Benefiting from Merger Arbitrage

Benefiting from Merger
Arbitrage
Alternatives
Dr Tim Wooge
Senior Product
Developer –
Liquid Alternatives
Allianz Global Investors
This does not include
strategies that invest in
companies based on
M&A speculation or
rumoured deals. It also
does not include hedge
funds in this space,
which usually employ a
fundamental approach
and invest in much
more concentrated
portfolios of targets.
1
Risk diversification with conventional assets has become increasingly
difficult in light of a low yield environment and relatively expensive
equity markets (as highlighted in our recent publication on “Volatility
as an Asset Class”). As investors try to identify alternative sources
of return, they are increasingly looking towards unconventional
but liquid risk premia, such as the volatility risk premium. The M&A
(Mergers & Acquisitions) arbitrage spread also represents one such
alternative risk premium that is sufficiently liquid and can provide
attractive returns and diversification effects for investors.
A typical acquisition deal involves the acquirer
offering a premium acquisition price for the target
company in order to win approval from the target
company’s shareholders and board. When an M&A
transaction is announced the target company’s stock
typically trades at a discount to the price offered by
the acquiring companies. The difference between
the target’s share price and the offer price is known
as the M&A arbitrage spread (“arbitrage spread”).
Typically, as the M&A transaction progresses
towards a successful close, the target’s share price
and the offer price converge and the arbitrage
spread shrinks. If, however, the transaction fails the
arbitrage spread rises quickly and the target’s share
price usually drops to a pre-announcement level.
The arbitrage spread is therefore an indicator of the
market’s expectation of deal failure.
Accessing the merger arbitrage
risk premium
Merger arbitrage (also known as risk arbitrage)
refers to an investment strategy that aims to
systematically extract this arbitrage spread from
the markets by investing in a diversified portfolio of
takeover targets shortly after the announcement
of the M&A deal1. The strategy compensates the
merger arbitrageur for bearing the risk of deal failure
which other investors in the target firms might
not be willing to accept. The supply and demand
imbalance between deal risk “insurance” providers
and takers results in structural market inefficiencies2
that can be exploited by merger arbitrage strategy
investors.
Focus: Benefiting from Merger Arbitrage
Figure 1: Acquisition of Algeta ASA by
Bayer AG in 2014
Share Price in NOK
370
26.11.2013
Figure 2: Failed Acquisition of RSA Insurance
Group PLC by Zurich Insurance Group
600
28.07.2015
18.09.2015
See Shleifer and
Vishny (1997), Baker
and Savasoglu (2002).
2
The average bid
premium has declined
from 45 % (1996 – 2001)
to 36 % in the period
between 2002 – 2007
(Jetley and Ji).
Dieudonné, Cretin, and
Bouacha have also
found significant
regional differences:
the average bid
premium in North
America in their
1998 – 2012 sample is
29 % and 20 % in
Europe.
3
500
400
300
200
100
22-Sep
15-Sep
8-Sep
1-Sep
25-Aug
18-Aug
11-Aug
4-Aug
28-Jul
0
21-Jul
When the EUR 2.4bn acquisition of the Norwegian
pharmaceutical Algeta ASA by Bayer AG was
proposed on 26 November, 2013, the target’s share
price jumped 30 %, but it remained below the offer
price (see Figure 1) until the completion of the
transaction. A merger arbitrage investor could have
taken a long position in the target on 26 November
(at NOK 345.2) and would have received cash (at
NOK 362) in exchange for the shares at the close
of the transaction in March 2014, resulting in an
arbitrage spread of 4.8 % (over 3 months).
Figure 2, on the other hand, shows the downside
potential of a single transaction and reveals that the
main risk associated with merger arbitrage strategies
is deal failure. On 28 July, 2015, it was announced
that Zurich Insurance Group agreed to acquire
RSA Insurance, but the deal was abandoned in
September 2015 due to Zurich’s financial difficulties
at its general insurance unit. RSA’s share price
immediately dropped 20 %, causing the arbitrage
spread to widen and resulting in a loss on position.
Share Price in GBP
The upside for the investor in merger arbitrage
strategies equals the arbitrage spread of the portfolio
of takeover targets. However, if one deal fails or
a transaction is withdrawn, the downside for this
single position can be significant. In most cases the
target’s share price will fall back to the levels prior
to the announcement of the transaction and the
shares begin to trade again based on fundamentals
rather than the expectation of a deal. Considering
that historically the average premium has been
approximately 30 %, this can be a significant
drawdown3. However, constructing diversified
portfolios of a number of different takeover targets
can considerably reduce the likelihood of deal failure
as well as the impact of one failed transaction on
the profitability of merger arbitrage strategies. The
following M&A transaction examples illustrate the
dynamics of the arbitrage spread.
Arbitrage-Spread
Share Price RSA Insurance Group PLC
Price at announcement
Deal Offer
Proposal Date
Sources: Bloomberg, Allianz Global Investors. This is for illustrative
purpose only and no recommendation or solicitation to buy or sell
any particular security. Past performance is not a reliable indicator of
future results.
07.03.2014
350
330
310
290
270
3-Mar
17-Feb
3-Feb
20-Jan
6-Jan
23-Dec
9-Dec
25-Nov
11-Nov
250
Arbitrage-Spread
Share Price Algeta ASA
Price at announcement
Deal Offer
Proposal Date
Sources: Bloomberg, Allianz Global Investors. This is for illustrative
purpose only and no recommendation or solicitation to buy or sell
any particular security. Past performance is not a reliable indicator of
future results.
2
Focus: Benefiting from Merger Arbitrage
The risk in merger arbitrage –
risk of deal failure
As seen in the example above, deal failure can
have a significant impact on the profitability of the
respective position in the merger arbitrage portfolio.
Failure to close a transaction usually does not have
much to do with the broader market environment,
but rather with very specific risks instead.
Accordingly, each transaction is independent
from the other and the risk of large drawdowns
for a merger arbitrage strategy can be reduced by
diversifying the investment over a large set of M&A
transactions. The reasons why M&A transactions fail
can be grouped into the following categories:
• Shareholder resistance: target or acquirer
shareholders, board of directors or the
management team might reject the acquisitions
(e.g. hostile vs. friendly takeover).
• Regulatory / legal opposition: competition
authorities / industry bodies or governments can
reject the acquisition.
• Change in market conditions and/or financing:
the buyer can no longer finance the transaction
due to a tightening of the borrowing conditions.
• Major events: poor quarterly results, regulatory
changes, or due diligence reveal problems at
the target company which have an impact on
valuations.
Historically, the deal failure rate has fluctuated
between 2 % and 13 %, with a plateau of over 20 %
for several months in the US and Canada during the
financial crisis in 2008 – 2009. The average failure
rate in Europe is 8.3 % based on data from 19982013. Specifically, some deal parameters have been
identified that have an impact on the failure rate.4
They are as follows:
See Cretin, Bouacha,
and Dieudonné (2010)
and (2013).
4
• Hostile takeovers are far more likely to fail (30 %
vs. 5.9 % failure rate)
• Private equity deals are more likely to fail than
strategic deals (15.3 % vs. 6.1 % failure rate)
• Deals with an initial arbitrage spread between
5 % and 10 % have the lowest failure rate (3.4 % vs
10.6 % of deals with a spread between 15 % and
20 %)
• Deals with small acquirers (in relation to the
targets) have higher probabilities of failure(17 %
failure rate where acquirers are smaller than
targets vs 4.2 % where acquirers are five times the
size of the target)
Actively considering these parameters during the
deal selection process and carefully constructing
diversified portfolios can considerably reduce the
likelihood of deal failure and reduce the drawdown
potential of merger arbitrage strategies.
Merger arbitrage strategies provide
diversification potential
As merger arbitrage strategies are primarily
dependent on deal risk, they show low to moderate
correlation with broader equity markets. Compared
to other asset classes, they display attractive
diversification potential that investors can explore
(see Figure 3).
Figure 3: Correlation analysis of monthly returns shows diversification potential of merger arbitrage strategies
S&P Merger Arbitrage Index from 31/01/2006 – 31/08/2015
S&P Merger Arbitrage
S&P Merger Arbitrage
MSCI World
JPM GBI Global
VPT*
Commodities
1.00
0.47
–0.11
0.50
0.32
1.00
–0.28
0.64
0.49
1.00
–0.24
–0.28
1.00
0.42
MSCI World
JPM GBI Global
VPT
Commodities
Correlation
1.00
< 0.2
+0.2 to +0.65
> +0.65
Sources: Bloomberg, Allianz Global Investors. Calculation based on monthly total returns from Bloomberg. The VPT Index represents the Variance Premium Trading IndexTM
developed by risklab GmbH. risklab GmbH is a subsidiary of Allianz Global Investors. Past performance is not a reliable indicator of future results.
3
Focus: Benefiting from Merger Arbitrage
1,800
2,500
1,600
2,000
1,400
1,500
1,200
1,000
1,000
Deal volume
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
600
2001
0
2000
800
1999
500
Number of deals
3,000
1998
Annual M&A activity in USD bn
Figure 4: Breakdown of M&A transactions per annum
No. of deals
Sources: Bloomberg, Allianz Global Investors. Included are transactions where the target is a public company, the value of the transactions is
known and where the acquirer holds less than 50 % of the target’s shares before the transaction and seeks more than 50 % with the transaction.
In market downturns, the correlation between
merger arbitrage strategies and broader markets
can increase, which is mainly caused by index
ETF providers or risk-averse investors who will sell
index constituents indiscriminately, even if they are
subject to a takeover bid. As the macroeconomic
environment for M&A transactions might become
less favourable during market downturns, the risk
of deal failure may increase as well. Furthermore,
transactions that involve a stock-for-stock or
other hybrid forms of payment can increase the
correlation with the markets and cause higher levels
of volatility because of their sensitivity to the target
and acquirer share price.5
Large opportunity set available in
M&A market
The current M&A market environment is very
buoyant and provides merger strategies with a
large pool of investable transactions from which the
arbitrage spread can be extracted. Because of an
upturn in strategic activity (i.e. non-private equity)
due to strong corporate balance sheets and high
CEO confidence, the M&A market may be moving
back towards the peaks of 2007 (see Figure 4). This
trend is expected because companies still have large
amounts of cash available to fund corporate activity.
Moreover, inorganic growth via acquisitions is an
excellent way of improving earnings.
Understand. Act.
• In light of a low-yield environment and relatively
expensive equity markets, risk diversification with
conventional assets has become increasingly
difficult. Investors are therefore increasingly
looking towards unconventional but liquid risk
premiums, such as the M&A arbitrage spread,
which can provide both attractive returns and
diversification potential.
• Merger arbitrage refers to an investment strategy
that aims to systematically extract the arbitrage
spread from markets – i.e. the difference between
the target’s share price and the offer price – by
investing in diversified portfolio of takeover
targets shortly after the announcement of the
M&A deal.
• The upside for the investor in merger arbitrage
strategies equals the arbitrage spread of the
portfolio of takeover targets. However, if one deal
fails or a transaction is withdrawn, the downside
for this single position can be significant.
Constructing diversified portfolios of a number
of different takeover targets can considerably
reduce the likelihood of deal failure as well as
the impact of one failed transaction on the
profitability of merger arbitrage strategies, though.
As merger arbitrage strategies are primarily
dependent on deal risk they show little correlation
with broader equity markets. Compared to other
asset classes they display attractive diversification
potential that investors can explore.
• The current M&A market environment is very
buoyant and provides merger strategies with a
large pool of investable transactions from which
the arbitrage spread can be extracted.
To extract the
arbitrage spread in
stock-for-stock
transactions, long
positions in the target
and short position in
the acquirer have to be
set up. Glans and Vo
(2013) find that both
value- and equalweighted portfolios of
stock-for-stock
transactions
experience significantly
higher levels of
volatility than portfolios
of cash transactions.
5
4
Focus: Benefiting from Merger Arbitrage
Literature:
1) M
. Baker and S. Savasoglu (2002). Limited
arbitrage in mergers and acquisitions. Journal of
Financial Economics.
2) M
. Mitchell and T. Pulvino (2001). Characteristics
of Risk and Return in Risk Arbitrage. Journal of
Finance, vol. 56, no. 6 (December): 2135 – 2175.
3) A. Shleifer and R. Vishny (1997). The Limits
of Arbitrage. Journal of Finance, vol. 52, no. 1
(March): 35 – 55.
Imprint
Allianz Global Investors GmbH
Bockenheimer Landstr. 42 – 44
60323 Frankfurt am Main
Global Capital Markets & Thematic Research
Hans-Jörg Naumer (hjn), Ann-Katrin Petersen (akp),
Stefan Scheurer (st)
Allianz Global Investors
www.twitter.com/AllianzGI_VIEW
Data origin – if not otherwise noted:
Thomson Financial Datastream.
Calendar date of data – if not otherwise noted:
October 2014
4) G. Jetley and X. Ji (2010). The Shrinking Merger
Arbitrage Spread: Reasons and Implications.
Financial Analysts Journal (66 / 2). Pages 54 – 68.
5) F. Cretin, S. Bouacha, S. Dieudonné: Risk Arbitrage,
a probabilistic approach over 1998 – 2010 in the
US and Canada. SSRN. October 2010
6) F. Cretin, S. Bouacha, S. Dieudonné: MAGMA
Europe, a tool to analyse the European M&A
market. SSRN. October 2013
7) C. Glans and P. Vo (2013). Merger Arbitrage
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5
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