Notes from the Desk: Merger Arbitrage Market Update

Many clients are attracted to our approach to the merger arbitrage strategy as we execute it in the Arbitrage Fund for its typically even-keeled nature, with a fairly stable historical risk/return profile. Merger arbitrage generally seeks absolute returns with low levels of volatility over the long term, but returns are traditionally sourced from equity securities. While these equities typically trade based on the fundamentals of the announced mergers and acquisitions (M&A) transactions in which they are involved, rather than overall market direction, during times of heightened market volatility we often see correlations converge, and merger-related names are not entirely immune to these market events. We have seen this several times before – for example, in the midst of the Global Financial Crisis of 2008, more recently at the onset of the COVID-19 pandemic in the first quarter of 2020, and now once again during Q2 2022.

The reasons for recent market volatility are numerous – geopolitical tensions, inflation, rising interest rates, and recession fears, to name just a few. The net effect for the merger arbitrage strategy has been a dramatic widening in deal spreads across nearly all pending M&A names. Merger arbitrage is not an inversely correlated strategy, and when arbitrageurs unwind positions en masse – which can happen due to forced de-risking (especially amongst levered investors) and panicked selling – spreads dislocate, as the arbitrage community is simply not large enough to offset widespread selling with new buying. To give a sense of the scale of the spread widening we have seen, the table below presents the average spread of the 25 largest deal holdings in the Arbitrage Fund as of May 31, 2022, at various points in time.

	1 Day Post Deal Announcement	4/1/2022	5/2/2022	6/16/2022
Average Gross Spread – Top 25 Deals	3.5%	4.1%	5.0%	11.4%

Source: Water Island Capital. As of June 16, 2022. Represents 25 largest positions by long exposure to alpha security, as a percent of net assets. Reflects direct investments only.

The spread of a deal the day after it is announced can generally be considered a baseline rate of return for the deal (assuming its successful completion), and this is often the widest point at which a transaction will trade as all hurdles to completion remain outstanding. Yet as of June 16, the 25 largest deals in the portfolio on average traded at rates of return more than three times greater than their average spread the day after each deal was announced.

We understand such spread widening can lead to drawdowns that may seem alarming, especially for a strategy that tends to only move in small increments, but it is important to remember that this volatility reflects nothing but mark-to-market movements, not any changes to the fundaments of the underlying deals in the portfolio. While these drawdowns are hard to avoid if one intends to remain invested, in our prior experience their duration has been short-term in nature – after the volatility subsides, deal spreads begin to narrow as each transaction proceeds to a successful close. Historically, according to Dealogic data, more than 90% of announced M&A transactions successfully close, while in our own portfolio on average just 1% of the deals in which Arbitrage Fund has invested have broken while held in the portfolio. We expect the success rate of announced M&A to remain consistent with historical norms, as merger contracts have become increasingly strong since the Global Financial Crisis and it has become exceedingly difficult for even the most remorseful buyer to extricate itself from a definitive merger agreement.

As we see it, there are three reactions a merger arbitrage investor could have in response to this type of volatility. The first is to capitulate, which we see most often amongst levered multi-strategy hedge funds as they close out their arbitrage book to focus on other strategies they deem more attractive. Another is to go to cash and sit on the sidelines in an attempt to wait out the volatility. The last, and the course we have chosen, is to see opportunity amongst the chaos and remain fully invested. We have a high degree of conviction in the deals in which we have invested and we believe diverging spreads have led to attractive rates of potential return. We believe the transactions in the portfolio will eventually close, freeing up capital to be redeployed in newly announced deals, with the added benefit of rising interest rates (which have historically served as a tailwind for merger arbitrage returns). Deal flow remains robust, and widespread dislocations in valuations can often lead to shareholder activism, potentially spurring additional M&A or topping bid scenarios. Lastly, ongoing market volatility can provide the ability to trade around spreads and find opportunistic entry points. All in all, we are optimistic about the return potential for the strategy, but we do anticipate relatively higher volatility to remain present in the months ahead. As such, we intend to adhere closely to our stringent risk management protocols as we navigate these choppy waters.

Commentary represents the manager’s current opinion and may contain certain forward-looking statements. Actual future results may differ from our expectations. Our views may change at any time, and we have no obligation to update them. Commentary should not be regarded as investment advice or a recommendation of any security or strategy. Investing involves risk, including loss of principal. Past performance is not indicative of future results. Visit the glossary for definitions of terms.

RISKS: Investments are subject to risk, including possible loss of principal. There can be no assurance that the fund will achieve its investment objectives. The fund uses investment techniques and strategies with risks that are different from the risks ordinarily associated with equity investments. Such risks include merger arbitrage risk (in that the proposed reorganizations in which the fund invests may be renegotiated or terminated, in which case the fund may realize losses); short sale risk (in that the fund will suffer a loss if it sells a security short and the value of the security rises rather than falls); concentration risk; high portfolio turnover risk (which may increase the fund’s brokerage costs, which would reduce performance); foreign securities risk (in that the securities of foreign issuers may be less liquid and more volatile than securities of comparable US issuers, and may be subject to political uncertainty and currency fluctuations); market risk; sector risk; derivatives risk; LIBOR rate risk; hedging transaction risk; counterparty risk; swap risk; options risk; liquidity risk; active management risk; investment company and ETF risk; leverage risk; small and medium capitalization securities risk; currency risk; and temporary investment/cash management risk. Risks may increase volatility and may increase costs and lower performance.