The M&A bubble is bursting

REUTERS/Romeo Ranoco

Hedge funds are getting bloodied in one of their favorite games, after years of a giddy boom in mergers and acquisitions with ever sillier valuations, made possible by an endless flow of easy money from yield-starved investors and fee-hungry banks, under the eyes of regulators who’d conveniently fallen asleep.

But that M&A bubble is now collapsing. And many hedge funds that were into merger arbitrage got caught on the wrong side of the bet.

Merger arbitrage is a bet that an announced acquisition gets completed. With the announcement, the share price of the target company shoots up to somewhere near the bid. If there’s hope that the bid will be raised, the share price might overshoot the bid. Once the target company agrees to be taken over, shares usually trade slightly below the acquisition price until the acquisition is completed. These price differentials can be exploited by merger arbitrage.

These can be huge, leveraged bets on what are expected to be minor price differences. Risks are thought to be low – unless the merger collapses. That’s when these “arbs” can get their heads handed to them.

This is now happening. So far this year just in the US, about $400 billion in deals have collapsed. It already blew past the full-year total of last year’s withdrawn deals of $231 billion and the 5-year average full-year total of $243 billion, according the Dealogic. Even if no more deals are withdrawn this year, the current total would already set a new full-year record.

This hangover from the multi-year merger bubble includes Pfizer’s $160 billion merger with Allergan, “the biggest withdrawn deal on record,” as Dealogic put it. It collapsed “two days after the US Treasury Department announced stricter rules for tax inversions.”

While the Treasury’s efforts to crack down on this tax avoidance scheme have been in the open for a while, the market didn’t think that it was the sole reason why Pfizer would buy Allergan, and that the merger would go through anyway. Turns out, the market was wrong. Tax avoidance was the only reason.

Allergan shares plunged 15% that day to $236.55 a share and have since dropped another 5.8% to $222.69 at the moment, down $100 or 31% from their peak on December 1 shortly after the merger announcement. The fact that shares traded sharply below their December 1 peak even before the deal collapsed shows that serious doubts had crept into the calculus.

Other failed mega deals this year include Halliburton’s $38.7-billion bid for Baker Hughes. It collapsed after the Department of Justice, following a nearly interminable review process, sued to block the deal because of its anti-competitive nature. There were seven such mega deals that burned and crashed this year.

REUTERS/Romeo Ranoco

On Tuesday, the barely limping brick-and-mortar retailers Staples and Office Depot, trying to survive in a world with shrinking demand for office supplies, threw in the towel on their $6.3 billion deal after a federal judge sided with the Federal Trade Commission and granted a preliminary injunction. Allowing the only two national office-supply chains to combine would, the judge said, “substantially impair” competition. Their shares plunged.

And more mega deals have scheduled an appointment with doom. The Deal Book:

Energy Transfer Equity, a Dallas-based pipeline operator that initially had to coax a majority of the Williams Companies board to agree to its $38 billion offer in September, was frantically searching for a way out of the deal by springtime.

Things started to look shaky when Williams Companies sued Energy Transfer and its chairman, Kelcy Warren, in mid-April, claiming he had breached the merger agreement.

Then Mr. Warren said several times during the company’s earnings conference call last week that the deal “can’t close” because of a complicated tax opinion. Williams firmly believes it can.

Investors overwhelmingly think the deal, as it was agreed on seven months ago, is doomed. Of about 150 fund managers surveyed by Evercore ISI, 84% do not expect the deal to close in its current form.

Then there is the drug maker Abbott’s $5.8 billion acquisition of Alere, which makes medical diagnostics tests. At the end of April, less than three months after their deal was announced, Alere put out a statement saying that Abbott was trying to terminate their agreement but that Alere had denied the request.

In both cases, lawyers said the merger agreements were impenetrable. Based on all publicly available information, neither Energy Transfer nor Abbott has a clear way out of its deal. Yet the market is treating these situations as if they are practically doomed….

Another tax-inversion pharma-oligopoly deal that is now looking shakier is Shire’s $32-billion acquisition of Baxalta. Shire is headquartered in Irland, Baxalta in Illinois. It would, they said at the time, create the world’s biggest rare-disease drugmaker.

These collapsed and collapsing deals are among the factors ruining the M&A party: through May 4, according to Dealogic, US targeted new M&A volume plunged 21% from a year ago.

But there’s hope for arbs that jump into the game now and that can handle the risk and the anxiety in this post-bubble tumult: the gap between the acquisition price and target-company’s share price has widened substantially, given theprobability that these deals may fall apart too. Arbs that jump in at the right moment and are lucky enough to get into a deal that will actually be completed will pocket a greater return – and a lot more gray hairs to boot.

After a blistering five-year boom of near limitless possibilities, it is suddenly getting tough in another asset class – one that mere commoner millionaires are not invited to play in: the high-dollar art market. Read…  Another Asset Bubble Cracks: Art Sales Plunge

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