Overlooked and Unloved, Merger Arbitrage Could Drive Returns in 2022

As M&A activity breaks records, managers turn to an old favorite for diverse investment opportunities.

Chris Ratcliffe/Bloomberg

Chris Ratcliffe/Bloomberg

Merger arbitrage may be the hottest ticket for solid returns this year.

Kevin Russell, CIO of UBS O’Connor, the hedge fund, wrote in his annual letter on Wednesday that the manager will increase its attention and allocations to merger arb in 2022. The strategy, in which investors buy and sell the stocks of two companies involved in a merger, has been a core element of O’Connor’s approach since the hedge fund manager launched in 2000. In recent years, Russell wrote, the manager hasn’t viewed the strategy as a fundamental driver of returns, but now feels that it warrants increased investor attention.

“I haven’t been focusing investor attention on it,” Russell told Institutional Investor. “The returns in the strategy were just okay last year; they weren’t spectacular. [But] we’re seeing the outlook for returns to be significantly higher in 2022.”

Russell said that the record-breaking M&A deal activity that the market saw last year is a strong indicator of the strategy’s potential in 2022. At the end of 2021, M&A dealmaking set an all-time record when it surged past $5.8 trillion, and few think the activity will slow down anytime soon. As II previously reported, 92 percent of respondents in Deloitte’s 2022 future of M&A trends survey expected deal volume to increase or stay the same over the next 12 months.

“We expect ongoing high levels of deal announcements and deal activity [to continue],” Russell said. In addition to ongoing heavy volumes, there’s a backlog of deals that didn’t close in 2021, and this has created another opportunity to generate returns for investors. He added that the investment banks with whom O’Connor partners all expect robust M&A activity to continue this year.


Chris Pultz, a portfolio manager at Kellner Capital, an alternative investment manager that specializes in merger arbitrage, said that rising interest rates will also bolster the strategy’s performance. Merger arbitrage, Pultz said, is one of the few investment strategies that is positively correlated with interest rates. “As interest rates rise, the spreads on the deals and the rates of return increase as well,” Pultz told II.

For players like Kellner, which are dedicated specifically to the strategy, these factors provide an advantage. Pultz, who has been with the firm since 1999, said the investment strategy goes in and out of vogue, depending largely on the spread environment, the deal environment, and interest rates. Over a decade ago, large hedge funds like Perry Capital, which shut down in 2016 and became a family office, and Jamie Dinan’s York Capital, which wound down in 2020, directed their assets under management largely to merger arb. While money is always moving in and out of the strategy, less money is explicitly dedicated to it, and overall, fewer players are in the space, Pultz said.

While merger arb has historically been considered a cyclical strategy, Russell said he believes the strategy is pivoting to become a consistent, uncorrelated investment approach. “The market [has] had a difficult start to the year, and M&A has not,” he said.

Deal uncertainty adds a certain level of risk. With funds generally taking a long position in the company being acquired and shorting the company making the acquisition, a failed deal will leave a mark. If the merger or acquisition isn’t completed, as was the case in the failed $30 billion deal between Aon and Willis Towers Watson in July 2021, participants stand to lose money.

However, Pultz said, M&A transactions have historically enjoyed a high success rate, and these failures are few and far between. Russell added that while some of the blame for potential failures and other challenges, such as heightened regulatory scrutiny, can be laid at the feet of investors and managers, all parties are aware of the potential pitfalls and usually take steps to avoid them.

“We and most other investors have already accounted for this higher approval risk in assessing deal breaks and are requiring higher baseline returns,” Russell wrote in his letter. “More importantly, companies announcing the deals and their advisors also know that this regulatory landscape has shifted, so we can expect them to be more measured in the forms of consolidation and market power being pursued.”