Most turbulences are behind for merger arbitrageurs

Markets remained treacherous with multiple micro, macro and political movers. Trade concerns receded but remain live as the U.S. tackles Chinese tech. Investors also weighted the implications of a U.S. withdrawal from the Iran nuclear agreement. We expect the issue to hover at least until the summer and Iran to be initially cautious in its response before considering a more radical path. Besides, investors kept on digesting (strong) EPS reports, particularly sensitive to any guidance suggesting an earnings peak. Overall, investors are increasingly pricing a growth stagnation with higher inflation, in the U.S. especially. As a result, cyclical assets weakened, rates surged and boosted USD. This helped European and Japanese markets outperform.

CTAs and the U.S. long-biased managers were the most affected by current uncertainties. Merger funds also took a hit from bond yields and several deals’ unfavorable developments. The other strategies were resilient.

Since February, merger spreads widened meaningfully.

Rising bond yields, a key component of merger returns, contributed to about half of the widening. A hike of 50bp in Libor implies about a 150bp widening in annualized spreads. A second key factor was increased regulatory and deals’ duration uncertainty, in the U.S. but also for operations related to China one way or the other. An obvious example was the NXP Semiconductors / Qualcomm deal, under pressure from these factors and a key negative contributor for many funds. Market volatility also played out, as well as the growing share of jumbo deals, usually more sensitive to adverse developments. Amid very supportive conditions for M&A (from the tax reform in particular), weaker deal rationales are also mentioned as a greater source of deal volatility.

These turbulences are not shaking managers’ faith, to the contrary. While they expect rising rates to translate into structurally higher deal spreads going forward, they believe most of the downside is now priced, with more appealing entry prices. Their high leverage reflects their confidence.