Is this the year for Merger Arbitrageurs and M&A?

The last five years has been a torrid time for the mergers and acquisitions market, and in turn for those investors seeking merger arbitrage opportunities. What do firms such as Touchstone Investments, Twin Securities, and Tyrus Capital have in common? They are all merger arbitrage specialists – funds who aims to profit from the spread between a target group’s share price after a takeover announcement and the closing price at completion of the deal. Several large funds scaled back their merger arbitrage operations during the financial crisis as deal activity dried up and their ability to borrow was curtailed. The lack of competition means merger arbitrage funds can make high double-digit returns in a couple of months even from mainstream deals. Therefore, I would investing in a merger arbitrage fund ahead of the expected recovery in M&A activity.

M&A deal volume peaked in 2007, just before the financial crisis, at US$4.1 trillion. Deal volume then experienced a sharp decline and in 2012 deal volume was $2.2 trillion after a more optimistic first half of the year due to high projected growth rates in emerging countries. The fact that the European bond markets rebounded in late 2012 and the USA did not default on its debt should augur well for M&A in 2013. The Dow Jones Industrial Average also topped 14,000 for the first time since 2007 last month.

Mergers & Acquisitions have started strongly this year. Some of the deal activity includes:

·         Sinopec’s acquisition of a 50% interest in some of Chesapeake’s oil and gas properties in the Mississippi Lime Shale formation for US$1.02 billion cash. The valuation is notable for falling short of expectations as Chesapeake are a company that are having to sell due to large debt problems and are looking like a forced seller.

·         $11 billion merger between bankrupt AMR Corporation (parent of American Airlines) and US Airways Group.

·         Liberty Global’s $23.3 billion purchase of UK cable operator Virgin Media.

·         Michael Dell’s deal along with partners Silver Lake private equity firm and Microsoft to take Dell private for $24.4 billion in the biggest leveraged buyout since the financial crisis.

·         Heinz is under a $28 billion bid from Buffett’s Berkshire Hathaway, 3G capital backed by Brazilian billionaire Jorge Paulo Lemann (who led leveraged buyout of Burger King in 2010). Berkshire and 3G will contribute $4bn of equity each, and Berkshire will buy another $8bn to $9bn of preferred stock paying a 9 per cent coupon. The bid values Heinz at $28bn, including $5.1bn of net debt, and is subject to shareholder and regulatory approval. In addition to the buyers’ cash, JPMorgan and Wells Fargo have committed debt financing of $14.1 billion for the deal.

The US Federal Reserve has held benchmark interest rates at 0.25% for over four years and the European Central Bank has held interest rates at 0.75%. Trillions of dollars have been injected into US, European and Japanese economies in an effort to kickstart them. Additionally, markets are liquid and stable. Investors are also moving assets out of cash and are searching for high-yielding and riskier assets. This is a market ripe for M&A activity.

Yet if the market is going to continue to derive interesting opportunities for merger arbitrage investors, then a few developments are necessary.

·         Cash-rich corporates are conserving their mounds of cash. As of 1^st October 2012, corporations globally were sitting on a record $1.5 trillion of cash and their balance sheets have never been stronger. However, corporates are facing a “use it or lose it” conundrum where investors are pressuring cash-rich companies, such as Apple, to either use the funds for acquisitions and increase capital expenditure or pass it over to the shareholders either through share buybacks or dividends. I suspect that companies are starting to “use it” and will continue to do so as cash-rich corporates can cherry pick underleveraged companies at attractive prices in the current environment.

Time to pop a bottle?

·         M&A activity typically lags 12 months behind the stock market pick-up and 18 months behind corporate CEOs’ confidence. Business confidence has been improving since Q4 2012 as worries about the eurozone debt crisis and a potential slowdown in China’s growth have subsided. Therefore, we may be seeing M&A activity catching up with stock market and corporate CEO sentiment.

·         The environment right now is earnings accretive for M&A. There is a record spread between the free cash flow and the earnings yield. Additionally, the low corporate bond yields on offer is rendering debt-financed M&A activity especially appealing.

·         Many companies’ market capitalisations are trading below replacement value and this is above the historical average – 28% of the European market is trading below replacement below which is well above the average of 14%. Therefore, buying is abnormally cheap compared to building a company in the current environment. With such attractive equity market valuations M&A activity should be around the corner.

·         In 2012, 10% of all global M&A activity involved international companies acquiring US targets. This trend is expected to continue in 2013 as companies in developed countries with relatively slower-growth – Australia, Canada, Japan, Europe – seek opportunities in the USA with its better growth. Companies from emerging countries, such as China and India, are also attracted by the US recovery – Chesapeake’s sale of assets to Sinopec is one such example.

·         There is a discrepancy between M&A activity in the USA and Europe. Banks have resumed lending in the USA whereas in the Eurozone banks are still not lending. M&A activity will receive a pick-up if the EU can get their banks to restart lending.

The only likely detractor from an M&A recovery in 2013 will be heightened regulatory scrutiny, particularly in the case of cross-border deals. Yet, much of M&A activity is psychological. The deals in 2013 thus far would have helped to raise confidence that the worst of the financial crisis is over. Whether merger arbitrage investors are able to open that bottle of Pernod-Ricard Perrier-Jouet will depend on whether companies buy into the confidence and keep on spending.