I was writing a long post on risk arbitrage and how it seemed attractive but didn't finish it after things changed rapidly and got scary real fast after the Trump election. Spreads used to be somewhat large (5%+ for somewhat "safe" deals; right now spreads for similar deals appear to be around 1-2%) and I believe spreads were attractive a few months ago due to:
- Peaking credit cycle/private equity/buyout/merger cycle: M&A is very cyclical and I had charts clearly illustrating how they peak (usually very close to stock market peaks). It seemed like we were getting close to a peak--sort of reminded me of 2007 when I was blogging and investing--with almost everyone buying each other for ridiculous prices, including numerous massive mergers/buyouts. Usually risk arbitrage appears to produce larger spreads (hence good for risk arbitrageurs) near the peak and it seemed like that time was now.
- Possible capital shortage for risk arbitrage: Merger spreads are usually very tight (1% of deals with moderate "risk" that are about to close within 6-12 months) because arbitrage funds and investors are always seeking out abnormally large spreads. Right now, due to the number of deals, including some mega-deals--basically deals you will see once in your life in those industries--there were some articles suggesting that there isn't enough risk arbitrage capital. I can't be certain but it seems plausible that capital may have been tight given numerous $15 billion+ mega-deals in the agrochemicals, pharmaceuticals, and technology industries were underway. Even if funds had capital, they would have been reluctant to allocate a lot to a few deals--risk arbitrage for professionals is based on entering a lot of deals and spreading out the risk, duration, etc.
- Underperformance by big risk arbitrage funds: Sort of tied into the prior point, it is possible that some blow-ups and severe underperformance by big risk arbitrage funds may have kept capital away from some attractive deals. John Paulson, who is famous for his short-selling of real estate but his expertise is really in risk arbitrage, was down something like 18% in his special situations fund (it deals with risk arbitrage as well as things like spinoffs but his losses appear to be mostly from risk arbitrage).
- Bond yields are rising rapidly: I think many expected yields to rise but the pace (without any adverse economic event i.e. no recession/no crash/etc) has been surprising to me. Rising yields means companies are going to have a harder time financing deals. Those that entered deals may try to back out of them if the situation gets bad. Although not comparable to then but during the financial crisis, there were many companies that tried to back out of mergers. I think this risk is increasing by the minute and you need to be really careful.
- US$ is rising rapidly: Situation is different if you are American but if you are a foreigner, risk arbitrage becomes less attractive as US$ increases in value--assuming you don't hedge the currency. Except for a portion of my savings held in a US$ account, most of my investments are from C$ and unhedged. Given how risk arbitrage deals have very small returns (usually 5% to 10%), rising currency can wipe out most of your gains. Unlike when you own stocks for the long term, you won't get a chance to make it back since the deals close quickly (whereas currencies have very little impact for long-term investing).
- Incoming US government possibly taking hard stance against foreign investment: Although it is hard to read Trump--he says a different thing depending on who his audience is--I think the US government is going to be strict when it comes to foreign investment. I think many deals where foreign firms are buying US firms are very risky right now. I think you need to be careful with any deals that involve China. I am invested in the Syngenta buyout by ChemChina and I think the risk has increased that the US government will block that deal somehow (Syngenta is a Swiss company but does a lot of business in American agricultural states); similarly, I am not sure if the Bayer buyout of Monsanto will pass easily (Bayer is German but I think Trump administration is negative towards European companies as well).
- Potential stock market correction or crash: Impossible to predict a stock market correction but US stocks have been rallying with very little reason in my opinion. I see all sorts of conflicting signals (how could bond yields rise and stocks still go up? Wouldn't a strengthening US$ lead to lower US corporate earnings? so on) and until they are resolved, risk arbitrage seems riskier than usual. In theory, risk arbitrage is uncorrelated with the market. However, companies will try to weasel their way out of deals if things go wrong (this is what happened during the financial crisis; some will try to re-negotiate a lower price if the firm being acquired's stock falls; otherwise will try invoking MAC (material adverse clause) for all sorts of dubious reasons including deteriorating profitability of the firm being acquired; etc). I feel like the spreads need to be wider to get involved now.
Tags: mergers and acquisitions