Global merger and acquisitions (M&A) activity is gaining speed with last quarter’s $805 billion in announced deals topping the $650 billion quarterly average over the last five years, as well as being the best first quarter over the same period. We’re on track to pass last year’s $2.9 trillion in total deals, but even with so much action there hasn’t been a lot of room for hedge funds to maneuver the straightforward cash and stock deals.

“Spreads remained tight in the first quarter, averaging between 3% and 6% in cash or stock deals with little perceived risk,” says the first quarter report from Paulson Merger Funds, managed by Paulson & Co, a copy of which was reviewed by ValueWalk. “Due to the low yield in simple spreads we have continued to de-emphasize this part of the portfolio.”

Instead of settling for low yields, the investor letter details some key strategies for finding better investments in an M&A environment that appears to have unattractive spreads.

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Viewing liquidation like a cash deal

One strategy is to invest in a company that is being liquidated, usually as a bondholder instead of a shareholder, and the economics are similar to a cash merger depending on the purchase price, amount of distributions, and timing of distributions. Paulson Merger Funds gives the example of Residential Capital where it bought a claim from an insurance company at the end of last year. The liquidation trust made a 70% distribution, mostly covering the funds costs, and then when the market priced in litigation claims the liquidating trust units rose from $7.80 at the beginning of the year to $14.70, and Paulson made an 88% return on the deal.

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Complex transactions increase spreads

Another tactic is simply to look for complex transactions that involve more than a simple combination of cash and stock. Because there are more moving pieces, other investors may not be able to pin down the merger arbitrage and spread tend to be wider. When Verizon Communications Inc. (NYSE:VZ) decided to buy Vodafone Group Plc (ADR) (NASDAQ:VOD) (LON:VOD)’s 45% stake in Verizon Wireless, it paid $59 billion in cash, $60 billion in Verizon stock subject to a collar, and $11 billion in additional consideration, with most of the proceeds being distributed to Vodafone shareholders in the form of a dividend and some Verizon stock. The result was a deal with 26.8% annualized return.

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Paulson going long on possible M&A deals

Paulson’s next strategy is actually a classic value play – finding potential takeover targets before any deal has been announced. The key is to mitigate risk by investing in companies that are trading at a discount anyways and could go up even if no one makes a bid. Choosing companies in a sector that’s currently undergoing consolidation is the catalyst that could unlock shareholder value. In some cases, Paulson will also hedge these long positions either using industry ETFs or a competitors stock.