5 Funds With a Lot to Gain From M&A

A.J. D'Asaro: Merger arbitrage is a niche strategy in the market-neutral category in which managers buy the stock of an acquisition target and profit from the spread between its current price and its eventual buyout price. Historically, that spread has been 3% to 5% plus the short-term interest rates at the time.

Funds in this space vary from where they are focused in the market-capitalization spectrum. Many funds have decided to focus on small-cap deals, which historically have been a better-returning segment of the universe. And the reasons for this are that small-cap deals usually close faster, can be all cash, and are less complicated than large-cap deals where antitrust regulation usually comes into play.

In this space, we have several small-cap merger-arbitrage funds, such as Kellner Merger (GAKAX) or SilverPepper (SPABX) or Touchtone Merger Arbitrage (TMGAX). And once they achieve a certain level of assets, they will close. On the other end of the spectrum, there are the giants in this space: the Arbitrage fund (ARBFX) by Water Island Capital and the Merger fund (MERFX) by Westchester Capital Management, which collectively manage $8.2 billion in assets. Those funds have opted to change their strategies to accommodate a larger asset base.

In quarter two of 2014, $500 billion of merger-arbitrage transactions were announced globally. This is the highest level of deal activity since the heyday of 2007. The main contributors to this increase in deal activity are high levels of cash on corporate balance sheets, record-low interest rates, and inflated stock prices--all of which provide ammunition for companies to acquire other companies. And tax-inversion deals have recently become popular.

Because of this, many merger-arbitrage funds have experienced jumps in performance. And if this deal activity continues, these funds represent great opportunities going forward.