Making Sense of Merger-Arbitrage Funds
A primer on one of the oldest alternative strategies.
Merger-arbitrage funds are navigating rough waters these days as M&A activity has slowed down and regulatory scrutiny has increased. These funds have shown some variation in their performance based on their level of diversification, concentration in specific deals, portfolio exposure to other event-driven opportunities, and cash holdings. Good funds stick with their core competency: Invest in the safer merger deals with reasonable return potential and low probability of a deal break. Investors who choose the more reliable funds may find that merger arbitrage still makes sense as a strategy to include in their portfolios.
Merger arbitrage is one of the oldest hedge fund strategies, often described as a subset of event-driven investing. The primary differentiator for event-driven strategies is the existence of a specific catalyst, an “event” to unlock value for the investor. This is distinctly different from investing on the basis of valuations, statistical relationships, and/or factor-based analysis. Merger arbitrage is also unique in that it has less reliance on an incremental investor to pay a higher price for a security because of favorable demand/supply characteristics.
This strategy is one of the simplest to execute. After a merger deal is announced, the arbitrager buys the stock of the company to be acquired and pockets the spread between the market price of the target company following the announcement and the deal price upon closing. This spread exists because the target company’s stock does not immediately appreciate to the deal price because of uncertainties associated with regulatory approvals, antitrust matters, and other complexities. Say, for example, Company A makes an announcement to acquire Company B at a 40% premium to its current market price, say $100. Company B’s stock price might go up to only $137 immediately after the announcement, but not $140. This $3 spread corresponds to a 2.2% return for the investor ($3/$137 -1). If the deal closes in three months, the investor earns approximately 8.8% annualized. Depending on the type of the deal, merger arbitragers may or may not sell the acquirer’s stock short. For instance, in an all-cash deal, they do not need to short the acquirer’s stock, but they might short a relevant sector exchange-traded fund as a hedge in the event of a sectorwide sell-off leading to a deal break. For stock-for-stock acquisitions, the acquirer’s stock is shorted at a ratio consistent with the initially announced deal terms to lock in the spread at the close.
How Does It Benefit Your Portfolio?
The strategy produces a bondlike risk/return profile. The upside is limited, akin to a bond’s coupon, but the downside loss potential is significantly larger if the deal breaks (analogous to a default event in a bond investment where the investor loses a large portion of the principal less the recovery amount, though the risks are, of course, quite different). In the previous example, the investor’s upside is 8.8% annualized return, but his/her downside is as large as 40%, all else being equal. This means prudent risk controls and diversification need to be in place to limit the downside. This strategy also provides strong diversification benefits in a portfolio of traditional investments like stocks and bonds. Even though, on a mark-to-market basis, deal spreads exhibit some correlation to the broad equity markets, as long as no deal break occurs, equity correlations aren’t a primary driver of returns, as ultimately the completion of the deal determines the payoff. The relatively low beta (0.1 to 0.2) of merger-arbitrage funds to equities reaffirms their diversification value.
From a purely quantitative perspective, an allocator should note that the return distribution of a merger-arbitrage strategy may not look normally distributed for the reasons that were mentioned above. An asymmetric upside and downside risk/return profile presents leptokurtic qualities associated with fat tails. In very simple terms, this means that the investors may observe a large number of small monthly returns coupled with a small number of disproportionately larger down months. Therefore, mean-variance-based optimization models with blind normal distribution assumptions should be taken with a grain of salt when making allocation decisions regarding the size of an investment.
What Is Going On in the World of Mergers and Acquisitions?
The global merger and acquisition market has experienced two opposing forces in the past 18 months. While 2015 was a record year for worldwide M&A activity, surpassing $4 trillion, 2016 has shaped up to be a record year for “broken deals,” as the U.S. Treasury and Justice departments intensified their scrutiny of mergers and acquisitions. For example, the collapse of the $160 billion deal between Pfizer (PFE) and Allergan (AGN) cost funds dearly after the Treasury Department announced new rules regarding the treatment of tax-inversion deals, in which a company switches its structure to become the subsidiary of a foreign entity to lower its tax rate. The surprise factor in the announcement was the inclusion of a three-year look-back provision that enmeshed the Pfizer/Allergan tax-motivated deal (and other inversion-related deals). Another deal gone awry was the $28 billion merger of U.S. oilfield-services providers Halliburton (HAL) and Baker Hughes (BHI), which was terminated after regulators in Europe and the United States opposed it on the basis of antitrust laws. And national security concerns blocked a deal between Royal Philips NV (PHG) and Chinese consortium GO Scale Capital.
As these deals fell apart, they affected the M&A market in several ways. First, they caused deal spreads to widen, creating a more robust market for merger arbitragers. Wider spreads allow merger-arbitrage funds to construct trades with higher internal rates of return. Second, they led to slower deal flow globally. In the U.S., for instance, deal volume in the first half of 2016 was down 20%, totaling $700 billion across 5,300 deals, according to Thompson/Reuters. Merger-arbitrage operators generally look to have 30 to 90 deals in their portfolios, emphasizing circumstances in which the deal-break probability is extremely low. Out of the 5,300 reported deals, only 200 to 300 of them make it to the universe of “investable” deals because that overall number includes private deals as well as very small deals.
According to Morgan Stanley and CapIQ, S&P 500 companies still hold $1.9 trillion of cash on their balance sheets, about 12% of total revenues. Cash-rich balance sheets will probably motivate companies to seek strategically driven acquisition opportunities. However, a higher level of government scrutiny in the long run, and the upcoming U.S. general elections in the short run, could be potential impediments to deal activity for the remainder of the year.
Merger-Arbitrage Options in Liquid Alternatives
Merger Fund (MERFX), which has a Morningstar Analyst Rating of Silver, and Arbitrage Fund (ARBNX), which has a Bronze rating, are the largest merger-arbitrage players in the liquid alternatives space. These funds’ long-term risk/return profiles resemble short- to medium-term bond funds, with 10-year annualized returns of 2.56% and 3.07%, respectively. Both funds’ return engines rely primarily on merger spreads with some event-driven positions such as spin-offs, split-offs, closed-end fund arbitrage, and other corporate reorganizations. In terms of year-to-date performance, a smaller Bronze-rated competitor, Touchstone Merger Arbitrage (TMGLX), has outperformed both aforementioned funds with a 2.40% return. This fund’s significantly smaller size ($200 million) has been an advantage because its manager was able to avoid some of the broken mega-deals like Pfizer/Allergen. All of these funds have highly experienced teams, long track records, and well-diversified portfolios. Liquid alternative funds in this space generally lag their hedge fund counterparts because they do not use as much leverage and tend to run more-conservative portfolios, generally avoiding hostile takeovers, leveraged buyouts, and rumored deals.
In the very long run, particularly prior to the Fed’s quantitative easing, studies have shown that merger spreads traded at approximately 3 times the risk-free rate (and managers conventionally believed so). This relationship has weakened, however, as short rates have come down to near-zero levels. Safer merger deals today trade around the 3% to 4% levels, as opposed to the 10%-15% range when the risk-free rate (the three-month U.S. Treasury bill, for example) was close to 5%. So, empirical evidence suggests that merger spreads may provide better opportunities with higher interest rates, offering a beneficial diversifying opportunity in that scenario. This strategy still faces longer-term structural challenges driven by compressed risk premiums in the wake of extremely low interest rates, but investors who have conservative expectations in the long run might consider investing in merger-arbitrage funds as a diversifying component in their traditional portfolios.
Tayfun Icten does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.