Acquisition target Tiffany & Co. is among those whose stocks fell after the arrival of the coronavirus pandemic. A shop in Madrid in mid-May as Spain phased out some lockdown closures.
Photo: mariscal/ShutterstockSome hedge funds that wager on mergers and acquisitions are taking an unusual approach to navigating the uncertainty caused by the new coronavirus: They’re betting against the target.
For these so-called merger-arbitrage investors, this marks a big shift in strategy. They typically make money by buying up the stock of target companies in M&A deals, betting the share price will rise after a combination is announced and nears completion.
But many are finding that reducing their long position, or even shorting the target—betting its price will fall—is now a better option as prospects mount that deals get delayed, close at lower prices or fall through because of the crisis.
The switch comes as the probability of deals crumbling has jumped, hitting 33% in mid-March from 4% in January, according to Northstar Risk Corp., a software provider to hedge funds. It has since fallen but remains high at 20%. Northstar based its data on the spreads—the difference between an offer price and where the stock currently trades—of around 300 deals.
“There is an increasing feeling that more and more buyers will walk away or try to renegotiate,” said Florence Tournier, head of European strategic equity at brokerage firm Churchill Capital. “Buyer’s remorse is the biggest theme in the U.S. at the moment,” she added.
Merger-arbitrage manager Raj Vazirani thought his January bet on a $5.5 billion Texan bank merger was a safe one. He felt confident as David Brooks, Independent Bank Group Inc.’s chief executive, extolled the deal with Texas Capital Bancshares Inc. on a conference call that month.
Three months later, Mr. Vazirani reversed his view on Texas Capital, after Mr. Brooks repeatedly declined to comment on the tie-up during an earnings update in April. Mr. Vazirani exited his long position in Texas and started selling the stock short.
Of 20 positions, Mr. Varzirani would normally hold around 17 as long holdings and the rest as shorts. Today, that breakdown is about even.
The “strategy of buy and hold worked for nine years,” during the bull market, said Mr. Vazirani, chief investment officer of New York-based Vazirani Asset Management. “I don’t think it will work this year.”
His move to short Texas Capital stock proved prescient. The banks last week called off the merger, citing the Covid-19 pandemic.
“ ‘Buyer’s remorse is the biggest theme in the U.S. at the moment.’ ”
Merger-arbitrage funds employ a niche investment strategy often at the center of the flurry of trading spurred by the news of a takeover deal. They managed about $24 billion globally in the first quarter, a small slice of the hedge-fund universe, according to industry tracker HFR. The usual bias toward long positions makes sense: Some 98% of deals announced in the past five years have gone on to close.
Such funds would typically hold 90% of their portfolios in long positions, said Andy Baker, who runs special-situations trading at Barclays PLC. More funds that hadn’t dabbled in shorts are now calling to discuss ideas, and those that had shorts on already are increasing their proportion of the portfolio, he said.
The new norm for arbitrage investors came to the fore in March as they joined an overall selloff in equities. Stocks tanked, including those of Tiffany & Co., which LVMH Moët Hennessy Louis Vuitton SA agreed in November to acquire for $16.2 billion, and GrandVision NV, which is set to be bought for €5.49 billion ($6.1 billion) by eye-care rival EssilorLuxottica SA following an agreement in July 2019.
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Jamie Sherman, portfolio manager at Kite Lake Capital Management, said he has been shorting transactions for which the market hasn’t properly priced in the risk of deal failure. “In this market, spreads are a lot more volatile day to day, and conservative sizing and flexibility in trading is more important than ever,” he said.
Roy Behren, managing member and a portfolio manager at Westchester Capital Management LLC in Valhalla, N.Y., bet on shopping-mall owner Simon Property Group Inc.’s $3.6 billion deal to acquire rival Taubman Centers Inc. He bought Taubman stock, believing the deal was strong because of a contractual clause preventing Simon from using Covid-19 as an excuse to walk away.
But mall operators are now fighting for survival as the fight against Covid-19 discourages shopping. Both Indianapolis-based Simon and Taubman, based in Bloomfield Hills, Mich., temporarily closed their malls.
Simon agreed to pay $52.50 a share for Taubman, but today the stock trades around $40. The volatility and outlook for malls pushed Mr. Behren, whose firm manages $4.2 billion in assets, to sell some stock. Mr. Behren thinks the deal will still get done, but believes the risk of it collapsing has increased and the price could get renegotiated.
The market dislocation has paid off for some. Luke Lynch, founder of Aslan House Capital LLP, a London event-driven hedge fund, said his firm had shorted GrandVision in November, believing the market had underestimated the antitrust concerns surrounding the deal. Once the pandemic became clear, he held on to the short, which he has since covered. The European Commission has twice suspended its review, according to regulatory filings.
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Write to Julie Steinberg at julie.steinberg@wsj.com and Ben Dummett at ben.dummett@wsj.com
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