I had the pleasure of interviewing Michael Gabelli, President & CEO of Gabelli and Partners, Managing Director — Director of Global Business Development, Director of Alternative Investments at GAMCO Investors and Associated Capital Group.
In layman’s terms, what is Merger arbitrage? Can you please describe your firm’s approach to “Merger arbitrage” and what differentiates you from other firms who employ the strategy? Why is this an important segment of the investing universe and how successful have you been historically?
Merger arbitrage (MARB) is an investment strategy that speculates on the successful completion of a merger or an acquisition. It is a type of “event-driven” investing that attempts to exploit pricing inefficiencies, caused by a corporate event.
At Gabelli, we rely heavily on our research focus, leveraging our own research analysts to gain an in-depth understanding of deals, asking questions of the management of companies. We run a more diversified portfolio (with position limits) than many firms and generally do not utilize leverage to enhance returns. We also do not speculate on possible targets, and stick to announced deals where the parties have already entered into a merger agreement or the acquirer has already commenced a takeover attempt.
To generate returns that are independent of the overall market, event MARB focuses on deal spread, which difference between the market price for the target and our PMV estimate of the target’s value. Every merger transaction has its own unique set of hurdles to completion, and our team works on trying to understand all of them, from fundamental and legal research, to trading. We analyze and continuously monitor a pending transaction, for all the elements of potential risk, including: regulatory, terms, financing and shareholder approval.
M&A activity has been quite high across the globe this year, but many experts are saying they expect this activity to decline in 2019. What is your thought on this and how does this affect your outlook for Merger Arbitrage investing?
There’s no doubt deal activity was high this year, as worldwide M&A activity totaled $2.5 Trillion during the first half of 2018, an increase of 61% compared to the first half of 2017 and the strongest first half for Global M&A since records began in 1980. But, in what could be signaling the start of a trend, U.S. M&A deal activity decreased in September by 8.3% with 982 announcements compared to 1,071 in August.
M&A activity depends on a variety of factors, and one of the headwinds right now is trade uncertainty, which has created a temporary lull in deal activity. However, the economy continues to run strong and companies are seeing strong cash flows as a result of tax reform. In addition, gridlock in a divided Congress tends to be good for markets and with increased clarity in the political landscape after the midterms, US-based CEOs should have more confidence in announcing transactions. This is all very positive for M&A, coupled with a heated economy and rising interest rate environment that is being pushed by the FED. Rising rates are generally good for arbitrage transactions and good for our portfolio specifically as our returns are somewhat correlated with short term rates. Essentially, even if deal activity declines from the first half of 2018, we still see positivity and opportunity in the marketplace that is not going away.
What are the biggest risks to deal-making activity? How does the uncertainty looming from the U.S.-China trade war or Brexit regulatory changes affect your thinking and the possibility for specific deals?
The biggest risk in the types of deals that we invest in is regulatory uncertainty. Brexit regulatory changes, while unclear, should be within acceptable parameters. The U.S – China trade war will lead to more volatile regulatory outcomes as we have seen, and we will continue to selectively invest in deals that we deem to be least likely to be affected by any political backlash. Since July, when NXP-Qualcomm expired, other deals have presented to the market with exposure to the same risks, and cleared in spite of the tensions. We think that deals in the market currently like Rockwell Collins-UTX, Disney-Fox, and Praxair-Linde, which face similar regulatory hurdles, will eventually get approved as only small amounts of their businesses are in China. While these deals do not have the same issues that plagued NXP-Qualcomm, the risks still exist.
It seems that we are now in a rising interest rate environment, with an upbeat jobs report in November likely keeping the Fed on track for a December rate hike and possibly beyond. How will this affect merger arbitrage spreads? Do deals deliver higher returns when rates are higher?
Deals tend to offer larger spreads when interest rates are higher because some of the money that is currently chasing merger deals in a lower interest rate environment will shift towards other securities that have become higher yielding, such as treasuries and investment grade corporate bonds. Historically, nominal returns benefit from rising interest rates.
Unlike other investment strategies which are typically interest rate sensitive, a rising rate environment should positively affect merger arbitrage strategy returns. MARB spreads are historically highly correlated to short-term interest rates. As rates rise we would expect, on average, spreads to widen and returns to increase, benefiting the MARB strategy.
Would you recommend a MARB strategy to any investor? What is the best way for individuals to take advantage of this asset class?
We would recommend the MARB strategy to any sophisticated investor who is interested in diversifying his/her portfolio in order to achieve a lower correlation to the general equity market. We would also recommend the strategy to someone who is not necessarily just interested in the highest return potential possible, but for someone who wants consistent solid returns with low beta, or market correlation. It is a low volatility strategy with similar risk-reward profile to fixed income, but benefits from rising interest rates compared to bond funds.
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