After having delivered relatively upbeat returns in 2018, Merger Arbitrage lagged behind in the first half of 2019.
After having delivered relatively upbeat returns in 2018, Merger Arbitrage lagged behind in the first half of 2019. In this report, we discuss the reasons for this underperformance and the outlook for the second half of the year.
Merger Arbitrage is a defensive strategy within the universe of hedge funds. It has historically delivered buoyant returns in difficult market environments, such as during the DotCom bust in the early 2000s, the Global Financial Crisis a decade ago, and market selloff episodes throughout the past decade. In 2018, the HFRI Merger Arbitrage was up +3.3% while the MSCI World was down -7.4% and the Barclays Global Aggregate Bond Index was up +1.8%. Last year, Merger Arbitrage once more demonstrated its ability to navigate difficult market conditions.
There are three main reasons the strategy lagged behind during the first half of 2019. First, from a macro perspective, a market driven by dovish announcements from central banks is a beta-driven rally. In this context, you cannot expect low beta strategies such as Merger Arbitrage and Market Neutral L/S to join the party. Second, from a fundamental perspective, Merger Arbitrage suffered from tight deal spreads at the beginning of the year. These were caused by lower M&A volumes overall, and particularly in Europe and China. In the US, volumes have remained strong but the number of deals has shrunk. US cross-border deals have also sunk to multi-year lows on the back of higher political uncertainty (trade tensions, Brexit). In the end, the confrontation between low deal supply and high demand—coming from both general and specialist investors—caused crowdedness and spread tightening. Third, the spread widening in May and June, partly related to new deal announcements and renewed trade tensions, caused mark-to-market losses.
Looking ahead, the combination of stronger CEO confidence in 2019, lower financing costs, and record levels of private equity dry powder should prove supportive. Since early May, M&A volumes have actually rebounded and deal spreads have widened, providing opportunities to deploy capital at attractive entry points. Meanwhile, if trade tensions between the US and China escalate further, the low beta/low volatility features of the strategy will help protect portfolios.
We have maintained an Overweight stance on the strategy over the past quarters and we reiterate that view now. Beyond better opportunities related to wider deal spreads and higher M&A volumes, strategies that provide protection in bad times are even more appealing in a world of low or negative interest rates.