Merger-Arbitrage

Background:

Merger or risk arbitrage funds have achieved impressive returns in recent years, sparking the interest of investors and their advisors in the process. During 2000, for example, when most stock indices moved in the wrong direction, many merger funds returned over 15%, with little volatility. Few investors are familiar with this part of the investment world. This is primarily because it has long been the preserve of large investment houses and professional investors. This report introduces the subject and sets out to provide answers to the following questions:

1. What exactly is merger arbitrage?
2. What are the key risk factors and qualities required for investment success?
3. What investment performances can we anticipate?

Merger Arbitrage:

When a company decides to merge with or acquire another, and makes public its offer, a merger or acquisition is set in motion. The reasons prompting such an action are numerous and typically include the desire to enter new markets; obtain new technologies, production facilities or brands; achieve economies of scale; and lately, to acquire scarce human resources. The terms of an offer can range from a stock swap, to cash, to a mixture of the two.

For example, in a stock for stock merger, assume company A offers shareholders of company B, 0.5 shares of A for one share of B. Further, assume that before the offer is made public, A trades at $42 and B at $14. It is what happens next that interests the arbitrageurs. Immediately following the announcement, the shares of B will move up and A could move down a little. The size of these moves depends on the answers to questions such as:

1. What is the likelihood of the acquisition closing?
2. Are there issues such as shareholder approval or antitrust legislation that could derail or delay the deal?
3. What is the likely time frame for deal closure?
4. Are competing bids possible?

If consensus is that the deal will not see competitive bids, the price of B will approach, but not reach 50% of A - the "offer" price. The greater the level of concerns relating to such questions, the greater will be the difference or "spread" between the share price of B and the "offer" price. Should B settle at $18 and A at $40, this would represent a spread of $2 (or 11.1 % of $18). Arbitrageurs would buy at this price, should the risk/reward characteristics meet their objectives. Simultaneously, to lock in the potential $2 profit per share, they would short sell an equivalent value of A. This hedging action limits the profit to the amount of the spread; it also serves to insulate the investor from stock and market risk. Finally, the arbitrageurs would plan to reverse these trades as the spread closed to zero.

An example of such a trade is the recently announced GE/Honeywell merger where GE offered Honeywell shareholders 1.055 shares of GE stock for one share of Honeywell. With shareholder approval obtained, and several regulatory hurdles cleared, closure is expected within one month. With GE and HON currently trading at $47 and $48.21 respectively, the spread is $1.375 i.e. [{1.055x$47}-$48.21] or 2.85% of the Honeywell price. The spread is narrow, but prospects for imminent closure look very good and the annualised return is high.

Risk Factors:

An arbitrageur faces two risk factors. Firstly, a deal can be delayed, reducing its annualised percent return. Secondly, and more critically, a deal might not close. In our example above, the latter scenario would result in the share price of B dropping back to, and possibly below its former $14 - a fall of potentially $4 or more from the $18 purchase price. Additionally, A could rise in price, representing a loss on the short position. In fact many deals do not close, and even the best arbitrageur experiences a "failure" rate of 1 in 10 deals.

In a cash offer, where shareholders of the target company are offered cash, an arbitrageur needs to protect against market risk, and will typically accomplish this by shorting an appropriate industry index.

Success Factors:

Merger arbitrage is clearly not for the uninitiated. Arbitrageurs need to be able to predict possibilities of a deal's closure and its timing. This requires good knowledge about companies and their industries, strong analytical skills, and extensive experience and a solid grasp of legal, antitrust and other regulatory issues. In addition, strong risk management controls are essential.

The better arbitrageurs hold diversified portfolios, make only modest use of leverage and monitor the progress of each deal very closely; taking quick protective action should news turn negative. They are skilled in hedging market risks, aiming for their returns to be reflective of their business skills as opposed to being predicated by market moves.

Future Returns:

Merger arbitrage is classified as an "event-driven" investment strategy, as returns in this arena are driven more by the volume of mergers, acquisitions, tender offers and other corporate re organisations, than by the movement of equity prices. However, some market correlation does exist, as volatile down-trends do tend to delay deal closures. The recent growth of industry globalisation has seen a spate of cross-border mergers which are expected to continue in the years ahead. If the past is any predictor of the future, merger funds can look forward to equity-like annual returns with minimal volatility or market correlation.