Merger Arb Hedge Funds to Make Comeback Amid Turbulence, K2 Says

One of the most overlooked hedge-fund strategies is poised to shine this year as record mergers activity coincides with deepening uncertainty about the global economy’s direction, according to an investor with more than $10 billion in such pools.

Merger arbitrage, a strategy that produced returns approaching 20 percent in its heyday in the 1990s, has been among the least popular investment choices for investors in recent years as annual returns haven’t exceeded 5 percent since the beginning of the decade. That’s poised to change this year, with hedge funds betting on the success or failure of mergers and acquisitions possibly doubling returns compared with historical averages, according to Franklin Resources Inc.’s K2 Advisors, which invests in hedge funds.

As sliding oil prices and concern about the state of China’s economy have spurred a worldwide market selloff, K2 is betting that merger arbitrage funds will benefit and is boosting its allocation to such pools. Such funds generally bet on the discrepancy between the share price offered to acquire a target company and the stock value in the period before a deal closes. Price gaps seen in shares of target companies as well as acquirers typically widen during times of turbulence and slowing growth, giving hedge funds the opportunity to exploit the differences and boost returns.

“Throughout this recent bout of Volatility , we have seen the spreads, the anticipated returns on deals, almost double from a 6 percent annualized return expectation to around 11 percent,” said K2’s founding managing director David Saunders. “I am not so sure whether we have seen these types of merger arbitrage returns in quite some time.”

VIX Jumps

The Chicago Board of Options Exchange Volatility Index, or the VIX index, climbed to 28 last month, the highest since September. Almost $9 trillion was wiped off the value of global stocks in the first six weeks of the year. The selloff has coincided with robust dealmaking activity, with mergers and acquisitions valued at $612 billion already this year, after a record $4.3 trillion in deals in 2015.

Merger arbitrage hedge funds, which collectively hold just over $20 billion in assets in comparison to the industry’s almost $2.9 trillion, last posted double-digit gains in 2009, when they rose almost 12 percent, according to data from Chicago-based data provider Hedge Fund Research Inc. Last year, they returned 3.3 percent and they’ve advanced 0.3 percent in January and February, making them the top performers in the event-driven fund category. Event-driven strategies, a category that also includes hedge funds investing in companies undergoing restructuring, management changes and spinoffs, lost 3.4 percent in the first two months of the year.

The HFRI Fund-Weighted Composite Index, which tracks the performance of hedge funds globally, fell 2.3 percent in the first two months of the year.

‘Worst Disappointment’

K2 said in November that event-driven managers were the “worst disappointment” last year despite the pace of mergers and acquisitions as hedge funds crowded into the largest corporate deals. Still, there will be “healthy” opportunities this year for hedge funds pursuing this strategy, Saunders said.

Factors such as uncertainty about U.S. Federal Reserve interest rate increases and the level of emerging-market economies’ debt “play into investors’ nervousness and skittishness,” Saunders said.

Justin Tang, director of global special situations sales at Religare Capital Markets SP Pte in Singapore, said that in China in particular, many people “are skittish” about corporate governance problems, which increases the uncertainty about pending transactions.

Qihoo 360 Technology Co., the owner of China’s second-biggest search engine, in December agreed to be taken private in a deal valued at $10 billion. The offer represents a 2.76 percent premium to the share price as of Friday’s close in New York, implying an annualized return of 9.9 percent, according to data compiled by Bloomberg. The offer for U.S. chipmaker SanDisk Corp., which is to be taken over by Western Digital Corp., represents a 3.4 percent premium to the share price, implying an annualized return of more than 12 percent, the data show.

To contact the reporter on this story: Klaus Wille in Singapore at kwille@bloomberg.net. To contact the editors responsible for this story: Sree Vidya Bhaktavatsalam at sbhaktavatsa@bloomberg.net, Andreea Papuc

By: Klaus Wille

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