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An Event-Driven Strategy: Merger Arbitrage

Event-driven strategy seeks to invest in opportunities associated with corporate transactions such as consolidations, acquisitions, recapitalizations, bankruptcies, and liquidations. Merger arbitrage event-driven managers employ strategies that can capitalize on valuation inconsistencies in the market before or after mergers and acquisitions deals, and take positions based on the predicted movement of the underlying securities. Mergers can be cash deals, in which the acquirer proposes to purchase the shares of the target for a certain price in cash, and they can also be stock deals, where the acquirer exchanges its own shares for those of the target company based on a specified ratio.

The popularity of merger arbitrage as an investment strategy has grown over the years. As of August 2013, the total size was $211.2 billion through 51 deals closed in 2013, with 48 deals settled in cash, 17 deals done through stock offer, and 4 via a mix of stock and cash offers. Beyond that, a number of studies have demonstrated that merger arbitrage hedge funds have generally been able to realize positive alphas:

  • In the Generalized Style Analysis of Hedge Funds, Vikas Agarwal and N.Y. Naik found that even-driven arbitrage funds were able to generate positive alphas of about 1 percent a month.
  • In The Performance of Hedge Funds: Risk, Return, and Incentives, Ackermann, McEnally, and Ravenscraft concluded that merger arbitrage generates risk-return profiles that are superior to those of other hedge fund strategies
  • In the Merger Arbitrage Hedge Funds, Stanley B. Block argued that merger arbitrage hedge funds are able to earn strong returns in various types of market environment.

“If you want something done right, do it yourself.” — Napoleon Bonaparte

Merger arbitrage managers believe in their superior capabilities in capturing the “deal spread” between the current market price of the target firm and the amount the acquirer is expected to pay at the end. The approach that a merger arbitrage manager takes largely depends on the time of the trade and whether the offer is a cash offer or stock offer. Some managers attempt to short the shares of the target company if they expect the deal to break, and some managers will exploit situations that involve acquisitions of bankrupt companies. Typically these trades may involve purchasing the bonds of the target firm and exchanging them for cash or shares of the acquirer firm.

Similarly, the processes that merger arbitrage managers adopt vary but they typically follow four steps to establish and exit a transaction:

  1. Follow the announcement of a merger or acquisition. Thanks to the variety of media and phone apps, managers now have developed their own path in tracking these activities.
  2. Determine the probability of the merger or acquisition deal being consummated. According to a hedge fund investor survey, the factors that impact such probability are CEO confidence, sheer size, and activity level of the private equity industry.
  3. Consider the impact of legal issues on deal risk, analyze potential regulatory obstacles and anti-trust hurdles. It is becoming more and more common that a hedge fund firm hires a team of compliance and law professionals specific to assist in this function.
  4. Establish positions in the target and the acquirer firms. If the deal is through stock transaction, managers need to manage the spreads.

Portfolio managers concern about investment opportunities and the risks associated those opportunities. In merger arbitrage, the major risk element is specific to that event, which arises from that the stock price of the target firm will not increase to the level of the offered price because there is always a chance the merger or acquisition deal will not go through or will not be closed at the planned timing.

Merger Arbitrage Manager Due Diligence

  • For investors, it is essential to understand the merger arbitrage manager’s main strategy, whether it focus more on announced deals, or more on potential deals. Since the two strategies differ in the respective timing to be captured, taking positions in announced deals is less risky, but it would most likely generate lower returns; on the other hand, taking positions based on potential merger or acquisition deals involves a lot more risks but the strategy provides more upside potential.
  • Investors should make sure to figure out how diversified is merger arbitrage fund is. A diversified portfolio would downside protection if one merger deal did not go through, but it is important to note that the level of portfolio diversification should always be in line of the merger arbitrage manager’ capacity, as if he or she holds a deal that was not complete resulted from less-than-expected research efforts, such a diversified portfolio would lead to losses.
  • Merger and acquisition market is cyclical; merger and acquisition activities do not occur on a regular basis. Therefore, investors should have an idea with regard to what would manager invest or how would he or she react when the total number of potential deals decrease and hence the investment returns?

References:

  1. Risk Arbitrage and the Prediction of Successful Corporate Takeovers by Keith C. Brown and Michael V Raymond
  2. The Shrinking Merger Arbitrage Spread: Reasons and Implications by Gaurav Jetley and Xinyu Ji 2010
  3. Merger Arbitrage Hedge Funds by Stanley B. Block 2006
  4. Generalized Style Analysis of Hedge Funds by Vikas Agarwal and N.Y. Naik 2000
  5. The Performance of Hedge Funds: Risk, Return, and Incentives by Ackermann, McEnally, and Ravenscraft 1999
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