Lina Khan is upending Wall Street’s merger-arbitrage playbook

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Lina Khan is the most aggressive trustbuster the U.S. has had in decades. Roughly two years into her tenure, Wall Street is still learning the hard way just how far she’ll take her fight against some of America’s most powerful businesses.

Merger-arbitrage investors – who bet on the likelihood that proposed acquisitions will close – just had one of their worst months since early 2020 after Khan, who heads the Federal Trade Commission, sued to block Amgen’s takeover of Horizon Therapeutics.

The move, after major setbacks in two other large pending transactions in previous weeks, stunned investors in one of the most widely held arb bets. It was the FTC’s first lawsuit to stop a pharmaceutical deal since 2009, and it drove home how arb traders are still adjusting to the Biden administration’s stepped-up antitrust efforts.

Faced with the changing landscape, these funds are switching up their playbook. Some are unwinding struggling positions altogether, others are focusing more on trading swings in spreads as deal prospects fluctuate, or are scaling into wagers more slowly. And then there are those who pounce on troubled transactions with a view that they’ll eventually close and produce fat returns.

“The regulatory environment is the most challenging I’ve seen in my career,” said Brett Buckley, an event-driven strategist at WallachBeth Capital, who’s been working in the industry since the 1990s.

Some of the biggest open-ended arb funds are approaching midyear sharply trailing market benchmarks after eking out gains in 2022. The $3.5 billion Merger Fund is down 1.4% this year, while the $7 billion BlackRock Event Driven Equity Fund has lost almost 1%, data compiled by Bloomberg show. Meanwhile, the S&P 500 Index is up 11%, and six-month Treasury bills yield more than 5%.

A big part of the challenge for arb traders is the slowdown of public M&A activity, partially due to the antitrust push. There are around 40 pending deals worth more than $500 million in the U.S., compared with roughly 55 to 75 during average times, according to Buckley.

Antitrust enforcement hadn’t been much of an issue over the past decade, enabling arb investors to deploy a straightforward trading approach and lock in annualized returns in the neighborhood of 3% to 5%, which was appealing when borrowing costs were near zero. But generating those numbers has become harder with Biden administration regulators roughly doubling their efforts to block mergers.

In naming Khan, 34, to lead the FTC, Biden chose someone who helped lay the groundwork for the more aggressive stance. The Yale Law School graduate published a widely read law review article in 2017 arguing that Amazon.com was a monopolist that stifled competition, and that the prevailing antitrust approach didn’t address such tactics. Then, as a lawyer, she was instrumental in producing a report on antitrust issues for House Democrats that became the basis for bills focusing on corporate power.

“As an enforcer, one of your goals has to be deterrence,” Khan said last week at an event in New York. “You want to prevent illegal deals from happening in the first place.”

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In the new environment, robust risk management is crucial, says Neetu Jhamb at Versor Investments. For example, the fund systematically builds positions in risky deals over time to capture wider spreads and tracks whether deals are taking longer than expected to close.

“Our process interprets an unexpectedly long time without successful completion as a sign of increased risk of termination,” she said. “As a result, we have reduced positions in several challenged deals.”

The antitrust risk is evident in deal spreads, which are around the widest of the past decade, according to Evren Ergin, head of special situations advisory at UBS Securities.

Of course, the riskier backdrop potentially creates more room for profits as well.

Take the Amgen-Horizon situation: After the shock of the FTC’s mid-May decision, money managers turned to assessing its legal prospects. Horizon’s stock tumbled 14% on the FTC announcement. It has since rebounded 3.5%, partly because some analysts deemed regulators’ lawsuit a long shot. The swings gave arbitragers an entry point.

“For those who aggressively trade the space, it can be a really great opportunity because you get many chances to trade in and out,” said Joseph Rotter, head of the principal strategies group at Neuberger Berman.

Should Amgen’s takeover prevail in court, buying Horizon at the current price could generate nearly a 20% gain. Horizon is one of the most popular positions for arbitragers, attracting experienced players including Pentwater Capital Management and HBK Investments, according to filings data compiled by Bloomberg.

A Pentwater representative didn’t respond to requests for comment, while HBK declined to comment.

Granted, a failure would mean steep losses. Some arb funds now include more positions that short deal spreads and profit if transactions run into trouble.

Investors face a “barbelled” set of opportunities, said Rotter at Neuberger Berman.

Deals with regulatory risk trade at only a 60% to 70% likelihood of closing, which he said is low even compared to the Great Financial Crisis. Meanwhile, those with seemingly no such issues trade at tighter-than-normal spreads, squeezing returns.

“There are no more plain-vanilla spreads and you’re going to have to get used to a couple of deals a year getting blocked and blowing up,” said Chris Pultz, a portfolio manager at Kellner Capital. “But the spread environment is compensating you for taking these risks.”