How to spread bet M&A

Mergers and acquisitions activity (M&A) is back. According to Thomson Reuters, M&A grew by nearly a fifth this year to $2.25 trillion globally. Of that, emerging markets made up 17% of transactions a new record.

And with debt still cheap and many companies sitting on cash piles earning little by way of a return, next year could be even bigger if investment bank M&A teams are to be believed. "We feel M&A volumes will improve next year, there's certainly going to be more cross-border activity than ever, and Asia again will be a bigger part of the equation" says Scott Matlock, chairman of M&A at Morgan Stanley.

After all, it makes more sense for a predator to buy a target at the bottom of the cycle when assets are cheaper than during the boom years when you risk overpaying.

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On the flipside, deals require a degree of confidence from CEOs in particular - and that may well peter out next year. Sovereign debt woes are still stalking the markets; interest rates may have to rise to counter the growing threat of inflation; and if UK consumer confidence is any yardstick this month saw the lowest reading in two years no-one is feeling like splashing the cash on goods and services just now. Any of these factors may deter the dealmakers.

But, whether or not you buy all this hype about M&A picking up enough to set new records, one thing's for sure as a spread better, there's scope to make money from a deal.

The pairs trade - using two simultaneous spread bets - is the key. Often when deals are announced, shares in the target rise and those in the predator fall. That's because studies have shown that many M&A deals add little or no value, and the predator typically overpays for the privilege - as RBS demonstrated by buying ABN Amro at the top of the market.

The suspicion that a deal is being driven more by corporate egos than commercial common sense often boosts the target, but weighs on the predator's shares.

So one way to make money is to short the predator and buy the target using two separate spread bets. Note that to make a profit you will have to reverse both trades later. Get both of them wrong, however, and you'll be on the hook for some serious losses.

'M&A arbitrage' of this type is no place for a novice spread better, for sure. But anyone comfortable with pairs trading should keep their eye on newsflow about 2011 deals and get ready to pounce.