Merger arbitrage: generating uncorrelated returns

Since the global financial crisis in 2008, the global economy has recovered, stock markets and US GDP have traded to all-time highs and M&A volume has steadily grown. Underpinned by record high cash reserves, corporate funding costs at or near all-time lows and a slowdown in organic growth, M&A deal volume has recently accelerated, with Global M&A activity for Q2 2014, the highest in over six years and August 2014, the strongest August ever recorded. With acquirers being rewarded by rising stock prices in accretive acquisitions, competing companies are similarly emboldened to seek growth through acquisition, sometimes by topping bids of acquisition targets already in play or through hostile offers to those that may not be. With this as a backdrop, M&A volumes are expected to remain active.

Maximising long-term performance by managing downside risk

Though good risk-adjusted returns can be earned from the strategy across the cycle, the recent surge in M&A volume is a helpful tailwind to merger arbitrageurs. In its most basic form, merger arbitrage captures the spread in mergers of public companies after deal terms have been announced. The spread is the discount between the offer price and the target company’s stock price and reflects the perceived risk of a transaction not closing, as well as the time value of money. For an arbitrageur, the spread is the compensation for assuming the risk of deal closure.

Merger arbitrage becomes more complicated as the complexity of a transaction increases. Conditional merger agreements, financing contingencies, excessive regulatory risk and poor earnings are among the key risks to deal closure. All of these features will have an effect on spreads, the profitability, and the riskiness of investing in a merger transaction. The ability of an arbitrageur to successfully handicap these risks and avoid deals that break are the keys to maximising performance over the long-term.

While the strategy, when properly executed, can produce less-correlated, low-volatility returns, any individual deal carries substantial risk. That is because the spread in a transaction is often small compared to the potential downside if the deal breaks. While the annualised return of a deal may be high, the gross return is small relative to the premium offered. Therefore if the deal breaks, the downside can be 10, 20 or even 30 times the amount of the potential gain. The arbitrageur is uniquely qualified to assess the risk of deal completion in return for the remaining spread.

The second chart illustrates this point. In the midst of an agreed acquisition of Pinnacle Foods, the acquirer, Hillshire was itself subject to a hostile bidding war by two competitors, Pilgrims Pride and Tyson Foods. Arbitrageurs looking to profit from the initial $1-2 Pinnacle/Hillshire spread, suddenly faced losses of around $12 per share as Tyson prevailed in the bidding war and Hillshire walked away from its acquisition of Pinnacle. Sometimes the biggest wins in arbitrage are simply avoiding losses.

A broader toolkit for Merger Arbitrage – generating returns beyond pure spreads

While many managers are limited to capturing spreads on announced deals, by applying a rigorous selection criteria and a broader set of tools, it is possible to generate above index returns. After excluding deals with higher risk, a manager should seek to optimise returns from the spread portfolio. Variables that can influence performance include selection of deals, the relative weight of positions and the timing of entering and exiting the transaction.

Further, anticipating which announced deals may receive topping bids is another source of alpha generation. In a strategic transaction where an acquirer underbids for a target, and shareholder approval is likely to be withheld, an acquirer may be forced to increase consideration to close the deal or the target may be subject to a competitive bid by another company. In these situations, topping bids can cause sharp spikes in the targets stock price. For an arbitrageur, acquiring weighted positions in these companies after the deal is announced, but prior to the emergence of a new bidder, can produce outsized returns with lower risk.

Potential takeovers are another source of additional return. By evaluating the potential for industry consolidation and ranking prospective buyers and sellers, an arbitrageur may establish positions in anticipation of a takeover, thus capturing the full deal premium if an acquisition is announced. While the risks in these investments are higher than the risk of announced deals, the downside can be mitigated by choosing targets that trade at discounted valuations that could rise even if no take over occurs.

Conversely, in accretive acquisitions, excess returns can sometimes be earned by holding onto the acquirers stock after a deal has closed, until the synergies that drove the merger are reflected in the stock price. As we progress further into the cycle, as growth slows and merger activity declines, additional opportunities may be found shorting weaker transactions, in particular those with financing contingencies. During periods of recession as default cycles peak, expertise in bankruptcy increases managers flexibility to arbitrage spreads as bonds are exchanged for cash, new debt and equity or in liquidations where shares are exchanged for cash.

Uncorrelated to market indices – capital preservation and diversification benefits

Given returns generated from merger arbitrage are determined by the outcome of specific corporate events rather than broad market movements, executed well the strategy exhibits low correlation to broader markets. Thus, as well as being a useful driver of returns, merger arbitrage can be an effective diversifier for investors portfolio’s and importantly, can preserve capital during periods of heightened market volatility. InBev’s acquisition of Budweiser in 2008 illustrates this relationship. As markets sold off in 2008, Budweiser’s share price was correlated initially, but diverged from the market as deal fundamentals remained intact and the date of deal closure approached. This attribute makes successful merger arbitrage a valuable diversifier of returns and dampener of volatility within a broader portfolio.

Summary

Merger Arbitrage is one of the oldest hedge fund strategies and has produced attractive returns for investors for decades. The durability of the strategy is in its long-term proven ability to generate positive, absolute returns irrespective of market direction. With a strong stock market, low interest rates, strong corporate balance sheets, positive economic indicators in the U.S. and acquirers being rewarded for accretive acquisitions, M&A volume is expected to remain active. While the increased level of merger activity offers skilled arbitrageurs many opportunities, their ability to generate above-average risk-adjusted returns across the merger cycle depends, as always, on their ability to manage downside risk by being selective on deals and situations in which they invest and by investing in a broader scope of risk arbitrage opportunities.

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