By Felix Lo, Portfolio Manager of the Trium Khartes Fund
M&A activity traditionally spikes in the first few days of September following the summer lull. However, this year has been different; after a record-breaking August, September activity started slowly. A combination of concerns about market volatility, Delta variant surges in the US, and aggressive anti-trust enforcement appears to have finally checked the exuberant M&A market since late 2020.
However, by the end of the month, we have seen yet another record-breaking month in deal-making. As companies continue to struggle to deal with the impact of rising labour and energy costs, changing consumer behaviour, an unreliable supply chain and the need to re-stock dwindling inventories, acquisitions are often one of the easiest ways for management teams to solve their problems.
In fact, early findings from the KPMG 2021 CEO Outlook’s report highlighted that 49% of more than 400 CEOs at large companies intend to undertake acquisitions that will have a significant impact on their business over the next three years.
At the same time, private equity has continued to strike deals to take advantage of large valuation gaps between top-performing and underperforming companies, but also increasingly between companies both in the US and outside of the US.
Adjusting to a new antitrust landscape
In fact, deals have continued to be struck despite aggressive rhetoric from US authorities. Since her appointment in June, the new Federal Trade Commission chair, Lina Khan, has continued to flex her muscles as she seeks to reshape antitrust enforcement in the US. In just the last few weeks, the FTC has refiled its lawsuit against Facebook, withdrew the agency’s Vertical Merger Guidelines, and took aggressive action against Illumina after they decided to close their acquisition of Grail before regulators had finished their investigation into the deal.
And it’s not just the FTC. Willis Tower Watson and Aon abandoned their $31bn merger after the Department of Justice sued to block the transaction, while Biden issued a 72-point executive order to promote competition across the economy.
This hostile environment has led to merger arbitrage deal spreads to widen significantly. But for managers who can navigate this uncertain environment, there can be significant room for outsized returns.
Looking beyond the US
At the same time, all the pressures driving companies to do deals in the US are also there internationally. A combination of a more stable regulatory environment and lower valuations in Europe and Asia has meant we have been relatively underweight the US, and this has contributed to our outperformance as a result.
The UK in particular looks relatively cheap compared with the broader market. This market has lagged the rest of world and we believe the UK is brimming with deal potential. This is down to valuations. Companies traded in the UK often trade at a substantial discount to its peers elsewhere. This was underlined when Chinese giant Tencent announced plans to buy British video game company Sumo Group for $1.27 billion at a 43-percent premium. PE firms are also taking advantage as a US private equity group is poised to take control of the UK’s fourth-largest supermarket group, Morrisons plc.
Despite deal activity hitting record highs globally, we believe we are still in the early innings. The ‘animal spirts’ that arise late in the cycle does not appear to be here yet. Instead, the acquisitions today appear to be primarily driven by necessity or value. In the late cycle, we typically see risk perception melt away amidst unbridled bullishness and merger arbitrage spreads tend to compress into strong activity, which we haven’t seen. Instead, the heightened risk today makes it ideal for merger arbitrage as spreads ebb and flow.
The current environment also demands a focus on small-mid cap deals and in less popular international jurisdictions. Here there is less regulatory uncertainty and more fertile opportunity across geographies. With risk elevated due to a cocktail of slowdown concerns, covid fears and anti-trust worries, there exists a sweet spot for merger arbitrage investors willing to explore beyond US shores.