Despite the unprecedented global uncertainty, credit markets remain open for business and have proven to be robust enough to provide access to capital to some of the riskiest borrowers in need. What’s also surprising amid this economic disruption is that we’re also seeing record levels of cash on US corporate balance sheets coupled with pent-up private equity dry powder.
What does it all mean for investors who are ready to put cash back to work? Look to merger arbitrage.
ETF Trends caught up with Eric Becker, Co-Portfolio Manager of the new AltShares Merger Arbitrage ETF (ARB), which is part of Water Island Capital, a dedicated event-driven investment manager with 20 years of experience and over $2B in AUM.
How badly did Covid-19 impact M&A activity at the start of the year? How have things changed in recent weeks amid the strong rebound on Wall Street?
Eric Becker: The first quarter of 2020 was on track to be a strong quarter for M&A activity but ended up significantly below average as deal activity ground to a halt in mid-March on the back of the coronavirus-driven market distress. In April and May, we continued to see limited M&A activity as companies took a step back to assess the changed market environment and evaluate next steps. However, June has started with a ray of hope as we have seen deal activity begin to pick up. Most notably Grubhub, which after weeks of speculation agreed to combine with Just Eat Takeaway.
What is your outlook for M&A in 2H of 2020 and looking out to 2021? What are the most important catalysts that will support this?
Eric Becker: At Water Island Capital we have experienced and successfully navigated several periods of market stress, and what we have learned from the past, like the financial crisis in 2008, is that substantial declines in the M&A market often lead to sharp recoveries, similar to what we experienced in 2009/2010. We do expect to see a sharp recovery in the second half of the year and in 2021. In addition, the periods following such dramatic downturns have historically presented attractive opportunities for the merger arbitrage strategy. Following severe equity market disruptions and pullbacks, share prices for many companies in competitive industries can fall to levels that make them attractive to both larger companies within their sector and private equity firms who may be looking to opportunistically make acquisitions at depressed asset prices. We have witnessed such periods on multiple occasions over the past three decades – and in many such instances these target companies attract competing bids once they go down the path of maximizing shareholder value.
a) $2.5 trillion of private equity dry powder, highest ever
b) $2.4 trillion in cash on US Corporate balance sheets, highest in decades
c) Credit markets are open to financing transactions (unlike the period immediately following the financial crisis), and we think strategic operators will have a competitive edge over private equity buyers due to the synergies that strategic buyers bring to the table
Which sectors and industries are ripe for M&A in the coming months and why?
Eric Becker: The sectors that might experience the most activity with regards to aggressive bidding wars are often within sectors that are experiencing dramatic stress on their operations (think energy in 2000, tech stocks in 2001, and financial services in 2008), and often require their larger, financially stronger peers to support their ongoing operations. Conversely, many of the fastest growing sectors of the economy and the larger players within those sectors will look to take advantage of weaker peers (weaker balance sheets/weaker market positioning) to strengthen their own businesses through consolidation.
In the current environment, the oil and gas industry will likely need to consolidate. The effects of the pandemic and low oil prices will force some companies to merge simply to avoid filing for bankruptcy.
Financial services, the banking industry in particular, is another area where we expect mergers to resume post crisis. This has been a trend that extends back to the Global Financial Crisis. Banks are consolidating due to the inability of smaller banks to maintain pace with the technology investments that are required to compete with the largest institutions, and low interest rates have been pressuring margins. Additionally, brick-and-mortar community banks have been forced to shut down. Even those customers who preferred to walk into a bank branch have now been forced to bank online.
What exactly does a merger arbitrage strategy entail? What is the appeal for investors who already have diversified portfolios?
Eric Becker: Merger arbitrage is a subset of event-driven investing that focuses solely on investing in companies involved in publicly announced mergers, acquisitions, takeovers, buyouts, and tender offers. The profit opportunity in merger arbitrage is called a “deal spread,” which is the difference between the price at which the target company in a transaction currently trades and the price the acquiring company has agreed to pay to complete the deal. In its purest form, an arbitrageur will purchase the shares of the target company in such an event and, if the acquiring company is using its stock as a form of payment for the transaction, the arbitrageur will also sell short shares of the acquirer in order to lock in the deal spread. Transactions generally trade at a positive spread due to the risk that a transaction may be withdrawn or terminated.
A pure-play merger arbitrage strategy invests solely in definitive, publicly announced mergers and acquisitions. A definitive merger agreement is a contractual obligation binding the buyer and the seller to the deal, barring some extraordinary circumstance. (These extraordinary circumstances are few and far between, and are essentially limited to failure to secure a required shareholder vote, failure to secure financing if necessary, failure to secure regulatory approval, or a material adverse change in one of the parties’ business.) Once a transaction is announced, the shares of the target tend to trade not in line with broader market movements, but rather in line with the fundamentals of the deal. When executed properly, the strategy should provide an absolute return stream with low correlation and low beta to broader equity and credit markets, low volatility, and strong capital preservation characteristics. Due to its risk/reward profile and its non-correlated nature, one of the strategies’ most common uses is as a portfolio diversifier, particularly as a fixed income alternative. The structure of a merger arbitrage trade is actually quite similar to a zero-coupon bond, which is purchased at a discount and pays its face value upon maturity. An arbitrageur purchases a target company at a discount to the deal value and receives the deal value upon the completion of the merger. Unlike bonds, however, rates of return in the merger arbitrage strategy have historically benefitted from rising interest rates.
What makes the ARB ETF unique?
Eric Becker: The key differentiators of AltShares Merger Arbitrage ETF are the rigorous security constraints, selection criteria, and risk management concepts that we instituted in the construction methodology of the ETF’s tracking index. We took our 20 years of experience managing active merger arbitrage strategies and distilled our approach into a ruleset which could be used to construct a passive ETF that still adheres to our team’s core principles of merger arbitrage, which have been tested through all manner of market environments since our firm’s inception. These ideals include risk-adjusting position weights based on potential downside as well as more frequent rebalancing than is typical for a merger arbitrage ETF (twice monthly), in order to keep pace with the dynamic and swiftly evolving M&A universe.
Perhaps more importantly, another core focus in our development of this ETF was to ensure we maintained a pure-play approach to merger arbitrage – in other words, we sought to minimize market exposure and generate returns solely by capturing deal spreads. In practice, this requires shorting shares of the acquirer in line with the deal terms on stock-for-stock transactions and hedging all foreign currency exposure on international deals. Ultimately, this is the difference between a fund that invests in merger arbitrage and a fund that simply invests in mergers.
Material represents the manager’s opinions and should not be regarded as investment advice or a recommendation of any security or strategy. Investors should not rely on these opinions in making their investment decisions. Our views reflect our best judgment at the time of the commentary and are subject to change at any time based on market and other conditions, and we have no obligation to update them. Investing involves risk, including loss of principal. Past performance is not indicative of future results.
This information is being provided to ETF Trends at their request. Water Island Capital, LLC makes no representation or warranty as to the accuracy or completeness of this information.Material represents the manager’s opinions and should not be regarded as investment advice or a recommendation of any security or strategy. Investors should not rely on these opinions in making their investment decisions. The discussion of market trends and companies throughout this commentary are not intended as advice to any person regarding the advisability of investing in any particular security. Some of our comments are based on current management expectations and are considered “forward-looking statements.” Actual future results, however, may prove to be different from our expectations. Our views reflect our best judgment at the time of the commentary and are subject to change at any time based on market and other conditions, and we have no obligation to update them. Investing involves risk, including loss of principal. Past performance is not indicative of future results.