“At the back side of the cycle when there are not many deals happening, you have the opportunity to swap debt for equity as companies revitalise,” said Jones, speaking at Fund Selector Asia’s recent Alternatives Forum.
During the latter stages of their recoveries, they can be heavily indebted and are willing to swap debt for equity. Paulson will hold the bonds for a short period of time for that swap.
“In that last phase it’s a great opportunity to add value,” said Jones.
Another strategy for Paulson is to find potential takeover targets so that it can capture the whole takeover spread.
The biggest risk for the fund is that deals might not close, said Jones.
“What you do to limit the situation is to focus on the types of things that suggest the high probability of the deal closing,” he added.
Low interest rates and robust CEO confidence, particularly when they see their peers boosting share prices through M&A, have created conditions for consolidation. Jones said opportunities have emerged because investment banks have pulled back because regulations in many jurisdictions limit their proprietary trading.
Several areas ripe for merger arbitrage include consumer staples, media and the consolidation of Europe’s fragmented telecom market, Jones added.
A recent example is the Italian mobile carrier 3 Italia, owned by Hong Kong tycoon Li Ka-shing, which is set to merge with Wind Group, owned by Russian telecom firm VimpelCom, in a deal announced early August.
“There are lots of players in the [European telecom] space and the region has high roaming costs when traveling from country to country. Those costs have to come down,” said Jones, “Increasingly the borders will disappear, which makes sense inside the EU.”
The EU has already reached a provisional deal to scrap mobile roaming charges across the 28 member states in mid-2017.
Other targets for mergers include US telecom operators, US cable operators (both content and carriers), generic pharma companies, speciality healthcare companies and some smaller to mid-size oil companies.
What makes this environment particularly attractive is that interest rates are quite low, Jones added, financing costs are low, and stock valuations for acquiring companies are high.
Additionally, Jones said companies have healthy balance sheets with record high cash reserves, companies have cut costs and organic growth is slowing, which is leading many to seek growth through acquisitions.
