UBS Hedge Fund Rides $4 Billion Bet on Merger-Arb Trade Revival

(Bloomberg) — It’s been a tough year for the merger-arbitrage market, which is delivering some of the worst returns across hedge-fund strategies as a slew of big deals have been roiled by regulatory hurdles. Some money managers have exited the trade entirely. 

But UBS O’Connor, a $12 billion hedge-fund unit of UBS Asset Management, sees some sparks in the months ahead that could boost the performance of merger-arb investors — who wager on whether proposed tie-ups will go through. The firm has kept a third of its portfolio in merger-arb the past couple of years, according to a person familiar with its business who requested anonymity because the information is private. 

The US presidential election brings the potential for a turning point in the regulatory backdrop, after Federal Trade Commission Chair Lina Khan’s aggressive trustbusting inflated deal spreads since she took over in 2021. Investors are also set to get updates from regulators on some long-awaited deals, as well as antitrust trial decisions on a couple high-profile transactions — in particular Tapestry Inc.’s takeover of Capri Holdings Ltd., likely before the end of the year.

This quarter “looks to be catalyst-rich, led most obviously by the US election, but also with many transactions that had extended through the year that may be reaching inflection points,” said Blake Hiltabrand, UBS O’Connor’s global head of business, who’s been in the merger-arb market for more than two decades.

The fund declined to comment on its positions. 

Merger arb has earned 3.5% this year, according to research firm PivotalPath. While that’s an improvement from mid-year, it’s still one of the weakest among more than 30 hedge-fund strategies tracked by PivotalPath, and it compares with an 8.3% gain for the industry broadly.

Optimism Dissipates

Merger-arb traders were stung earlier this year by developments in some large transactions, including the FTC’s lawsuit to block Tapestry’s $8.5 billion takeover of fashion rival Capri, the Biden administration’s opposition to United States Steel Corp.’s sale to a non-US buyer and a lengthy delay in the $53 billion merger between Chevron Corp. and Hess Corp. All of these depressed sentiment and caused money to flee the strategy.

The year started off on a bright note for the strategy as some multi-manager funds bolstered their focus on the merger-arb market, but “this optimism has dissipated over the course of the year, with the hot money moving on to more productive areas,” said Jonathan Caplis, founder of PivotalPath.

Deal spreads have remained wide as traders anticipate heightened regulatory risk will delay transaction closings, or even derail them. 

The regulatory worries create a chance to pounce on fat deal spreads, Hiltabrand said. Networking giant Cisco Systems Inc.’s $28 billion deal to buy Splunk Inc. was an example, he said.

The stock of Splunk, the acquisition target, remained stubbornly below the offer price after the deal’s September 2023 announcement because of its size and regulators’ tough stance on big-tech takeovers.

The companies estimated closing in August of this year. However, UBS O’Connor concluded that there was minimal anticompetitive overlap and considered that timing guidance too conservative. That wager delivered when the deal closed in March, months ahead of schedule, allowing investors to realize gains more quickly.

“A situation like this is turning regulatory headwinds into a tailwind,” Hiltabrand said.

Another notable dynamic of late, he said, is that spreads on some deals have remained relatively wide approaching deal closings, in contrast to the typical pattern where the gap narrows throughout the life cycle of a transaction. That’s another reason he expects better performance ahead, simply because some large deals are getting closer to fruition.

The past couple months have also brought a wave of fresh deals to bet on, including the $36 billion combination of Mars Inc. and Kellanova, the year’s largest US tie-up. 

Decisive Stretch

One thing the coming weeks promise is volatility as US elections come down to the wire.

The arb market may favor a victory by former President Donald Trump, “which would almost certainly bring a change of leadership at the FTC” and the Justice Department, Hiltabrand said. But he also noted reports of pressure on Vice President Kamala Harris from Democratic donors to adopt a “less progressive” stance toward antitrust. 

With the election approaching, traders are also watching other transactions that have seen wider spreads because of expected antitrust heat, such as the takeover of Discover Financial Services by Capital One Financial Corp.

“We’ve seen both broad rallies and selloffs in spreads since June on political winds and we believe that this will continue intermittently until Nov. 5,” Hiltabrand said. “This volatility may bring opportunities to initiate or add to positions at levels that we believe to be attractive.”

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