Friday, August 27, 2010

Risk Arbitrage and Leveraged Buyouts

The current rash of high profile acquisitions has, inevitably, raised speculation about an impending merger boom. This is probably a bit premature. While some of the conditions that would encourage a boom, such as corporate cash levels, borrowing costs and the equity valuations of potential targets are favorable to deal-making, equity volatility and concern about the economic outlook are likely to instill caution in boardrooms, at least for the time being. The value of U.S. deals announced year to date still lags behind the same period of 2009, which was itself a very soft year. While transaction volume outside of the U.S. has been stronger (and risk arbitrage is a global activity), so far this year it has managed to boost global year-to-date activity only marginally over 2009 levels. In part because of the cyclicality of their trade – recent experience is hardly the first merger drought − many of these traders are now ensconced within “event-driven” hedge funds, which have other strategies such as distressed investing or convertible arbitrage that they can pursue if the merger cycle is unfavorable.

These circumstances would suggest that things are improving somewhat for risk arbitrageurs, if not dramatically. However, although it seems unlikely that merger activity could quickly return to the frenetic pace of 2005 - 7, conditions may in fact be improving more rapidly for risk arbitrageurs than the headline statistics would suggest. The reason is that the composition of current deal-flow is more favorable to them than it was during the buyout boom. Risk arbitrageurs are benefiting from the problems of the leveraged buyout funds.

An arbitrage requires at least two tradable legs – one long and one short. When an acquirer is a private entity such as an LBO fund, and thus does not trade, no arbitrage may be possible. This is not always the case – for example, if the target’s debt trades at a discount, and its debt covenants have a change-of-control provision that requires an acquirer to repurchase the debt at par, a risk arbitrage may still be possible (long the debt/short the equity). However, even if such a trade is possible, it is a rather narrow one, because the amount of the relevant debt outstanding is, in almost all cases, a fraction of the deal size. It is difficult to estimate how much of the acquisitive activity during 2005 - 7, when LBO funds dominated the merger market, actually offered trading opportunities to risk arbitrageurs. At a guess, it was only 65% of the value of deals completed.

The acquisition market has changed in the meantime. LBO funds are having difficulty obtaining the amount of leverage that they could readily access during the buyout boom. In a complete reversal of their experience then, in several recent deals they were handily outbid by non-financial purchasers. Trade buyers’ can raise debt far more easily and cheaply than LBO firms in the current environment. Although some of the most powerful LBO firms continue to be able to complete large deals, LBO funds in general are concentrating more of their attention on middle-market transactions. This is a segment that generally offers less compelling opportunities to risk arbitrageurs than large and complex deals, since arbitrage is most attractive to pursue where liquidity is ample.

The opportunities available to risk arbitrageurs are not measured solely in terms of transaction size: the premium that the acquirer ultimately pays for the target is also a crucial metric. Recent experience has also been quite favorable to them in this respect. Contested bids, such as those that feature in several current transactions, can also expand their opportunities, although at some cost in terms of increased risk. Hedge funds that are equipped to exploit these opportunities – whether risk arbitrage specialists or more diversified “event-driven” firms – may not be experiencing a golden age, but this is certainly a productive period for them.

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