Once or twice every decade, M&A markets go through a bust and returns of merger arbitrage and event-driven funds slip. It does not take long until pundits and performance chasing hedge fund investors ask: Is merger arbitrage dead?
Reading the financial press certainly conveys that impression. A number of event-driven funds have shut down in recent months, many of whom use merger arbitrage as one of their principal strategies: Knight Capital’s (NITE) Deephaven Event-Driven Fund shut down in January, as did the QCM Arbitrage Fund (QARFX). The U.S. subsidiary of London’s Tisbury Capital followed suit shortly thereafter and closed its U.S. operations due to losses. Bear Stearns (BSC) used to run a large merger arbitrage book – it’s safe to assume that it is in the process of being downsized. “I’m practically wearing a diaper to work,” the WSJ’s Peter Lattman quoted one disillusioned arb.
Even funds not normally associated with merger arbitrage are likely to be affected by the collapse of mergers. Infamous Sowood, which shut down last summer, is usually seen as a victim of subprime losses but also known to have carried a number of merger arbitrage positions. Sowood is an eerie reminder of the LTCM debacle: although LTCM was primarily a bond shop, it was running a sizable merger arbitrage portfolio and dragged down that strategy when it liquidated. We won’t know until after the fact how many liquidating credit hedge funds were running side pockets in merger arb. Nevertheless, the withdrawal of only a few large and overleveraged disciples of mean reversion can wreck havoc on our niche strategy.
Hedge fund investors only contribute to the overshooting of the flight from a strategy as soon as its return slips just a little. Tisbury Capital is struggling to contain outflows. Supposedly hedge fund investors are smart money, yet they exhibit all the herd mentality characteristic of performance chasers. The pattern of flight from unpopular strategies repeats itself like clockwork, not just for merger arbitrage, but almost any alternative strategy. Just a few years ago, when merger arbitrage returns declined, James Altucher declared the strategy unattractive (that was before his weekly FT column changed its focus to restaurant tips and self-help advice). In 2005 , when GM was downgraded and Kirk Kerkorian made a tender offer for its stock, convertible bond arbitrage funds had a bad year and that strategy was declared dead. The favorite argument of the obituary writers is the efficient market hypothesis: everyone knows about the inefficiency, therefore it disappears. Never mind that the next year convertible bond arb’s made a strong comeback. GLG Partners (GLG) has even gone public recently, even though it suffered a terrible 2005.
In this cycle, merger arbitrage has not yet been declared dead as a strategy. We hereby do so:
Yes, too much money is chasing the strategy.
Yes, there is not enough dealflow.
Yes, everybody knows about it, so the inefficiency has disappeared.
Now that we have obituary out of the way, we can look forward to a strong rebound.
Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which invests using merger arbitrage.