Merger arbitrage is an investment strategy that often lurks in the shadows of the equity world, out of sight of many investors due to its arcane nature, peculiar details and sometimes pedestrian returns. Largely the domain of hedge funds and other alternative asset managers, merger arbitrage is a sophisticated strategy with a myriad of ways to be practiced and, we believe, very clear potential benefits for a long-term investor that can include the potential for higher equity returns and lower volatility in an environment where we expect merger activity to persist.
What is Merger Arbitrage?
In simple terms, merger arbitrage is the practice of investing in the securities of companies that are involved in acquisitions. Most typically, following an announced cash offer to buy a company, the stock of the acquired company is bought by the merger arbitrageur. In the case of a stock offer, the stock of the acquiring company is also sold short, adjusted for the exchange ratio. (See an example of such a trade at the end of this article.) The acquired company usually trades at a discount to the final bid price due to uncertainty over the deal closing and the time it will take for this to happen. Technical factors, such as disinterested investors selling their shares in the acquired company, could also potentially contribute to the discount. This discount is also referred to as the “spread” -- the difference between the current price and the bid price. This is the basis for calculating the expected return on the deal. The spread, as a percentage of the acquired company’s price and adjusted for dividends along with transaction costs, is annualized by the time the deal is expected to close to produce an expected annualized return. A substantial amount of research goes into making the decision to invest in a deal from an arbitrage perspective, and the intensity in which the deal is scrutinized over its life is quite substantial. In our opinion, this is not an area for the inexperienced.
While the process described above is probably the most common way to implement this strategy, there are numerous ways to attempt to capitalize upon mergers. From betting on the likelihood of a merger (what we believe is the riskiest way to make money on a merger and not in fact arbitrage; simply put, this is speculation) to setting up a reverse spread (betting that a deal will fall apart) to leveraging deal returns with debt, many possible approaches exist that are designed to generate returns with acquisitions. The PIMCO Pathfinder Strategy approach prefers a conservative method for merger arbitrage, focusing on announced deals and not using financial leverage to enhance return potential. Usually, we seek out deals that have a level of complexity to them as these are typically the deals that can offer returns beyond the median “arb” trade that are equity-like (preferring opportunities that we believe offer the potential for >7% annualized return) but with a particular focus on risk management.
Why do we tend to be so conservative? Consider this: Merger arbitrage is also called risk arbitrage. While we target many of our long-term investments to offer a four-to-one upside-to-downside ratio (for example, a stock offering 40% potential upside with 10% potential downside in a bear case scenario), we have found merger arbitrage usually has a return profile that is the inverse of this.
Hypothetically speaking, if the deal closes, you could stand to make 10%. If the deal breaks, you could stand to lose 40%. Obviously, the damage that one bad deal causes can negate much of the good work you’ve done in other investments. There are a number of tactics used to help manage risk. We believe the best of these is solid fundamental research. Also, we’ve found that by focusing on announced deals with higher than average spreads -- between the 60th to 80th percentile of the return distribution -- and investing in developed markets that tend to have more predictable legal outcomes, our potential to generate equity-like returns with a lower correlation to the overall equity market and less volatility is substantially improved.
What are the Potential Benefits to Investors? Merger arbitrage has existed for decades. In fact, it was practiced by many pioneers in value investing, including Ben Graham and Max Heine. From a time in the first half of the 20th century when it was practiced only by a few investors to today where it tends to be more broadly practiced, the historical returns generated by this strategy have been steadily compressed over time, particularly over the last two decades. We attribute this to two primary factors. First, there has tended to be a positive correlation between interest rates and the returns earned from merger arbitrage. Second, as more capital has chased this strategy, returns also have been competed down. Over the last 20 years, it has been a tale of two eras for spreads. As seen in Figures 1 and 2, the spreads available from a median deal were significantly higher in the 1990s as opposed to the next decade.
Despite the compression in historical spreads and returns, the result of practicing merger arbitrage in the aggregate was the opportunity for relatively attractive returns with less risk than the equity market. Most importantly, historical returns tended to be consistent and positive in a variety of market environments. Figure 3 shows a series of annualized returns of the HFRI Merger Arbitrage Index, which tracks the performance of merger arbitrage hedge fund strategies; the index returned 9.4% per year on average with only two years of negative returns. Some of these returns may have been augmented with leverage, but the standard deviation from the series is only 7.1%, compared to over 19% for the broader equity market (as proxied by the MSCI World Index). Also, the correlation of this series with the equity market over this period was about 60%.
While this return series may be compelling to some, the somewhat muted average level of returns may not overly impress many investors. This tends to keep quite a few investors away from the strategy due to the perceived potential of capturing greater upside in the broader equity market. Things may not always be what they seem, though.
Take the last five calendar years and compare the returns of the MSCI World index, a measure of the equity market performance of the developed markets, to the unlevered HFRI Merger Arbitrage Index, a broad, unlevered composition of merger arbitrage returns A few things jump out when looking at the returns shown in Figure 4:
- Equities have provided a higher return in four of the five years
- Equity returns are multiples of merger arb returns in most years
These attributes can be misleading when taken in the context of a longer term horizon. Take a look at the same return series, but note the compound annual return (CAGR) over the entire five year period (bolded at the bottom of Figure 5).
These data suggest that investing in merger arbitrage for these five years would have provided almost double the return of the MSCI World index, despite the unlevered HFRI Merger Arbitrage Index providing far lower returns in four of the five years. The reason for this is that the unlevered HFRI Merger Arbitrage Index did not experience the substantial losses incurred by the MSCI World Index in 2008. According to Figure 5, a broad merger arbitrage strategy still lost money in 2008, but it lost far less than the index chosen to represent the overall equity market. While some investors might be regretting their exposure to merger arbitrage in certain years, a longer term view can help put the strategy into perspective.
So, when considering the potential merits of merger arbitrage, we would suggest that the optimal way to use this strategy in a broad equity portfolio is selectively: less merger arbitrage when outsized equity returns tend to be ample, but more merger arbitrage when the return environment appears more challenged. Investing a fixed allocation into merger arbitrage might have a role in a broader asset allocation approach, but our experience suggests that enhanced return potential can be achieved by varying the allocation to merger arbitrage within equities based on the current market environment.
Potential Advantages of Appropriate Concentration The dispersion of historical returns within merger arbitrage has been quite broad. And as mentioned, investing in a deal that breaks can negatively affect returns. Looking at 2010 as an example in Figure 6, you can see just how broadly returns were distributed by examining the points on the curve. Looking at every point on the curve, the worst outcome achieved was approximately -90%, while the best outcome was close to +70%.
Based on the return data from Bloomberg, 2010 appeared to be a relatively good year for mergers to close (91.3% of all announced deals actually closed). From this group of mergers tracked by Bloomberg, the average annualized return was 4.45% and the standard deviation was 3.85%. Bloomberg shows that terminated deals lost only 4.3% on average, likely due to the buoyant nature of the equity markets and the cyclical economic recovery that was underway.
But one of the potential problems with investing broadly across all deals is that you may end up owning many deals that you don’t want and that possibly carry substantial downside risk. An investor may be able to do better than a 4.45% average annualized return (using 2010 as an example) by being able to select the best deals available at the time: In other words, seeking to exclude the “losers” and pick the “winners.” How can this potentially be accomplished?
The PIMCO approach to merger arbitrage, as previously mentioned, is to focus on trying to avoid losses. In addition to an extensive due diligence process looking at the merits of the mergers themselves, we feel losses can be minimized by being selective with deals having an outsized bid premium (if a deal breaks, you generally have farther to fall if the premium is high), focusing on deals with a fundamental underpinning where we believe we have a clear research advantage over many pure arb investors, and zeroing in on deals with what we deem to be attractively priced but not offering supernormal expected returns. We believe “swinging for the fences” and pursuing the highest yields in merger arbitrage may expose you more to the deals with higher risks and those that are most likely to break, potentially leaving you with a substantial loss. Excluding deals with less than a 2% gross spread as well as negative spread deals – those deals trading above the stated bid price – may also be a good idea to the extent that on a standalone basis, you would expect to lose money on them. However, this strategy may also have a cost as a deal with a negative spread may portend a competing offer at an even higher price.
Figure 7 shows that only two deals lost money and an average annualized return of 11.7%. Blindly selecting deals or further concentrating within merger arbitrage would likely result in much higher risk with potentially little incremental return, but we think that an informed approach to concentration has some merits due to the inefficiency we believe to be inherent in this asset class.
Investment Conclusions
Merger arbitrage, while perhaps more prevalent as a strategy now than in the past, continues to be an area where we believe investors have the potential to capture equity-like returns with less risk than the overall equity market. This statement comes with our caution that investors desiring to capture these potential returns should have experience and appropriate competency due to the outsized downside that may occur from a poorly executed approach. And while more prevalent than it once was, we believe merger arbitrage is still complex enough (and tedious enough to some) that ample opportunities still exist for those willing to do the work.
Investing broadly in the strategy may have its own merits and specific risk factors, which can be an attractive trait. Stepping away from the broad approach to a security-specific one may give way to return profiles that can be more attractive, but this doesn’t happen without the addition of higher risk. A concentrated approach to investing in any asset class or strategy can result in substantial downside. For those using a more concentrated and non-index approach to merger arbitrage, a much larger investment of time and effort is required. In any event, we believe this strategy has the potential to be a powerful addition to an equity portfolio or to an overall collection of investments if used wisely.
Sample Deal Mechanics
Mid-Size Bank (B1)/Large Bank (B2)
Deal Terms: 1 B1 = 0.1257 B2 (fixed exchange ratio merger – Buy 1 B1 and Sell Short 0.1257 B2)
Pre Announcement (12/16/10): B1: $5.79 B2: $61.66
Post Announcement (12/17/10): B1: $6.85 B2: $57.26
The value of B2’s offer = B2 * Exchange Ratio ($57.26 * 0.1257) = $7.20
After announcement, B1 trades at a $0.35 discount ($7.20 – $6.85)
The discount is called “Spread”(S) and represents the arbitrage upside and potential profit
“Percent Spread” = $0.35 / B1 Price = $0.35/ $6.85 = 5.1% gross
10.5% IRR assuming 6 months to close (excluding dividends & borrow costs)
Downside (D) is defined as a reversion to pre-deal prices:
B1 would revert from $6.85 to $5.79: the arb investor would lose $1.06
B2 would revert from $57.26 to $61.11: the arb investor would lose $0.48 (being short 0.1257 shares)
Total Downside of $1.54 implies an 81% chance of the deal closing (D/(D+S))