relies for its success on correctly predicting whether a transaction will happen or not against an often volatile backdrop.
The combination of a slowing economy, increased regulatory scrutiny and the challenge of executing highly leveraged transactions in skittish debt markets is forging opportunities for such specialist Wall Street funds.
“From a risk/reward perspective, it’s a more attractive environment since there are real strategic rationales you can underwrite as an arb,” said one executive at a merger arb fund.
The question of whether Elon Musk will follow through on his $44bn agreement to buy Twitter has proved the most captivating. Late last week, Musk notified Twitter that he was terminating the deal, accusing the social media platform of misleading him over its number of fake accounts.
Even before Musk formally reneged on the deal, investors were sceptical the billionaire would complete the transaction, with Twitter shares trading roughly a third below the $54.20 a share he had offered. The stock was down almost 7 per cent at $34.35 in pre-market trading on Monday.
But with Twitter’s board vowing to pursue legal action to force Musk to complete the deal, some merger arb funds are likely to wager on the outcome of the stand-off.
“To be honest, I think it is an amateurish attempt at a termination,” said Roy Behren, who runs a $5bn merger arb fund for Westchester Capital.
Twitter’s share price still needs to reflect the chance that the deal is renegotiated at a lower price, or that the company secures a damages judgment or termination fee, he added.
The transaction is far from the only one with a spread of more than 10 per cent between where the target’s stock is trading and what the acquirer has agreed to pay. For merger arb funds, a gap of at least 10 per cent is regarded as indicating a significant degree of doubt over whether a deal will close.
While Musk’s intentions have been the key variable in the Twitter deal, it is fear over how US competition regulators will treat Microsoft’s $75bn acquisition of video games group Activision Blizzard that has created uncertainty over whether it will happen — and an opening for merger arb funds.
The spread of 18 per cent reflects concern that antitrust authorities, who are increasingly hostile towards Big Tech, will subject the takeover to a strict review and potentially even block it.
Merger arb funds have also been drawn to the $15bn deal that Intercontinental Exchange, the owner of the New York Stock Exchange, struck in May for mortgage software provider Black Knight.
Some funds reckon that competition regulators could step in, while others point to the possibility that the companies could challenge any opposition from authorities just as AT&T successfully did in 2019 when it defeated the Department of Justice’s bid to block its $80bn purchase of Time Warner.
Acquirers usually have almost no discretion to walk away from signed agreements, making scrutiny from competition authorities the most common impediment to a deal closing.
Once a takeover is agreed, the target’s shares will typically trade at a small discount to the offer price. The gap narrows but is not eliminated until shareholders are paid at the closing, which typically happens three to six months after a deal is first agreed.
As rising interest rates raise the cost for takeovers dependent on debt, two outstanding leveraged buyouts — Apollo’s $7.1bn purchase of car parts maker Tenneco and the $16bn acquisition of television ratings group Nielsen by Elliott and Brookfield — each have had spreads beyond 10 per cent. Tenneco’s discount has, however, narrowed to less than 5 per cent recently as financing for the takeover has started to come together.
Alongside an assessment of the risk that a given deal fails to complete, a spread also reflects the opportunity cost to a merger arb fund of choosing to wager on the outcome of a particular takeover rather than putting money into US government bonds.
Merger arb funds typically aim for annual returns in the mid to high-single digits, though their lack of correlation with broader equity markets heightens their appeal for some investors.
Arguably the most complex but still potentially rewarding case for merger arb funds is the fate of US budget carrier Spirit Airlines. Since signing a stock-and-cash merger with arch rival Frontier in February, JetBlue has made an all-cash offer for Spirit.
With a risk that competition authorities could thwart both potential deals, Spirit has twice postponed a shareholder vote on the Frontier transaction, a delay that keeps JetBlue’s hopes alive. The two competing transactions — alongside the potential intervention from regulators — offers an attractive backdrop for funds prepared to wager on the eventual outcome.
The number of variables in play is a sharp contrast to the onset of the pandemic in March 2020, when a plunge across equity markets at one point appeared to derail every pending takeover.
“You were worried if Tiffany stores were ever going to open up again,” said the executive who works at a merger arb fund, referring to the uncertainty over whether the $16bn deal that French luxury group LVMH had agreed before the pandemic for the US jewellery chain would ever happen.
The rapid intervention by the Federal Reserve in financial markets meant most deals ended up closing at or near their original terms.
Despite the drama of LVMH’s 2020 pursuit of Tiffany, Musk’s approach to Twitter has made it even more intriguing for merger arb funds. Legal experts have said that the agreement to buy Twitter is watertight, but Musk’s stubbornness and financial resources raise the prospect of a messy legal battle.
“Twitter should continue to trade well above the standalone value of the company,” said Behren of Westchester Capital. “The company has the better argument and there is validity to the merger agreement that should be enforced.”