This is where merger arbitrage funds come in. The arbitrageurs are effectively betting that the merger or acquisition will cross the finish line. If the arbitrageurs are right, their payoff is the difference -- or spread -- between the offer and what they paid for the target’s shares.

All of this sounds great, except that merger arbitrage funds have performed horribly in recent years. The Merger Arbitrage Index returned a measly 2.5 percent annually over the last five years through July 2016 due to a confluence of headwinds.

Like hedge funds generally, merger arbitrage has been a victim of its own success. According to HFR, a research group in Chicago that tracks hedge fund performance, merger arbitrage funds managed a paltry $100 million in 1990. That number ballooned to over $21 billion by June of this year. And unlike many other hedge fund strategies, the money is still flowing to merger arbitrage -- assets in the strategy have grown by 4 percent so far this year.

Also, the environment that followed the 2008 financial crisis was no friend to merger arbitrage. There were too few deals and many of them were completed, while interest rates remained low -- all of which, together with the piles of money chasing deals, translated into thin spreads. 

Tight spreads are kryptonite for returns. A 2010 study of merger arbitrage by Gaurav Jetley and Xinyu Ji looked at spreads and returns from 1990 to 2007 and found -- no surprise -- that lower spreads resulted in lower returns. 

This brings us back to our recent round of deals left at the altar. In 2014, deal flow picked up after U.S. drug-makers sparked a global takeover frenzy. More deals meant more opportunity for busts, and all of a sudden arbitrageurs confronted a minefield. They began demanding higher payoffs for their trouble. Average spreads soon crept above 5 percent -- a mark prized by arbitrageurs -- and remain a lofty 5.9 percent today.

There's already evidence that higher spreads are translating into higher returns. The HFRX Merger Arbitrage Index has returned 6.8 percent over the last year through July 2016, while the HFRX Aggregate Index -- a broader measure of hedge funds -- has returned just 0.3 percent over the same period.

Of course, there’s no guarantee that merger arb specialists will successfully sidestep all abandoned deals. But the opportunity to do so gives them and their investors a glimmer of hope in what is otherwise a brutal environment for hedge funds.-- Rani Molla contributed graphics to this column.

This column was provided by Bloomberg News.

 

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