With merger and acquisition activity on a torrid pace in 2015, here's how to anticipate the next deal.
It's been a remarkable year for financial markets, highlighted by extreme volatility, severe weakness in commodities and a raging debate about interest rates, among other things. But there's another ongoing market trend of great importance to investors, one that could offer substantial opportunity: M&A.
Merger and acquisition activity has been on a torrid pace in 2015, on track to surpass 2007's record levels. Through October, more than $4 trillion worth of mergers have been announced year-to-date, and activity in the third quarter was the strongest on record for that period, according to Citi.
The flurry of deals is mainly a reflection of three factors: low interest rates, robust corporate balance sheets and a global economy that remains sluggish. Low rates make funding acquisitions more affordable, and companies that have a difficult time growing their earnings when the economy is soft often look for attractive merger candidates to help spur their growth.
MERGERS, ACQUISITIONS AND YOUR PORTFOLIO
So how can investors take advantage of this trend? For starters, here's what not to do. Simply guessing at which companies might be takeover targets and buying as much stock as you can is not a good idea. Investors should never buy a stock based simply on a hunch that the company may someday be a buyout target.
Instead, investors might consider employing what's called an “event-driven” strategy. Event-driven investing focuses on capturing the value gap created when companies undergo transformative events, or “catalysts.” The idea behind the strategy is to invest in a company undergoing a material change that is expected to impact shareholder value.
We define catalysts as either “hard” or “soft.” A hard catalyst, such as an announced merger, tends to have a defined outcome, which creates a more predictable return. A soft catalyst, perhaps a company undergoing a senior management change, can have a range of outcomes.
One advantage of these investments is that, because they are focused on company-specific developments and not broader market events, they are less correlated with day-to-day market movements. By extension, such event-driven strategies have the potential to generate positive returns regardless of overall market moves.
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From my perspective, the record M&A activity this year has created the most attractive opportunity in the last 10 years, with merger spread investments near all-time high rates of returns. When compared to other yield asset classes, including high yield bonds, real estate investment trusts and even many illiquid yield investments, merger spreads may offer higher returns with much less duration risk. As a result, merger investments can potentially provide investors equity-like returns with less volatility than usually associated with stocks, according to data from Bloomberg and Hedge Fund Research Inc.
With the stock market both volatile and near all-time highs, and fixed income yields hovering near historic lows, investors should consider different ways to diversify their portfolios. Event-driven strategies are one way to do that.
Mark McKenna is global head of event-driven equity at BlackRock.
