Increased deal risk scares away the arbs

Inside of investing there is a culture known as 'arbitrageurs.' While there's many different types of arbitrage, merger arbitrage has become an increasingly-used strategy amongst traders and investors during the last few years. The primary reason: the private equity boom.

Merger arbitrageurs try to purchase stocks after a buyout has been announced but before it has been completed. For example, if a stock is being taken out for $22 per share and is currently trading for $20 per share, the 'arbs' might buy the stock betting that the deal is completed and they can keep their 10% assumed rate of return. Understandably, the increased private equity activity during the last few years has helped to fuel a boom in this strategy.

But the Wall Street Journal's "Heard on the Street" column is reporting [subscription required] that many arbitrageurs are pairing back their exposure to the merger arbitrage space due to losses amounting to more than 2.5% already this month. What's the reason for the weak performance? Simply put, the increased borrowing costs for private equity funds have made many deals unlikely to be completed because they make less sense for private equity investors.