October 25, 2016 8:54 am

Hedge Funds Look for Hard Hats in a Year of Collapsing Merger

While last year set a record for the amount of money spent on corporate mergers — $4.7 trillion — this year is so far setting a very different record: the dollar amount of deals that have come undone.

Since the beginning of January, $400 billion worth of corporate mergers have been withdrawn in the United States, almost three times the previous record for the same period, set in 2007, according to Dealogic, which analyzes such data.

On Tuesday, the retailers Staples and Office Depot called off their $6.3 billion deal. The collapse came about a week after the dismantling of the proposed $35 billion merger of the oil services companies Halliburton andBaker Hughes, and one month after the death of the drug giant Pfizer’sproposed $152 billion merger with Allergan — all canceled because regulators raised concerns.

Broken deals have whipsawed hedge funds that focus on merger arbitrage, a type of trading that places bets on the likelihood that deals will be completed. As one “arb,” as traders in merger arbitrage are known, described the current mood of the industry: Every day is like showing up unsure of whether to wear a helmet or a diaper.

“You’re definitely seeing a hangover from the M.&A. party from 2015,” said Aly El Hamamsy, a partner in Cadwalader, Wickersham & Taft’s mergers-and-acquisitions group, which occasionally advises arbs. “Things will stay interesting for a few months at least.”

Hedge Funds

Anxiety is higher than many arbs say they have experienced in years. Merger arbitrage was the worst-performing investment strategy in April other than macro funds, which bet on the direction of global economic trends, according to Hedge Fund Research. The merger arbitrage index, which is compiled by HFR, declined 0.75 percent during the month.

The fallout follows a boom year in mergers and acquisitions, during which companies felt emboldened to make aggressive — albeit risky — moves to grow. Deals have been collapsing because regulators are raising antitrust concerns, as in the cases of Staples and Office Depot and Halliburton and Baker Hughes, or because regulators are clamping down on deals that move American companies abroad to cut their tax bills, as was the case with Pfizer and Allergan.

Market forces are also at play. A merger of the energy pipeline rivals Energy Transfer Equity and Williams Companies is wobbling because of a sharp decline in energy prices since the deal was announced in September.

Historically, merger arbitrage has been the calm hinterland of the investing world. Traders usually buy up shares in the company that is being acquired; those shares tend to trade slightly below the buyer’s offer price, often by just pennies. Once a deal is done, that gap closes, and arbs will make money on the difference. (Some trades involve hedging through the acquirer’s stock as well.) Such trading has been considered low risk for small returns.

These days, it is a different story. Take this April, for example. It began with Anbang Insurance Group abruptly withdrawing its $14 billion offer for Starwood Hotels and Resorts, ceding it to Marriott International for a lower price. The next bombshell came three days later, when the Treasury Department issued new rules to curb cross-border mergers aimed at lowering an American company’s tax bill, a move that ultimately led to the breakup of Pfizer’s deal with Allergan.

Though the Treasury had long signaled it would clamp down on such combinations, many arbitrage funds did not expect that the new rules to be so cataclysmic. Before the rules were disclosed, the market gave about a 50 percent chance the deal would close.

Allergan’s stock dropped 20 percent in overnight trading after the Treasury announced its new rules, according to a letter after the deal collapsed from the hedge fund Ramius to its investors. The letter, which was reviewed by The New York Times, said, “We regret this setback, and ask for your patience as we follow our discipline to attempt to earn back lost value in a prudent fashion.” Ramius was already down 2.91 percent for March before the deal was scuttled, after being up 4.37 percent in February, the letter said.

But the pain did not end there.

Hedge Funds

Soon thereafter, even more mergers seemed doomed, especially because at least two companies have made overtures to kill transactions in cases of buyer’s remorse.

Energy Transfer Equity, a Dallas-based pipeline operator that initially had to coax a majority of the Williams Companies board to agree to its $38 billion offer in September, was frantically searching for a way out of the deal by springtime. Things started to look shaky when Williams Companies sued Energy Transfer and its chairman, Kelcy Warren, in mid-April, claiming he had breached the merger agreement. Then Mr. Warren said several times during the company’s earnings conference call last week that the deal “can’t close” because of a complicated tax opinion. Williams firmly believes it can.

Investors overwhelmingly think the deal, as it was agreed on seven months ago, is doomed. Of about 150 fund managers surveyed by Evercore ISI, 84 percent do not expect the deal to close in its current form.

Then there is the drug maker Abbott’s $5.8 billion acquisition of Alere, which makes medical diagnostics tests. At the end of April, less than three months after their deal was announced, Alere put out a statement saying that Abbott was trying to terminate their agreement but that Alere had denied the request.

In both cases, lawyers said the merger agreements were impenetrable. Based on all publicly available information, neither Energy Transfer nor Abbott has a clear way out of its deal. Yet the market is treating these situations as if they are practically doomed, a change that can dent arbs’ returns, at least in the short run.

Taking a cue from these troubled deals, some investment funds that do merger arbitrage trading are working with lawyers to pore over agreements to make sure they are placing trades on deals that are not likely to come apart.

A more predictable end befell two deals that spent at least a year each under regulatory review.

Halliburton agreed to acquire Baker Hughes in November 2014 for $35 billion. After an excruciatingly long regulatory review process, the Justice Department sued to block the deal in April. The two companies decided to terminate it on May 1.

On Tuesday, Staples and Office Depot called it quits on their own $6.3 billion merger attempt after a federal judge blocked the deal. As was the case in the oil patch, these two retailers were halted from combining because in doing so, they would, in the judge’s words, “substantially impair” competition.

A riskier environment for arbs also opens up an opportunity for greater returns. As the market becomes more skeptical about pending deals, arbitrage traders could make a bigger return on deals that do close. After the Treasury’s new rules, the market became more uncertain about the Irish drug maker Shire’s $31 billion acquisition of Baxalta. Even though the deal is set to close in less than a month, traders that buy in now could receive a decent return.

These broken deals have had a chilling effect on new deals, but they are unlikely to stop the market completely. Lawyers say chief executives and boards are already asking more-detailed questions about potential contracts and will continue to do so. They want to learn from the mistakes of deals gone awry.

“There will be a heightened focus on the negotiated deal terms,” said William J. Curtin, global head of mergers and acquisitions at the law firm Hogan Lovells. “Whether the additional piece is a slowing of transaction activity, I believe it remains to be seen.”