Poor, poor hedge funds.
Returns have plummeted and investors are fleeing. Pensions headed for the exits, and now endowments are close behind.
No hedge fund seems to be immune from the fallout. Brevan Howard and Tudor Investment are just the latest marquee funds suffering an exodus of investors.
But hope for some hedge funds and their hangers-on is springing up in a seemingly unusual place: abandoned mergers and acquisitions.
It’s been a tough year for corporate nuptials. Close to $500 billion worth of proposed mergers and acquisitions have gone belly-up this year, the largest such tally in nearly a decade. Some of the biggest broken transactions include those between Pfizer and Allergan, Honeywell International and United Technologies, and Halliburton and Baker Hughes.
That’s bad news for the bankers who marry companies and charge a fortune for their blessing, but it’s potentially great news for merger arbitrage hedge funds and their investors.
Merger arbitrage is one of the oldest -- and historically one of the most profitable -- games on Wall Street. The HFRI Merger Arbitrage Index has returned 7.8 percent annually from January 1990 to July 2016 (the longest period for which data is available), with a standard deviation of 3.9 percent.
Those numbers may not seem impressive at first, but they're spectacular. The Merger Arbitrage Index had a Sharpe Ratio of 1.25 during that period, nearly triple that of the S&P 500 (0.45) and well above that of the Barclays U.S. Aggregate Bond Index (0.95) over the same time -- no small feat in a period that saw an epic drop in interest rates. (The Sharpe Ratio measures risk-adjusted returns; a higher ratio indicates that investors are more adequately compensated for risk.)
There's an added bonus in all of this -- merger arbitrage is exceedingly simple. Here’s how it works: An acquirer announces how much it plans to pay for a target, which usually is more than the target’s current share price. Hearing the news, investors gobble up shares of the target, driving the target’s share price closer to but short of the acquirer’s offer.
The reason investors pay less than the offer is because there’s no guarantee that the transaction will ultimately be consummated -- and if it isn’t, the target’s share price is obviously likely to take a dive.