Merger Arbitrage

The key themes of the first half of the year continued into the third quarter, leading to an active summer of M&A. Deal activity in the $1-5 billion market capitalization range continued to be robust, and some of the record-high $150 billion of U.S. private equity dry powder was put to work, as reflected by financial sponsors’ above-trend share of M&A volumes. Announced deal value increased 2% sequentially and 50% year-over-year, as the ‘work-from-anywhere’ culture allowed companies and bankers to avoid the typical summer slowdown. At quarter-end, the deal universe had an average annualized spread of 14.5%, aggregate deal value declined to $377 billion, and the total arbitrage profit pool declined to $20.7 billion.

Risk arbitrage investors began the quarter playing defense given the Department of Justice (DOJ) lawsuit filed against Willis Towers Watson and Aon plc in June. The companies terminated the deal in July, creating a de-leveraging event that continued into early August. Large stock-based deals, in particular, were impacted, as the group’s average gross spread began the quarter at 11% and peaked at 21%; however, spreads eventually began to tighten, and such deals normalized with an average gross return of 13% by quarter-end. Beyond the volatile trading, other notable events during the quarter included the close of Salesforce’s purchase of Slack Technologies, Inc. and Alexion Pharmaceuticals’ sale to AstraZeneca plc.; the protracted battle for Kansas City Southern also finally came to an end. Although activity was heavily skewed to mid-sized deals, the quarter saw announcements of Merck’s acquisition of Acceleron Pharma Inc. and Baxter International’s purchase of Hillrom.

The continued surge in M&A comes against a backdrop of opposing forces. Low interest rates and normalizing global growth are leading companies to not only focus on plugging holes found during the pandemic-related shutdowns, but also on finding alternative sources of topline growth. While the fixed-income market has been incredibly accommodating, leaders at the DOJ and Federal Trade Commission (FTC) seem to be less enthusiastic about the continued pace of M&A. President Biden’s expansive Executive Order issued in July—which directed every government agency to think of new applications for current antitrust legislation—appears to be influencing some of the FTC’s recent actions, as the agency has removed guidelines and failed to complete investigations prior to HSR expiration in some cases. This has yet to deter companies from announcing and closing deals; however, the quarter saw fewer +$10 billion deals announced than usual, and arbitrage investors must be conscious of the uncertainty being sowed as longer deal timelines and the possibility that more companies may have to defend their transactions in court become considerations. This environment is likely to present opportunities for arbitrage investors to create alpha, as the potential exists for similar looking M&A transactions to have different outcomes based upon their respective sizes and legal approaches to the FTC.