Global Dealmaking Could Fall Off A Cliff This Year. Here’s How To Position Your Investments So They Don’t Follow.

Reda Farran

3 months ago4:45 mins

Global Dealmaking Could Fall Off A Cliff This Year. Here’s How To Position Your Investments So They Don’t Follow.

2021 was a record year for dealmaking around the world – but that could all be about to change. Markets have become much more volatile since the Russia-Ukraine war broke out – and central banks raising interest rates hasn’t helped. There are three sectors of the finance industry that could be hit hard by a drop-off in dealmaking – here’s what you need to know.

What’s going on?

Stock markets are experiencing a heightened bout of volatility following Russia’s invasion of Ukraine, and that’s pushing many firms to cancel their initial public offering (IPO) plans. The uncertainty makes it much harder to attract new investors, after all. Plus, falling stock markets mean any company looking to go public would have to settle for a lower valuation.

And it’s not just equity markets: the volatility is hitting debt markets too. That – together with the increased cost of debt financing as central banks raise interest rates – has led many firms to cancel plans to raise cash by issuing debt.

These canceled fundraising deals have a knock-on effect on other deals too, like mergers and acquisitions (M&A). If a company was going to fund an acquisition by selling bonds and the bond deal gets canceled, then the acquisition will likely be canceled too.

According to Bloomberg, almost 80 companies have put at least $25 billion worth of IPO, debt, and M&A deals on hold since the start of the war nearly a month ago. That’s partly why the number of global IPO and corporate bond deals has plunged 74% and 28% so far this year, respectively.

Source: Bloomberg
Source: Bloomberg

Why should I care?

A plunge in global deals is bad news for three sectors of the finance industry: investment banks, merger arbitrage funds, and private equity firms. But you can avoid potential losses by decreasing your exposure to these sectors – or even turn the situation into an investment opportunity by shorting stocks and exchange-traded funds (ETFs) exposed to these areas. Let’s look at each in a little more detail.

1) Investment banks

Investment banks take a cut from every deal they work on. So it’s no wonder many of them saw record profits in 2021 amid a dealmaking frenzy that broke all-time records. But now that activity’s taking a dip, banks could see their dealmaking revenue shrink, dragging down their overall profits.

Investment banks heavily exposed to Europe are the most at risk: the value of M&A deals in the region is down by more than a fifth this year already. And according to Bloomberg, dealmakers in Europe are unsure whether a further $300 billion or so worth of M&A and IPO transactions will go ahead.

2) Merger arbitrage funds

Let’s take a step back and look at what merger arbitrage is, exactly, first. When a company wants to buy another company, it makes an offer to purchase its stock at a premium – that is, above the current market price – to incentivize shareholders of the target company to accept the deal.

But here’s the thing: there’s no guarantee the deal will actually succeed, so the target company’s share price doesn’t immediately jump to the offer price. The difference between the two prices is called the “spread” – and the bigger the risk that the deal will fail, the bigger the spread. If the deal does succeed, the price of the target company will eventually rise to the offer price and the spread will narrow to zero.

That’s where merger arbitrage comes in: the investment strategy involves buying the target company’s shares and selling the acquirer’s. Funds that do this are solely betting on the success of the deal – not on any other factors, like the rise and fall of the stock market. If the deal succeeds, they’ll earn the spread. But if the deal fails, the loss can be high – often higher than the gains when the deal succeeds. Of course, merger arbitrage funds mitigate that risk by diversifying across a wide number of deals. So even if one fails, the others should still succeed, containing losses.

The biggest risk, then, is that many deals fail at the same time. And, as we’ve seen, that’s already starting to happen on the back of conflict-induced market volatility and rising interest rates. Two passively-managed merger arbitrage ETFs that could be in trouble are the Proshares Merger ETF and the IQ Merger Arbitrage ETF.

3) Private equity firms

Private equity (PE) firms are major contributors to M&A, debt issuance, and IPO deal activity. That’s because they’re in the business of buying out companies – and they fund those acquisitions by issuing debt. Then, a few years later, they sell the companies to other firms or list them on the stock market via IPOs. According to Bloomberg, PE firms accounted for a record 24% of the value of global acquisitions last year.

But this year, rising interest rates and increased market volatility are creating a more challenging environment for PE firms to buy out other companies. And a tough IPO market means they’ll struggle to exit investments they’ve already made. Taken together, that could dent PE firms’ profits – and spell bad news for the share prices of publicly listed ones like Blackstone, KKR, 3i Group, and so on. You could short these individual firms, but a safer and easier way to bet against them is to short the iShares Listed Private Equity UCITS ETF: a fund tracking 78 companies active in the PE space.

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