Merger Funds Are Ready to Rally. Why They Look Better Than Bond Funds.
The urge to merge is back—and Biden administration appointee Lina Khan, the former chair of the Federal Trade Commission, is gone.
“Everybody is sick and tired of the government interfering in private commerce,” says Roy Behren, the manager of the Merger Fund. “We saw an extremely activist Federal Trade Commission led by an inexperienced academic, and she has forestalled many transactions that were announced.”
While the Khan FTC insisted it was protecting the public from monopolistic practices, merger arbitrage managers like Behren are celebrating Khan’s departure and the Trump administration’s replacement of her with the more merger-friendly Andrew Ferguson.
Less regulation and a dealmaker as president should improve returns, as the likelihood has increased of more merger deals being approved more quickly and ultimately closing.
Both the number and speed of regulatory approvals are relevant. “The big risk with merger arb is time,” says manager Scott Johnson of the NexPoint Merger Arbitrage fund. “If the definitive merger agreement tells me I’m going to get $20 at closing, how long it takes for that deal to close determines what my return is. If the stock is trading at [$19.50] and the deal closes in four months, I make an 8% IRR [annualized internal rate of return]. But if the deal closes in eight months, I make a 4% IRR.”
One way Khan delayed mergers was to issue what are called “second requests” for more information about proposed deals to see if they were anticompetitive, even when Johnson and other arbitragers believed they weren’t. These deals would eventually close but take longer to do so. Johnson points to waste-disposal company Waste Management’s $7.2 billion acquisition of Stericycle in November as an example. “Stericycle does only medical waste. Waste Management’s not in medical waste,” he says. “There was no overlap in their businesses.”
He calls this FTC strategy “regulatory tourism” in the private sector. Regulators “just go in and do a second request and prolong the deal for no other reason than to make boards and CEOs think twice about getting involved in a merger,” he says. Such requests, he believes, will largely disappear now.
The improved outlook for merger funds comes at a good time, as the bond market has become increasingly volatile in an uncertain interest-rate environment. Because of their low volatility and returns that aren’t correlated with the stock market, merger funds can be used as a bond fund substitute. Whether the stock or bond markets rise or fall, merger funds’ returns move independently, being based solely on whether proposed deals close.
Yet investors must understand the nuances of arbitrage strategies. Morningstar includes merger funds in its “event driven” fund category, but not every corporate event is a merger. The category’s best performer in the past five years, the Camelot Event-Driven fund, does a lot more than merger arb.
“We’ll invest in mergers, distressed situations, activist situations, and then special situations such as spinoffs or company breakups,” says the fund’s co-manager, Paul Hoffmeister. “We allocate to those different substrategies based on how we see the risk/reward profile in them.”
Camelot co-manager Thomas Kirchner sums up the common theme for each investment. “It’s a change in the corporate structure where you’re reorganizing the company—whether that’s a merger, breakup, or bankruptcy—and that unlocks some kind of hidden value,” he says.
While Kirchner and Hoffmeister argue that there will be better merger opportunities going forward, as of Dec. 31, Camelot had only 14% of its assets allocated to merger arb plays. Some 32% was allocated to activist situations, when a large shareholder of a company is trying to force its management to unlock value, often by selling assets.
The Camelot team will often piggyback on powerful activist hedge funds’ investments. One such power broker they follow is Starboard Value, which recently began to pressure Kenvue, a healthcare spinoff from Johnson & Johnson, to address its lagging share price. Such bets can produce higher returns than merger arb, but with more volatility and unpredictability, as activists don’t always win their fights.
Camelot’s standard deviation—a volatility measure—has been 8.1% in the past three years, compared with NexPoint Merger Arbitrage’s 1.9% and the Merger Fund’s 2.6%. That’s a lot less than the S&P 500 index’s 17.4%, yet Camelot might make a better equity substitute than a bond one.
While the merger outlook has improved, there are still a few risk factors to consider in the more lenient Trump administration, such as to technology sector mergers. Concern over the influence of the largest social-media, search, and e-commerce platforms crosses political parties. “Gail Slater, who’s going to head the antitrust division at the Department of Justice, is pro mergers,” says NexPoint’s Johnson. “What she is against, as is Andrew Ferguson, is Big Tech. They’re going to continue going after Big Tech.”
The other risk is to cross-border mergers, as the new administration is hostile to foreign influences on American business. “It depends on the industry and country,” says manager Daniel Lancz of First Trust Merger Arbitrage, another solid, low-risk merger fund. China and its influence on the U.S. tech sector is a particular concern. “When you start getting into certain industries that have sensitivity, whether it be to national security or just the general advancement or misuse of technology for the advancement of another country over the United States, I think those are going to be the type of transactions that probably warrant more caution,” he says.
Even so, the sailing for merger funds should be smoother going forward than for rockier bond funds.