In this article, we explore the growing investor appetite for merger arbitrage in the context of rising M&A activity. We also discuss how managers have been adapting to the structural decrease in deal spreads and have maintained alpha generation intact.

• Firing on all cylinders. M&A activity is up strongly year-to-date, especially in the US. In Europe, the cycle is now taking off, with large deals announced end-April in the telecoms, media and technology (TMT), pharma and materials areas.
• These levels of activity have provided numerous opportunities for alternative managers at a time when investor appetite for merger arbitrage keeps growing. Additionally, performance has been in line with expectations. Event-driven has posted average returns close to 3% year-to-date and has been the best performing strategy in Q1 2014 according to HFR.
• An important factor affecting the way M&A is played by risk arbitrageurs has been the significant spread compression over recent years. Plain vanilla deals currently offer annualised returns in the 3%-4% range. As a result, risk arbitrageurs have had to climb up the scale of complexity to deliver returns. They have focused their investment universe on deal structures where returns can be much higher, i.e., in the 5%-10% range. This includes topping bids, hostile deals and transactions taking place in multiple jurisdictions or exposed to anti-trust risk.
• After having posted double-digit returns in 2013, event-driven funds are leading the pack in 2014 thanks to their skills in picking the right deals and sizing positions adequately. Rising opportunities related to skyrocketing M&A activity are consequently likely to confirm merger arbitrage’s position as one of the strategies with the best outlook for the rest of 2014.

Firing on all cylinders: M&A is booming
M&A has recently received a significant boost, especially in the US, where volumes in Q1 2014 returned to pre-financial crisis levels. As shown by Fig.1, volumes in the US now represent more than 45% of global M&A activity. However, activity has also started to take off in Europe recently, with large deals announced end-April in the telecoms, media and technology (TMT), pharma and materials areas.

M&A activity in the US has been concentrated in a few sectors such as communications and consumer non-cyclicals. These two sectors represented 53% of volumes in Q1-14 (see Fig.2). Notable deals included the $68 billion offer for Time Warner by Comcast and the $21 billion acquisition of Forest Laboratories by Actavis. After adding energy and financials, these four sectors represented 80% of US M&A activity in Q1.

Several factors help explain this M&A frenzy: i) CEO confidence is rising as recovery prospects improve and concerns over a eurozone break-up fade; ii) margin pressure is high; and iii) companies are cash-rich and financing is available. Additionally, stock market trends have been highly bullish and interest rates remain low but are expected to rise over the medium term. This latter factor is adding pressure to bring forward M&A deals in sectors such as telecoms. Some sectors also present attractive valuations for strategic acquirers (gold mining for example).

Investor appetite for merger arbitrage keeps growing
There is increasing evidence of very strong investor appetite for event-driven investing, as shown by Fig.3 based on a survey by Credit Suisse.

This investor interest is also corroborated by the flows we are seeing across strategies. Event-driven is by far the strategy that has received the largest inflows on the Lyxor platform over the last six months, with assets under management rising by 16%.

Performance has been in line with expectations
Merger arbitrage funds have delivered consistent returns over the last five years. In 2013, they posted double-digit returns while showing very low volatility. In 2014, they are leading the pack thanks to their skills in picking the right deals and sizing positions adequately.

Rising opportunities related to skyrocketing M&A activity are therefore likely to confirm merger arbitrage’s position as one of the strategies with the best outlook for the rest of 2014.

Plain vanilla deals offer little upside
An important feature of the last decade has been the spread compression in the merger arbitrage space. This decline is estimated to be in excess of 500 bps over the last decade and took place in the context of falling interest rates globally. Jetley and Ji suggest the three following factors also played key roles in explaining this trend:[1]

• Strong inflows into merger arbitrage and special situations led to increased trading and lower spreads. According to HFR,[2] net inflows into merger arbitrage hedge funds equalled $4.2 billion between 1990 and 2013. Net inflows into special situation funds over the same period were much higher at $148 billion (see Fig.4a and Fig.4b). It is important to note that special situation and multi-strategy funds also invest in M&A deals.
• Lower bid premiums and the decreased popularity of hostile deals have all contributed to spread compression.
• Transaction costs have fallen over recent decades. While this is a structural feature of financial markets,3 the implication for risk arbitrageurs is that the cost of maintaining a position has fallen. At the same time, managers have also increasingly played large cap companies, which are more liquid. The fall in transaction costs implies that deals that were not economically viable in the past have become profitable and have attracted inflows.

Up the scale of complexity to fuel returns
Confronted with shrinking spreads, merger arbitrage players have had to climb up the scale of complexity to deliver higher returns.

They have focused their investment universe on deal structures where returns can be much higher, i.e., in the 5-10% range. This includes topping bids, hostile deals and transactions taking place in multiple jurisdictions or exposed to anti-trust risk.

For example, the $22 billion acquisition of Omnicom by Publicis (transaction value as of 22 April) is a stock deal delivering a spread above 5%. The terms of the transaction involve the exchange of one share of Omnicom for 0.81 shares of Publicis. A classic arbitrageur will sell 0.81 shares of Publicis (the acquirer) for each Omnicom share acquired (the target) in order to lock in the spread. This so-called merger of equals will be the largest ever deal in the advertising industry. It was announced in July 2013 and is expected to be completed by August 2014. Completion has taken more time than expected due to the slowness in obtaining regulatory approvals in China and tax issues in Europe. The key risk for investors is a deal break and this risk is asymmetric, i.e., losses in the break scenario are bigger than the gains in the completion scenario.

Most merger arbitrageurs use options either to hedge risks, enhance returns or take advantage of views of the timing of certain events over a deal’s life. Managers can sell out-of-the-money puts if they believe a target price cannot drop below a certain level or buy in-the-money calls while waiting for a topping bid. Options are also useful in pre-merger plays to express views on anticipated targets. At present, managers lose a large portion of the premium if they wait until an announcement is made. However, playing anticipated deals involves the risk of buying shares of a company for which no offer is made. Options provide leeway in managing this risk.

Bonds can also be favoured over equities to play deals, even if this is less common. Few managers currently have the expertise (or the mandate) to apply their analysis across the entire capital structure. However, the lower liquidity of bonds versus equities can result in higher arbitrage opportunities and at the same time there is potentially a smaller amount of capital to be deployed with bonds.

Faced with shrinking spreads, risk arbitrageurs have played complex deals to boost returns
Due to the low yields offered by plain vanilla transactions, merger arbitrage managers on the Lyxor platform are focusing instead on other areas where returns can be much higher. In particular, they are emphasising investments in complex deal structures (Vodafone), competitive bids (Sprint/Softbank/Dish), hostile takeovers (Osisko/Goldcorp), accretive acquirers (Thermo Fisher, Actavis) and pre-announced deals (Life Technology/Thermo Fisher).

In terms of sectors, communications and healthcare are leading the pack among industries offering consolidation opportunities (see Fig.5). In effect, as wireless growth slows and capital requirements rise, smaller telecom companies will have to consolidate in order to compete. The trend has already begun in the US with the merger between the number three (T-Mobile) and number four (MetroPCS) wireless players, the takeover of Sprint by Softbank and ongoing speculation concerning an acquisition of T-Mobile by Dish or Softbank. The pharma sector is also buoyant, with most drug companies looking for growth through purchases of companies with solid pipelines in order to deal with expiring patents and relentless downward pricing pressure.

BOX 1
Thermo Fisher’s $15 billion acquisition of Life Technologies: a plain vanilla “cash offer”

Merger arbitrage managers usually wait until a bid is announced before examining the opportunity to invest in it. Typically, a company (the “acquirer”) issues a public statement indicating that it intends to buy the shares of another company (the “target”) for cash (referred to as “cash offer”) or in exchange for the shares of the acquirer (“stock” offer) or for a mix of cash and stock consideration.

In the case of cash deals, the price at which the acquirer offers to buy the target is a fixed amount representing a premium to the share price of the target before the announcement. We examine below the $15 billion acquisition of Life Technologies by Thermo Fisher as an illustration of a plain vanilla cash deal. The deal, which created the world’s largest scientific test equipment business, was announced in mid-April 2013 and completed in February 2014.

The premium represents the amount of money the acquirer believes it should pay to convince the shareholders of the target company to tender their shares in exchange for cash. As shown by the chart below, the offer of $76 per share in cash represented an $8 premium (12%) over the closing price of Life Technologies the day before the announcement (76/68 – 1). However, Life Technologies had announced that it was exploring strategic options three months before the Thermo Fisher bid. As such, the offer of $76 per share represented a 38% premium to the share price of the target before it announced it was exploring such options.

The spread is the difference between the offer price and the current price at any time after the deal is announced. In our example, the stock price rose to $73 just a few minutes after the deal was announced. The spread was therefore $3 or 4% (76/73 – 1). The spread represent the current potential return if a trader were to buy the shares of the target and wait until completion. After completion, the shares of Life Technologies were delisted and cancelled by Thermo Fisher.

BOX 2
Comcast $68.4 billion acquisition of Time Warner Cable: an all-stock offer

The proposed Comcast/Time Warner all-stock merger is a good example of a complex deal given that it involves signifcant anti-trust issues. Comcast is already America’s largest cable operator with around 22 million subscribers. It is also one of America’s most powerful media firms. At the same time, a stock deal remains more complex than others, as arbitrageurs have to consider many more variables such as the cost of shorting the acquirer, the liquidity and dividend yield of both stocks and stockholder decisions relating to the transaction.

The deal, which would be the third largest deal in the media and entertainment sector in history, is currently being scrutinised by the Federal Communications Commission. The deal involves significant approval risks because it would combine the largest and second-largest US cable companies. The new company would control about a third of the US pay-TV and broadband markets.

Since the deal’s announcement on 13 February, Time Warner Cable and Comcast’s stock prices have both fallen. The fall in the stock of the acquirer (Comcast here) is normal in stock deals because investors short the acquirer’s stock in order to lock in the spread. The fact that the stock price of the target has also fallen is more unusual and refects the recent negative momentum in the US consumer discretionary sector and concerns regarding the potential block from anti-trust laws. However, on 9 April, members of the US Senate Judiciary Committee did not raise any legal arguments under the anti-trust laws to reject the deal. Time Warner has rallied since then.

The ABCs of merger arbitrage

BLACK KNIGHT: An influential investor who seeks profitable companies to dismantle in order to enrich himself. In the M&A area, an investor is qualified as black knight when he wants to acquire a firm against the will of its management, as in a hostile takeover.

BIDDING WAR: A situation where more than one buyer is interested in acquiring a company. As a result, buyers successively propose higher offers.

HOSTILE TAKEOVER: Offer that was not approved by the target company’s management before its announcement.

MERGER OF EQUALS: Merger of two firms to form a new company. Shareholders of both companies will receive the new entity’s stock.

PACMAN DEAL: A defensive option in which the target company attempts to acquire its potential buyer.

POISON PILL: A strategy used by corporations to discourage hostile takeovers. The target company attempts to make its stock less attractive to the acquirer by using a “flip-in” that allows existing shareholders to buy more shares at a discount or a “flip-over” that allows stockholders to buy the acquirer’s shares at a discounted price after the merger.

PUT UP OR SHUT UP: UK stock market rule forcing a bidder to reveal its intentions and announce a firm offer before a certain date. If it fails to do so, it is considered as uninterested and cannot propose an offer for a given period of time.

TENDER OFFER: A tender offer is a public open offer by an acquirer to a company’s shareholders to tender their stock for sale at a specified price during a specified time.

WHITE KNIGHT: A friendly investor that acquires a corporation at a fair consideration with the support from the corporation’s board of directors and management. This may be during a period when the corporation is facing a hostile bid from another potential acquirer or bankruptcy.

GO SHOP PERIOD: A period in which a company has the right to seek other competiting bids. The current offer is considered as a floor price. Accepting another offer during this period may oblige the target company to pay termination or break-up fees.

Notes

1. See for instance Jetley G. And X. Ji (2010), “The Shrinking Merger Arbitrage Spread: Reasons and Implications”, Financial Analysts Journal, Vol. 66 (2).
2. HFR, Global Hedge Fund Industry Report – Year End 2013.
3. See French K. (2008), “Presidential Address: The Cost of Active Investing”, Journal of Finance, vol. 63 (4):1537-1574.