Over the next two years we expect mergers and acquisitions to increase globally to pre-crisis levels. Stock repurchase programs will be supplanted by corporations as a better strategic option in order to engender top-line and bottom-line growth prospects.
By enacting only stock buybacks and cost cutting measures in order to enhance EPS,corporations miss growth opportunities and strengthening market positioning. Thus at a time of slowing global growth (particularly EM and China), M&A may increasing be the strategic option to increase revenue and the potential for real future earnings growth versus a decrease in shares and head count. Investors hungry for earnings growth will reward companies that can execute on strategic deals that enhance real forward earning over the next two years.
The leading catalyst for increased M&A activity over the next two years are: 1) corporate cash hoards estimated by the FED to be $1.6 Trillion, 2) accommodative credit markets, 3) corporations seeking to expand their footprint in new geographies, expanding their customer base, or entering new lines of business, and 4) $1 trillion in uncommitted fund capital.
So far 2014 M&A volume stands at $318.6bn via 13 deals in 2014 YTD, up 75% on the same period last year ($182.1bn/ 7 deals) and is the highest YTD $10bn+ M&A volume since 2007 ($505.6bn/ 19 deals).
The potential to capture higher returns as interest rates increase while many bond investments are seeing values erode, is a compelling rationale for Merger Arbitrage to be viewed as a natural hedge to rising interest rates.
More importantly is beta reduction, especially at this point in time of the market cycle. Merger arbitrage beta is approximately 0.10 in flat to rising equity market and 0.50-0.60 in declining market. High Yield beta is approximately 0.50 and typically rises in declining equity market.
From a pure performance perspective, hedge funds have demonstrated the best risk/return profile for exposure to M&A over time. The ten-year average performance for merger arbitrage is 5.1% with an average volatility of 3.6% over the 10-year period.
We are recommending a 7% to 8% portfolio weight in merger arbitrage. M&A strategies have a low beta of 0.30 and correlation of 0.25 to the overall markets. Thus, we see allocations to merger arbitrage as an attractive way to capture risk-adjusted returns with low correlation to equity markets.