Q&A: Merger Arbitrage Revisited

Michael Gubenko:Were there any other types of arbitrage opportunities that arose from this volatility?

Jeff Lin:There's a large universe of non-merger related arbitrage situations that we explore for investment. Often, it's a function of what's going on in capital markets. When there is stress and a lack of capital chasing these kinds of investments, it can create interesting opportunities. Historically, we have been active in split-offs, exchange offers, and different forms of share-class or holding company arbitrage. These investments involve creative solutions where we can lean on our expertise on proration, on equity finance, on stock loan, and the size of our presence in the market to execute these complex trades.

Last year we allocated to several non-merger event-driven investments; one was a split-off of a consumer health company, a stock loan arbitrage in a media company, and a share-class arbitrage in a separate media company. The resources that we have at the firm proved again to be a huge advantage in identifying and setting up these convergence-oriented opportunities. In addition, as fundamental investors, we had the risk appetite to be short certain volatile securities while traditional arbitrageurs typically either don't have the mandate, the leeway, or the tolerance to take those risks.

Michael Gubenko:One major difference between now and when we last spoke is that interest rates have been sustained at elevated levels. Does that impact the opportunity set in any way?

Jeff Lin:Merger arbitrage spreads are generally fixed income investments. Part of the strategy is assessing the probability that the deal closes, and another element is evaluating the time it takes for it to close. Short term risk-free rates significantly impact the net annualized returns of cash deals. Unlike in all-stock transactions where the merger spread has a short component that earns a rebate, cash deals are now much more sensitive to how long a deal takes to close. For example, when short term rates are north of 5% and a deal trades at 9% IRR to a 6-month timeline, adding an additional 6 months from a lengthy regulatory review changes the return from 400bps over risk free to being 100bps less than risk free. As a result, we have to factor this into our analysis when we think about the risk reward to different scenarios in the timeline and typically, we find that we are more conservative than the market.

Michael Gubenko:Given the strong rebound across risk assets, many market participants are calling for a resurgence in capital markets appetite and deal activity. Is this beneficial for the merger arbitrage strategy?

Jeff Lin:Overall, more capital markets and deal activity is beneficial across our multi-strategy business. More IPOs, and more secondary offerings create opportunities to profit in arbitrage. And so yes, absolutely, this rally is a tailwind for M&A because there is more risk appetite in corporate boardrooms.

However, we have a presidential election this fall, which could bring a potential change in administration, and in turn antitrust policy. There is also the anticipation of lower short-term rates from the Fed easing later this year. And so, there are a few reasons to wait on M&A. With that said, tight credit spreads, general availability of financing, and an improving global economic outlook may outweigh some of those reasons to wait. On balance, the current market provides a conducive environment for being opportunistic investors in the kinds of complex situations that we have historically favored.