A Primer on Merger Arbitrage
Introduction
Student investment funds only seem to use one of two strategies: long only or, in some cases, long/short. Considering the wide spectrum of exciting investment strategies, it has always made me wonder why students restrict themselves to these two. Maybe because the logic behind traditional stock investing is straightforward for a beginner finance student to understand, or maybe it's due to a lack of exposure to alternative investment strategies. Whatever the reason, I find the world of merger arbitrage to be an interesting hybrid between economic theory, probability, and the strategic nature of Mergers & Acquisitions. This article will serve as an introduction to merger/risk arbitrage.
So, what exactly is risk arbitrage?
Risk arbitrage is taking advantage of the spread between a publicly announced merger's consideration (the deal price) and the market value of the stock. It is not betting or speculating on mergers happening. Further, it is not “buy low sell high” investing. It is an event-driven strategy that focuses on specific, identifiable, and clear catalysts.
Gross Spread = Deal Consideration - Target Post Deal Announcement Price
Why do merger arbitrage spreads exist?
When a company announces its acquisition of another company, the stock price of the publicly traded target trades at a discount to the deal price. Let’s say Company A is currently trading at $20 and Company B announces it will purchase Company A for $25 a share. The stock price of Company A will trade at a discount to the $25 deal price until the deal is consummated and the target shareholders receive the $25. if the market thinks there is a high chance of the merger or acquisition being completed, then the target’s stock price will be closer to the acquisition price, let’s say about $24.50. But if the market thinks there is a much lower chance of the acquisition, the stock price would trade lower, maybe around $22.30 and a moving scale in between based on risk. If you correctly predict the acquisition goes through, you pocket the difference.
This spread exists because selling a security at a discount to its deal price provides immediate liquidity to the seller. The spread is compensation to the arbitrageur for taking on risk that the stockholder (who owned the stock prior to deal announcement) no longer wants to bear. Chart 1 shows the stock price of Array BioPharma during the period leading up to and following the announcement of Pfizer’s acquisition of Array BioPharma. Notice how the stock price of Array spikes to $46.44 when the deal is announced, just $1.56 shy of the $48 deal price. This spread reflects the transference of risk from shareholders before the deal was announced to the arbitrageurs who have taken a new position in the stock upon deal announcement.
Where does the “risk” in risk arbitrage come from?
Economist Milton Friedman famously said, "There is no such thing as a free lunch." When anyone who has taken ECON 101 hears the term merger "arbitrage", one instantly imagines the riskless profit shunned by adherents of the efficient market hypothesis. However, merger arbitrage is a bit of a misnomer…there is risk involved in this strategy. In an alternate world where all deals announced by publicly traded companies were completed, it would indeed be a riskless profit, but if that were the case, then spreads wouldn't exist in the first place. Successful deals typically compensate the arbitrageur with pennies. On the other hand, the downside risk is asymmetric, and the target stock price typically reverts to the price prior to the deal announcement. This is why merger arbitrage is often jokingly compared to running in front bulldozers picking up pennies. It is imperative that the aspirant merger arbitrageur develop a knack for both identifying deals that have a high probability of completion and avoiding the minority of deals that fail. There are two important forms of risk associated with merger arbitrage.
The first risk is deal risk
This is the idiosyncratic risk of the deal in question. The primary deal risk involves antitrust concerns, regulatory concerns, and shareholder approval. In the United States, mergers must be filed with the SEC through a Schedule 13D filing or a proxy vote. If a target company’s Board of Directors approve a deal, then the shareholders of the company must approve the deal by a simple majority vote. This presents risk of an activist intervening or shareholders not approving of the deal. If the acquiring company is paying for the deal with more than 20% of its stock, then it is required by law to receive shareholder approval by the acquiring company’s shareholders. Proxy votes present opportunities for disgruntled shareholders to block the deal or adjust deal terms; activist investors become larger threats at this stage. Mergers must then pass one or more regulatory approvals. Under the Hart-Scott-Rodino Act, M&A transactions that are greater than $90 million must be sent to the Federal Trade Commission and Department of Justice for preliminary review. M&A deals without any regulatory concerns are typically cleared after preliminary review, but some are called for a Phase 2 review. This often leads to spreads widening and the market becoming more concerned about the probability of deal consummation. Depending on whether the deal is a cross-border transaction or involves international markets, the deal could also be subject to additional regulatory approvals. Below are key U.S. and international regulators that a merger arbitrageur must be aware of.
Some deals present few antitrust or regulatory concerns as is typically the case with mergers involving vertical integration (i.e. a tire company purchasing the rubber company it purchases rubber from) or small cap companies (as there is less chance of monopolies when dealing with smaller companies). Horizontal integration, however, presents greater antitrust concerns and sparks regulatory scrutiny for potential anti-competitive effects. The market will price this regulatory risk into the spread. Spreads will be wider or tighter depending on what the market perceives the risk of deal completion is. A tighter spread indicates greater certainty of deal consummation and a wider spread indicates market doubtfulness about the probability of deal consummation. As deals take longer to complete, the spread may begin to widen over time depending on the reason for the extended timeline.
Each of the regulatory approvals can involve multiple phases depending on the level of regulatory concern that the deal presents. The more regulatory approvals that a deal requires, the longer it will take for a deal to be completed which reduces the arbitrageur’s returns. Recall that Array traded at only a 3.36% spread to its deal price (Table 1). Now let’s consider Illumina’s acquisition of Pacific Biosciences.
On November 1, 2018 Illumina announced its acquisition of Pacific Biosciences for $8 a share, a 46% premium to Pacific Biosciences’ October 30th closing price (Table 3). The arbitrage spread as of November 1st, 2018 market close was 5.5%. Since then, the Illumina-Pacific Biosciences deal has been fraught with regulatory scrutiny from the U.K. Competition and Markets Authority related to concerns over competition in the DNA sequencing industry. This extended the deal timeline, reducing the annualized return and raising concerns about the deal being blocked. At the time of writing, the arbitrage spread now trades as wide as 42.5%, reflecting that the market predicts an extremely low probability of deal completion.
The second form of risk is the Time Value of Money
Simply put, a dollar today is worth more than a dollar tomorrow. For this reason, the longer a deal takes to complete, the smaller the annualized return on investment. Arbitrageurs want deals to close quickly and without regulatory scrutiny.Having cash tied up in a merger arbitrage deal for longer than necessary presents opportunity costs and reduces annualized returns.
Trading Merger Arbitrage: Transaction Types
There are two types of deals that affect the trading techniques an arbitrageur employs to harvest the arbitrage spread.
All Cash Transactions
The simplest merger arbitrage transaction to execute is an all-cash transaction. Pfizer’s acquisition of Array BioPharma was an all-cash transaction. This is when the acquiring company offers a cash payment above the current share price. To trade this strategy, the arbitrageur would buy the target stock and wait until deal completion.
Stock-for-Stock Transactions: Fixed Exchange Ratio
An acquiring company can use its own stock as currency in an M&A deal. The most common way to do this is using a fixed exchange ratio. This is when the target company stockholders receive a fixed number of the acquiring company’s shares per share of the target company they own. In stock-for-stock transactions the deal price is not fixed. Arbitrageurs must hedge the position by locking in the spread. This involves going long the target shares and shorting the acquirer shares by the correct ratio. Here’s an example to illustrate this:
Company A’s stock price trades at $20.00. Company A announces its acquisition of Company B that currently trades at $25.00. The deal terms specify that two shares of Company A will be paid to Company B shareholders for each share held of Company B. This means that 2 shares of Company A are currently worth $40.00 in cash. Shortly after the deal is announced, Company B’s stock could trade at $39.51 on the market, even though two shares of Company A are currently worth $40.00 in cash. This reflects the risk compensation to the arbitrageur. Without hedging this position, the arbitrageur is subject to a decline in the stock price of Company A. If Company A’s stock price falls to $18 a share, then Company B’s shares will be worth only $36. To hedge out this risk of Company A’s stock price declining, the arbitrageur can short 2 shares of Company A for each share of Company B that the arbitrageur owns. This locks in the spread because if Company A’s stock price declines, the investor pockets the difference between the market price and the price he shorted Company A at.
Harvesting the spread in a stock-for-stock transaction is different from a cash transaction where an investor simply purchases shares in the target. The arbitrageur must short shares of the acquiring company and go long shares of the target company in order to lock in the spread in a fixed ratio transaction. This is because the dollar value of the deal is unknown, but the number of shares exchanged upon deal consummation is certain.
The Holy Grail for Merger Arbitrageurs: Bidding Wars
Bidding wars are when two companies engage in a public battle to outbid the other for acquisition of the target company. Instead of small returns, bidding wars can result in massive upside, especially on an annualized basis. You can see an example of a bidding war between AT&T and Verizon on the target company Straight Path Communications’ stock price on the right.
Conclusion
So, what returns can an investor expect with merger arbitrage?
Investors employing a merger arbitrage strategy typically expect to earn 1%-2% spread over a similar duration fixed income security. If an investor were to place $100 in the IQ Merger Arbitrage Index in November 2009, that investment would be worth $138 in November 2019. If the $100 were placed in the S&P 500 Index at the same time, it would be worth $278. The IQ Merger Arbitrage Index had much lower volatility returns than the S&P 500 Index with a standard deviation of 11% compared to 52% for the S&P 500 Index during the same period. This risk-return profile makes the Merger Arbitrage Index more comparable to returns from fixed income. Investors can expect a 1-2% return on a given arbitrage situation. On an annualized basis though, the returns can be significantly greater. Remember that a 6% return earned in 6 months is equivalent to a 12% return a year. Given the relatively low risk of merger arbitrage, and assuming that the arbitrageur is selecting deals with a high probability of completion, the spreads can be expected to outperform similar duration fixed income securities. In addition, merger arbitrage is low beta with respect to traditional asset classes, and the majority of the total risk is attributed to idiosyncratic event risk. This provides a market neutral strategy that can generate Georgetown Collegiate Investors low volatility returns while diversifying and supplementing our existing portfolio holdings. Merger arbitrage is one investment strategy, among the universe of alternative strategies, that trained investors should have in their tool belt.
Continue the conversation with Abel at abel.amdetsyon@gmail.com or reach out on LinkedIn at www.linkedin.com/in/abelamdetsyon