In late July, credible news reports said that Aon and Willis Towers Watson were in settlement talks with the government, setting the stage for a deal between the two giant firms. Three days later the $30 billion deal collapsed, with the CEO of Aon saying the companies had reached an “impasse” with the Department of Justice.
According to Kellner Capital CEO George Kellner, the busted deal illustrates many of the changes that have taken place during his four decades working in merger arbitrage.
For one, returns in merger arb used to come from digging up fresh information no one else had on deals and companies. Over time, regulators barred analysts from talking one-on-one with companies and information started pouring out of phones, including false leads like the certainty of the Aon-WTW deal closing — just days before the opposite happened.
The uncertainty inherent in that deal became obvious when the DoJ vehemently criticized the combination of the companies as a blow to competition in the insurance brokerage business, according to Kellner, who started the merger arbitrage desk at Donaldson, Lufkin & Jenrette (now part of Credit Suisse) and formed his own firm in 1981.
“We still think there is value in being able to look at these situations and with 40 years of experience come up with conclusions that are valid and can distinguish us from others,” Kellner told Institutional Investor. “Frankly, the need nowadays is to be able to rapidly synthesize the information that is out there, as opposed to generating the information from scratch.”
But there is more damage now when deals break, he said.
“Virtually everybody in the arbitrage community had positions in [the Aon-WTW merger] so that when the deal blew up, the near-term consequences were painful and maybe more painful than they would have been historically when there were fewer players,” Kellner said. “There was less pressure on the securities when there was a deal break.”
With less dedicated money in the strategy, there’s also more volatility. Pure play hedge funds like Perry Capital and ex-Kellner analyst Jamie Dinan’s York Capital, which is now largely a family office, have exited merger arb in recent years. Adding to the volatility are multi-strategy firms that go in and out of merger arb. (Kellner Capital also expanded into other strategies, but 10 years ago, it decided to refocus its efforts on merger arb and shut down other single-strategy funds.)
“We take the same hit as everybody, but it won’t be as painful, and it won’t be permanent,” Kellner said. “That’s because we can trade around the position more aggressively and perhaps more thoughtfully than those who work for large organizations where they are less flexible than we are.”
Multi-strategy or event funds, where merger arb is only one of many strategies, are often forced sellers when deals break and risks are high, pushing spreads wider in the short-term.
“What our investors have come to expect from us are consistent and reliable returns,” said Stephanie Spinola, managing director at Kellner. “In our 40 years, we’ve had five down years.”
Since 1990, the hedge fund has generated returns of around 9 to 10 percent on an annualized basis. Now, the Kellner team is feeling especially optimistic, given the downturn in special purpose acquisition companies, potentially rising interest rates, and steady M&A activity.
“Right now the opportunity set is the best we’ve seen for a while,” said Chris Pultz, who joined Kellner 20 years ago from Neuberger Berman. “First, so many dedicated managers have exited the strategy that there’s not a lot of money chasing these spreads. Second, the SPAC phenomenon sucked a lot of money out of merger arb the last few years, but it’s a different SPAC market now.”
The effect of fewer competitors is real. Before the financial crisis, when rates were low and banks’ prop desks were fierce competitors, the annualized returns for a plain vanilla deal would be 2 to 3 percent, according to Kellner. Now in the same type of interest rate environment, with fewer players and record deal volumes, returns are 4 to 7 percent annualized. For deals with regulatory or other issues, returns get into the teens or higher, he said.
It helps that merger activity is also strong. “It’s the highest level of merger activity in four decades,” Pultz said.
Inflation fears and rising rates also contribute to a good environment for merger arb. According to Pultz, investors often question what happens to M&A when rates rise. He said they shouldn’t.
“The big worry is what happens to deal volume in a rising rate environment, and more importantly, in an inflationary environment,” he said. “But deal volume actually tends to pick up then. That’s because it’s cheaper to buy assets through mergers than it is to go and build a plant or factory from scratch or pay for R&D for a new drug, for example. When costs are going up, it’s a good environment for M&A activity. When inflation picks up, there are two good things for us: activity will be strong, and rates of return should go up, because of rising interest rates.”