On Aug. 6, the first broad-based merger spread widening occurred since the fall of 2011. The breakup of three announced deals that day widened spreads and provided a unique entry point to capture value through the anticipated convergence of these spreads.
Early that day the news broke that “Walgreens is staying in the U.S.” The Chicago company had chosen to keep its U.S. tax domicile after buying Swiss-based Alliance Boots GmbH, thereby forfeiting the highly controversial “inversion benefit.” Later that same day, Bloomberg reported both that Sprint Corp. and T-Mobile decided not to merge, and that Rupert Murdoch's 21st Century Fox “gave up” on bidding to acquire Time Warner Inc. The equities for the companies involved in these deals were down considerably on the news, selling off more than 10%.
Finally, Secretary of Treasury Jacob J. Lew urged Congress to act immediately to limit corporate inversion by making it a less economical option for U.S. companies. By market close, contagion had ensued in merger arbitrage, causing a broad-based spread widening that persisted for days. Many deal spreads were in the high teens by the end of the week after trading significantly tighter for several months, sometimes without regard for the nature of the deal — local or cross-border, simple or complex, short-term or long-term, with or without regulatory risks.
The causes of contagion
The widening of merger spreads was caused by a number of factors. In the weeks leading up to Aug. 6, there was an abundance of merger deal flow focused in the health-care sector and on corporate inversions.
Some investors were speculating on which companies might announce inversion deals, buying them and propping up their prices as a result. In some cases, with losses caused by widening merger spreads, risk management mechanisms might have recommended scaling back positions on existing deals, creating uneconomic sellers in otherwise attractive situations. Similarly, traditional long-only buyers who were long-term owners of shares of companies targeted for inversion benefits also started selling to minimize their overall exposure to U.S. regulatory risk.
Looking deeper into the cause of the contagion, leverage levels — a common driver of merger spread movement — do not explain investor behavior in this particular case. Leverage did remain below peak levels. However, overall deal quality was lower and deal complexity had increased.
In fact, leading up to Aug. 6, these two factors, when observed together, were far above the normal expected trade-off band (see graph below), and contributed to the wider derisking.
Current market conditions present an opportunity for investors to capture value by positioning for the convergence of merger spreads back to normal levels. A healthy credit market and the notion that market contagion irrationally widened spreads on many deals unrelated to corporate inversions, both support an opportunistic increase in the risk allocation to the merger arbitrage strategy.
Such an opportunistic increase needs to be nimble and dynamic, in nature and in structure, in order to capture the potential convergence before merger spreads normalize. Dynamically positioning for convergence can be effectively implemented through the use of variable leverage in managed accounts or by gaining exposure to hedge fund replicators/alternative beta via swaps. The managed account approach will effectively increase (and later reduce) exposure without the need to wait for the monthly subscription cycle. The replicators should also be able to reduce the need for a cash transaction if the appropriate counterparty setup is in place. Once the market normalizes, allocators should aim to bring back their exposures in line with their longer-term targets.
Mayer Cherem is a managing director and head of the portfolio solutions group at PAAMCO in Irvine, Calif. Mayer is also responsible for PAAMCO's opportunistic investments and chairs the Strategy Allocation Committee that formulates the firms top down investment direction.