By Alexander Ellerby (pictured), UCITS Research Analyst, Kepler Absolute Hedge – It’s a common instinct in investing: applying assumptions about the US market to other regions is something investors across asset classes and strategies have a habit of doing. The latest victim? Asian merger arbitrage strategies.
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By Alexander Ellerby
UCITS Research Analyst, Kepler Absolute Hedge
It’s a common instinct in investing: applying assumptions about the US market to other regions is something investors across asset classes and strategies have a habit of doing. The latest victim? Asian merger arbitrage strategies.
Asian M&A deals have long executed on much wider spreads than the US, averaging 10-12% on a net annualized basis against the latter’s 4.5-5.5% rate between 2009 and 2021. This can be attributed in large part to the increased complexity of Asian transactions, which often span multiple jurisdictions, and, as a result, a market with significantly less participation. Yet, deal completion rates between the two markets were effectively identical over the ’09-’21 period.
Since global markets entered something of a tailspin in late 2021, the risk free rate has shot up in Asia – and with it, spreads have widened even further. In fact, their widening has outpaced the rise in the risk free rate, despite the broader context not changing. This suggests that an idiosyncratic opportunity may have opened up, due in large part to a misalignment between market assumptions and on-the-ground reality.
Source: Bloomberg
US market faces ongoing challenges
While spreads have also widened in the US, trading volumes have fallen dramatically, in large part due to transactions in the US being majority funded by balance sheet expansion or PE (a dynamic must less prevalent in Asia). As a result, the US market, already crowded due to its well-understood nature, is seeing further crowding into the few successful deals that remain.
An additional challenge for investors into US merger arbitrage is the growing antitrust regulatory intervention which has plagued deals over the last couple of years. Indeed, some of the largest deals announced in 2022 have come under unprecedented scrutiny from the Federal Trade Community and other federal agencies.
The second quarter of 2023 in particular has seen maybe the most material regulatory intervention in US transactions in a generation, leading to significant spread expansion and strategy derisking. Asian spreads have been influenced by this pattern, despite these deals being on the whole unaffected by the changes, bar some intervention in the highly sensitive semiconductor space, where material historic consolidation and significant policy sensitivity in China in particular have introduced a well-defined element of risk. While this does not spill across to other sectors, it arguably adds to the overall risk premium applied by the market to Asian merger arbitrage transactions. Indeed, Asian regulatory protocols have otherwise remained relatively stable over the near term.
Clear catalysts for Asian dealmaking
As the US market remains subdued in a high interest rate environment, several factors are proving tailwinds for the Asian M&A market. The reopening of the Chinese economy, and the subsequent rebounding of its market, coupled with a renewed governmental focus on economic growth should provide a fertile pool of acquirers seeking regional expansion. This should also furnish the market with a more diverse and attractive set of deals, as mature acquirers that have withstood the economic shutdown look to deploy cash on their balance sheets.
More broadly, the more significant diversity of the underlying M&A markets in Asia, where deals in the core markets of greater China, Australia, Japan, South-East Asia, and India are subject to significantly diverse and uncorrelated drivers, have historically led to much less peak to trough transactional levels. We are seeing this again in the near term, with significant and idiosyncratic deal activity across these markets leading to broad opportunities at a time of heightened risk premium and overall decreased market participation in spread opportunities.
A further catalyst comes from the delisting and reshoring of US-listed Chinese firms, especially ADRs. Some of these are opting for going private, and with US valuations so depressed, there is a potential arbitrage opportunity in evidence.
Finally, the continued volatility of financial markets including in Asia lends itself to ongoing unusual spread behaviour, with a further widening of spreads possible. Certainly, volatility will play a role in keeping this opportunity set interesting in the near future.
Building from experience
The KLS Athos Event Driven fund contains around 55 M&A transactions, diversified across a range of Asian geographies. The team that manages the fund’s investments have deep experience in event-driven investing, and the fund focuses on short-dated and liquid hard-catalyst events in Asia Pacific.
Their focus is strategic, for example maintaining a long-term emphasis on smaller deals even as Asian mega M&A transactions have declined. These deals are less impacted by the broader market context and have provided a steady stream of opportunities for the Athos team.
Indeed, the fund has maintained its number of positions over the last three years, reflecting the growth in listed companies in Asia and the relative resilience of the Asian M&A market in a challenging period for global markets as a whole.
Alexander Ellerby, UCITS Research Analyst, Kepler Absolute Hedge – Alex joined Kepler Partners in September 2019 as a fund research analyst covering the alternative UCITS space. Prior to Kepler, Alex worked at QIC Global and Waverton Investment Management. Alex graduated from Newcastle University in 2016 with a BA in Politics and is a CFA charterholder.
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