Turning M&A deals into a stable source of returns

Why hedge-fund style approach of merger arbitrage can fortify a portfolio even when the markets are dropping

Turning M&A deals into a stable source of returns

Market jitters have thrown alternatives back into the spotlight this week. How valuable is a strategy that has no correlation to equity markets that are susceptible to tweets or virus scares?

Picton Mahoney Asset Management strengthened its line-up of alternative solutions recently by acquiring merger arbitrage strategies from Vertex One Asset Management Inc. The hedge fund-style approach, also known as risk arbitrage, is designed to fortify a portfolio by capitalizing on price inefficiencies caused by the successful completion of merger and acquisition deals.

Craig Chilton, portfolio manager, merger arbitrage, told WP that, typically, a company will not trade at the target price right up until the actual deal price. By buying the target at a discount to the eventual price and determining that the rate of return earned by holding it to consummation is attractive to risk, they can take advantage of those gains.

The portfolio is built by doing that over and over again. It may consist of some high-profile M&A deals but many more fly under the radar. Chilton said a good analogy is when an investor buys a bond at a discount to par, with a completed corporate deal equal to maturity.

While Picton Mahoney’s arbitrage funds are effectively investing in equities, they aim to achieve a bond-type return profile, with the portfolio as a whole looking like a fixed-income product.

“[It gives is] consistent, slow returns, irrespective of whether the markets are going up or down,” Chilton said. “That's important because what you're taking here is not equity market risk so much as an idiosyncratic risk of whether a deal that's been announced is going to succeed or fail.”

The lack of correlation to the equity market is, of course, one of the strategy’s big draws. Chilton stressed that even if the markets are plunging, that does not mean a deal will fail. He added: “It’s a unique source of return uncorrelated to other return streams. These are legally binding, heavily lawyer negotiated contracts, which don't allow for the companies to change their minds. It’s a return profile that’s quite distinct and unique from what most people have access to.”

Picton Mahoney’s main arbitrage fund returned 6.8% for 2019, while its products are split into levered and unlevered. A return of 4-6% over short rates is the typical target for the levered product.

While some M&A deals are known, enabling the team to familiarize themselves with the companies quickly, other times it requires getting up to speed with companies rapidly. But Chilton said that regardless of the complexity, pattern recognition comes into play, allowing the portfolio manager’s years of experience to quickly assess whether the deal is likely to succeed or fail. Depending on the time it takes to do due diligence and feel comfortable, the fund may not have a position until near the end.

Chilton added that the strategy shines when the market is under pressure. Over the past three days, the market has taken a hit and dropped about 8%, while his fund was down only 25 basis points.

He said: “It's that kind of stability in the midst of the storm that people like. If you were to look at our historical performance, even though we lag the equity markets during rallies, where we really make it up is when the markets are off 20% and we're still positive. We can make up for a lot of lag in one fell swoop.”

Drawdown risk is a selling point. He added that in 2008, when the markets dropped 30%, the strategy was relatively flat. An “obvious” fixed income replacement product, with an effective duration of three to four months (the typical length of the deal process), it also has capital gains tax efficiency.

“It’s a great all-weather exposure for anyone who wants some market neutral exposure that generates long run equity-like returns. It won't keep up to equities in the short run or in bull markets, but over the long run it creates quite compelling returns for the amount of risk taken.

“For anyone who's looking for a more defensive equity-like exposure, this would be it. The nice thing is that because it's such a consistent strategy, it's not fair weather and it's not the type of strategy where you have to think about timing. It’s should always be a slow and steady producer.”