The combination of record-level SPAC issuance and a flood of non-SPAC M&A has created a supply-demand imbalance in the event-driven asset class. With SPACs garnering most of the limelight, we believe investors are missing an excellent opportunity to deploy capital into “other” event-driven investments, most prominently merger arbitrage.
A Wild Year
It’s certainly been an interesting 12 months in the event-driven asset class. From soft catalyst event situations upended by the onset of COVID in Q1 2020, to the March 2020 “Arbageddon” widening in merger arbitrage spreads, to countless instances of hedge fund repositioning causing atypical volatility in typically boring share class arbitrage. It’s been a truly wild ride.
The combination of Q1 2020 performance challenges for the asset class and slow-to-recover new merger volume last spring and summer led to the perception that there was “nothing to do” in event-driven. The record issuance of SPACs in 2020 and early 2021, accompanied by some high-profile bouts of outperformance in former SPACs like Nikola, amended that narrative slightly. Recent commentary has been willing to stipulate that there was nothing to do in event-driven, apart from SPACs.
The Current Opportunity
As experienced event-driven investors, we’ve often chafed at the notion that event-driven’s attractiveness waxes and wanes as much as commentators would suggest. Indeed, our team mantra is “there’s almost always something to do,” and our historical results have supported this claim’s veracity.
That said, the current opportunity set in merger arbitrage is both compelling and mostly unnoticed, a unique combination. Amid the “nothing to do” narrative that prevailed last summer and the SPAC boom that followed in its wake, the quantity and quality of merger arbitrage transactions has grown quickly but quietly. What started as a slow trickle of new deal announcements late last summer morphed into a gushing stream of activity. Since Q3 of 2020, we’ve seen several hundred billion dollars of new mergers announced. This flood has come alongside >$100 billion of new SPAC issuances, with more announced every day. The result of all this activity is an environment historically unique on the metric that should matter most to investors: the ability to build a merger arbitrage portfolio that can deliver excellent future returns.
A key element of successful merger arbitrage investing is repeatedly asking: “What are we missing?” For the present set of merger arbitrage spreads, we’ve been consistently puzzled by the gap in our view of the fundamental likelihood of deal closure and the more pessimistic odds implied by prevailing market prices. As we’ve tried to figure out why more event-driven investors aren’t buying merger arbitrage spreads today, the most common answer we’ve received is “bandwidth.” Namely, that between the record levels of SPAC issuance and the steady flow of new merger transactions, there’s simply too much going on for event-driven investors to cover it all. This supply-demand gap was evident during last month’s volatility in SPAC prices and its trickle-down impact into other spreads in the event-driven universe – there’s simply too little capital chasing too much deal volume. And while we’ve heard plenty of fists pounding the table over the opportunity in SPACs, there has been a notable absence of interest in merger arbitrage and “other” non-SPAC event-driven investment opportunities.
As a result, we’ve taken the rare (for us) occasion to raise our hands. We think investing in merger arbitrage today represents a contrarian opportunity to profit from this historic imbalance between supply and demand in the event-driven universe. Our own merger arbitrage-heavy event-driven portfolio presently trades at expected values in the highest 25% of our history. More importantly, this attractive expected value outlook isn’t driven by one or two spreads where we have a different view from the market. Rather, the present attractiveness is incredibly broad-based, reducing the odds that the inevitable break in one or two deals will lead to disappointing overall returns.