Let's Make a Deal: The Outlook for Merger Funds

The recent spate of merger activity on Wall Street (including last week's $66 billion acquisition of Allergan by  Actavis ) has raised the profile of a niche segment of the alternative mutual fund universe, merger-arbitrage funds. Merger-arbitrage funds invest in the stock of takeover targets but hedge their stock market risk. Think of their returns as closer to those of a short-term high-yield bond fund, and you have some idea of what to expect.

The mechanics of a merger-arbitrage fund are simple--buy the stock of an acquisition target and short the stock of the acquisitor, then profit from the spread between the target’s current price and its buyout price. When deals close without complications, the company is bought and the investor pockets the spread. However, if a deal breaks, the stock of the acquisition target falls, causing losses. When the fund is run by a skilled manager, astute deal selection can limit broken deals and allow funds to capitalize on mispriced spread opportunities.

Merger arbitrage possesses unique alternative characteristics. Because the risks are limited to the risk of deals being canceled, which is different from stock market risk, the strategy exhibits a beta of nearly zero. Because of this, merger-arbitrage funds are classified as market-neutral and can be found in the market-neutral Morningstar Category. Additionally, because merger arbitrage benefits from rising interest rates, the strategy has gained a following as a fixed-income alternative for a rising-rate environment.

Morningstar tracks five funds focused primarily on merger arbitrage, but the strategy can also be present as a minority sleeve in event-driven or multialternative funds.

A Brief History of Merger-Arbitrage Mutual Funds
Merger arbitrage was exclusively the domain of hedge funds until Westchester Capital Management debuted  Merger Fund (MERFX) as the first merger-arbitrage mutual fund in 1989. Water Island Capital followed with  Arbitrage Fund (ARBFX) in 2000. Neither fund took off, however, until 2008, when merger arbitrage, because of its hedged nature, outperformed most traditional strategies by a wide margin. Indeed, the two largest merger-arbitrage mutual funds, Merger Fund and Arbitrage Fund, delivered positive returns in the second half of 2008 (0.98% and 2.10%, respectively), while equities and many other asset classes plummeted. As a result, the two funds’ combined assets jumped from $1.5 billion in 2008 to $2.9 billion by 2009, and they have continued to grow at a breakneck pace ever since. With a combined $8 billion under management today, the Merger and Arbitrage funds control an estimated 89% of mutual fund merger-arbitrage assets and approximately 20% of assets in dedicated merger-arbitrage strategies across both mutual and hedge funds, according to Barclays.

The success of Merger Fund and Arbitrage Fund has encouraged new merger-arbitrage entrants in the mutual fund arena. Two are longtime hedge fund operators, Glenfinnen and Longfellow, which have partnered with mutual fund distributors SilverPepper and Touchstone, respectively, to offer their strategies to the public. Another longtime hedge fund operator, Kellner Capital, has debuted its own mutual fund offering.

One advantage that new entrants may have is a lower asset base, which gives funds more flexibility to invest across the market-capitalization spectrum. While smaller, nimbler funds can easily load up to 10% of fund assets in their favorite deals, larger funds aren’t always so fortunate. Small deals are often too illiquid to build any meaningful position size, which could take weeks for a multibillion dollar fund. Merger and Arbitrage, the behemoths in the space, have adapted their process to invest in a broader number deals in order to combat capacity constraints. On the other hand,  Touchstone Merger Arbitrage , whose management favors small-cap deals, closed to new investors less than two years after launch in order to preserve its strategy.

A Year of Ups and Downs
The merger-arbitrage universe looked promising through September, with increased deal flow leading to higher profits for merger funds in the first three quarters. The second quarter had brought $501 billion of announced deals globally, according to Dealogic, including multiple mega-deals such as  Comcast’s (CMCSA) $45 billion acquisition of  Time Warner Cable . This total represented the most deal activity in a single quarter since the heyday of 2007. Third-quarter deal flow also showed substantial growth at $324 billion, an increase of 121% from the year-ago quarter.

The increased deal flow continues to benefit merger-arbitrage mutual funds in two ways. First, with so much supply in the marketplace, funds should have fewer capacity issues. This is a boon for the largest funds, which have enormous amounts of capital maturing each month that must be deployed into new deals. The Merger Fund, the largest and most capacity-constrained merger-arbitrage fund, invested only 85% of assets on average from 2011-13 because of the lack of available liquid deals. But as of March 31, 2014, the fund had invested more than 93% of assets, and in recent discussions management estimated that the fund had reached 98% of assets invested.

Second, spreads have widened in many deals from about 3% annualized to up to 6% annualized rates of return in straightforward transactions. There are a number of reasons why spreads can widen, including market turmoil and rising short-term interest rates, but heightened deal flow can encourage spreads to widen by leaving the market with fewer merger arbitragers as a percentage of market participants, as arbitragers' trades tend to narrow spreads.

Despite promising trends in deal flow, the performance of merger-arbitrage funds reversed suddenly in October. The culprit was a controversial tax inversion deal--the largest of the year--between  AbbVie (ABBV) and  Shire , which broke on political pressure from the U.S. Treasury. 

On Oct. 15, when AbbVie's board of directors announced it was removing support for the deal, citing the "unacceptable level of risk and uncertainty" of future tax rule revisions, Shire, its acquisition target, fell 34% by the end of the day, taking merger-arbitrage funds with it. An equal-weighted basket of the five merger-arbitrage funds tracked by Morningstar fell 3.0% from Oct. 8 through Oct. 17 in the runup to and aftermath of the deal break. In addition to the losses from Shire, spreads widened in virtually all deals (causing temporary losses), reflecting the greater uncertainty in merger arbitrage as a whole.

Looking Ahead
How should investors view merger-arbitrage funds in the wake of these events? While returns are flat for the year, merger spreads are much more attractive than at the beginning of the year. Following the AbbVie-Shire deal break, spreads widened indiscriminately in all merger deals, and they remain at elevated levels as of Nov. 12.

Greater perceived risk in the merger-arbitrage market causes merger spreads to widen, which creates an opportunity to reinvest at greater rates of return. In 2008, for example, market anxiety caused spreads to widen but led to increased returns in the following year. After falling 0.6% and 2.3%, respectively, in 2008, the Arbitrage and Merger funds returned 10.0% and 8.5% in 2009, in part because of widened spreads. While the market has seemingly panicked following AbbVie-Shire, history suggests this may be a good time to invest. Some funds, including Kellner Merger, have opportunistically increased gross exposure, based on management’s positive outlook.

Tax-inversion legislation, however, presents an ongoing risk, although one that may already be priced in to current spreads. Because of uncertainty over inversion deals, the merger-arbitrage market remains undervalued at this time. For investors seeking to gain access to this strategy, Silver-rated Merger and Bronze-rated Arbitrage are solid choices, with experienced management and long track records of success. Concerns over capacity issues with these large funds should be eased for now, considering strong deal flow this year. Bronze-rated Touchstone Merger Arbitrage is closed to new investors but offers a less-capacity-constrained mid-cap version of its strategy in Touchstone Arbitrage . Two new entrants, Kellner Merger (GAKIX) and SilverPepper Merger Arbitrage , are unrated by Morningstar but possess prior hedge fund track records.