M&A market update: Let’s make a deal!

Why Canada is the bright spot for merger and acquisition in 2023

Global merger and acquisition (M&A) investment totalled $291 billion through February, down from the $729 billion invested in the same period last year. While M&A deal activity was down in most major regions, including the U.S. where there was a 67% year-over-year decline to $131.5 billion, Canada remained a bright spot, with activity roughly flat over the last year at $10.8 billion of deal value announced.

Unlike the last two years, when the technology-sector led merger deals, 2023 is seeing deals materialize from a more diverse range of sectors. The industrial sector has led M&A deal activity to date, followed by the energy/power, technology and real estate sectors. We expect technology sector M&A to continue representing a leading share of deal flow over the next year, but we are encouraged by financial and strategic buyers stepping up and seeing the opportunity to do deals in more sectors and industries.

What’s driving M&A slowdown?

The relative slowdown in M&A activity this year is a likely consequence of the current macro environment, marked by higher inflation, interest rates, and market volatility. The large losses taken by banks, which provided syndicated financing for many of last year’s largest leveraged buyout (LBO) deals, have also impacted the financing market for M&A deals. With banks limiting or halting on writing debt financing for leveraged buyouts, private equity deals may be hindered or delayed, which could be driving a decline in the volume of M&A deals.

While we have previously discussed new and creative ways in which private equity firms are financing deals, including-self-financing without leverage, we are starting to see new players emerge in this market – a positive sign for future M&A potential. For example, Oaktree Capital recently announced that the firm was seeking to raise $10 billion in a new fund that will help finance large private equity takeovers by offering loans to leveraged buyout groups.

With banks cutting back on the size and number of loans they offer to acquirers, this is an opportune time for new players to step in and provide this much-needed financing. With private equity incentivised to do deals, approximately $1 trillion in PE coffers ready to be deployed, and public market valuations being far more attractive than those in the private markets, an increase in buyout debt financing could be the spark that sets off a surge in M&A deals.

SPAC market update

At the end of January 2023, Special Purpose Acquisition Corporations (SPACs) searching for targets were trading at a discount to trust value, which provided a yield-to-maturity of 6.0%. With SPAC arbitrage effectively equating to acquiring a Treasury bill at a discount, SPACs currently provide a higher yield than U.S. corporate investment-grade bonds with lower credit risk, shorter duration, and a tax advantage, as SPAC returns are primarily capital gains.

Given challenging market conditions, the more than 330 SPACs still competing for targets, negative sentiment for SPACs, and a terrible track record of de-SPAC performance, 2023 continues to present SPAC sponsors with the nearly insurmountable task of finding and closing a merger with target prior to maturity. We believe the majority of SPACs will be unsuccessful in closing a merger prior to maturity and will therefore be forced to liquidate and return capital to shareholders.

Through 2023, over 330 SPACs are set to mature, representing over $75 billion in capital. While no longer a market with the size, liquidity, and (more pertinently) return potential to attract speculators and larger investors, the SPAC industry should remain an attractive market for arbitrage investors throughout the year. Our strategy remains focused on targeting SPACs trading at a discount to trust value that offer an attractive yield held through liquidation.

March 2023 laps what was effectively the end of the peak of the SPAC bubble, which occurred from Q3/2020 to Q1/2021 by the typical two-year maturity period. We have already seen the wave of SPAC liquidations from this bubble-popping occur last year and spike in December 2022 with the SPAC sector halving in size through 2022.

Liquidation activity has remained elevated for the first two months of this year, with approximately 33 SPACs liquidating $9.8 billion in trust value back to investors. March 2023 is expected to see over 90 SPACs liquidate and return more than $25 billion in trust value, and a further $37 billion in liquidations is expected throughout the rest of the year. As the SPAC sector returns to an equilibrium, new opportunities may emerge in announced deals or SPAC IPOs, but we remain cautious and focused on our liquidation strategy.

Market outlook

There were few places for investors to hide in February 2023, with stocks, bonds, and commodities all reversing from January’s rally. The S&P 500 (USD) slid 2.4% in the month, the NASDAQ (USD) fell 1.0%, oil prices were lower, and gold suffered its worst month since June 2021.

Rising inflation worries led bonds to their worst February in three decades, with the Bloomberg Global Aggregate Bond Index (USD) declining by over 3.3% after short- and long-term yields increased during the month. The positive performance of the Pender Alternative Arbitrage Fund in a month where most traditional asset classes were declining demonstrates the value of adding a non-correlated absolute return-focused alternative strategy like merger arbitrage to a portfolio.

While central banks started the year with more dovish commentary on the pace of rate hikes, recent inflation and employment data have pushed rate expectations higher. The BOC recently stressed that its pause in rates was conditional and that it will be ready to raise rates should inflation not come down quickly or the economy continue to run hot. In the U.S., the Fed has been much more hawkish, suggesting rates may need to go higher to temper inflation.

With greater uncertainty on the path of interest rates, adding an allocation to merger arbitrage, which has historically been an effective interest-rate hedge and a source of low-volatility returns, could be prudent for investors.

While the size of the SPAC sector continues to shrink, SPAC arbitrage yields still provide investors with a relatively attractive, low-risk, and tax-efficient return relative to bonds. We will be selective and yield-sensitive in which SPACs we hold in our portfolio, but we continue to see opportunities in the SPAC sector.

The opportunity in merger arbitrage remains compelling, and after recent unprecedented actions by key U.S. regulators targeting large merger deals, we will be increasing our exposure to the fund’s key focus of small- and mid-cap merger deals and reducing our exposure to opportunistic large-cap mergers in which we have occasionally invested in the fund.

Overall, we continue to see favourable tailwinds in small- and mid-cap equity markets, and this provides us with confidence that deal activity could increase in our universe.

Amar Pandya, CFA, is Portfolio Manager of the Pender Alternative Arbitrage Fund and the Pender Alternative Special Situations Fund at PenderFund Capital Management. This article is adapted from commentary that originally appeared in Pender Commentaries. Used with permission.

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