There has been a significant increase in merger-related activity as the equity markets have recovered worldwide.
There has been a significant increase in merger-related activity as the equity markets have recovered worldwide. With corporations holding large cash positions, and equity valuations still below peak values, many companies are using this idle cash to improve their growth rates through acquisitions. So far this year, global merger-and-acquisition activity is up 10% from a year earlier, to $342 billion.
Merger arbitrage involves the purchase of companies involved in a corporate event in which control of the company is being transferred to another entity. There often is uncertainty about whether the deal will close on time or at all.
Because of this uncertainty, the target company's stock will typically sell at a discount to the price that the target company's shareholders will receive when the deal is closed.
In a transaction where the payment terms include a stock-for-stock component, a portfolio manager will often seek to “lock in” a return by buying long shares in the target company and short-selling shares of the acquiring company, in proportion to the terms of the transaction.
If the deal closes successfully, the portfolio typically receives the spread between the final completion price and the purchase price of the target company. If the deal fails to close, the portfolio could suffer losses on both the long position in the target and the short position in the acquirer.
Portfolio managers will often hold many deals to reduce this risk through diversification.
In transactions in which the compensation for the target company is primarily cash, the portfolio manager usually only establishes a long position in the target company with no short position in the acquiring company. The portfolio manager may use derivative instruments to get short exposure to the broad market, as a hedge against a general market downturn that could threaten the viability of deals.
To analyze the characteristics of the merger universe, data were sourced from a database compiled by Factset Mergerstat LLC. Criteria were then established and applied to those data to create a reliable and investible universe of more than 8,000 deals initiated from 1997-2009.
A review of the final data reveals some interesting patterns regarding the distribution of the deals globally. The number and value of deals in the United States had exceeded the number of international deals in the early part of the data set, but the international deal volume and values have grown significantly and now rival those of the United States.
Also, there are some similarities between the United States and foreign countries in the composition of the deal offers. The average percentage of the offers in stock was historically much greater for the United States than for the international deals, but that gap has since closed and the deal structures now look very similar.
Overall, the average deal has been two-thirds cash and one-third stock. The average has been as high as 75% cash and as low as 55% cash.
Eighty-three percent of the 8,374 deals in the final data set were successfully concluded over this time period. An additional 237 deals were still open as of the end of the analysis.
The average excess return for all deals using a daily method was 5.31%. The average excess return for all deals using a monthly method was 3.52%.
The excess returns were positive using both the daily and monthly methods, though some of the positive excess returns were lost in waiting until the end of the month.
Filtering the universe to exclude deals in which the offer price was below the market price on the day prior to the announcement, and on the day when the initial position was established, resulted in higher positive excess returns. Eliminating these deals from the universe raised the average excess returns for the remaining deals to 6.66% and 4.41%, respectively, representing an improvement in average return of 1.35 and 0.89 percentage points for the daily and monthly periods, respectively.
The increased return doesn't come at the cost of higher volatility. Indeed, the remaining universe of deals had a lower standard deviation for both daily and monthly returns, as did the broad universe.
This data set can be used to form simulated long-only portfolios as well as long/short portfolios that exhibit attractive return and risk properties. A mechanical implementation of a strategy that invests in a broad range of announced deals can deliver positive excess returns with an attractive return-to-risk ratio.
The strategy can be enhanced through hedging, which can improve the return-to-risk ratio by lowering the volatility of the portfolio, but it also lowers the return of the portfolio.
Salvatore Bruno is the chief investment officer of IndexIQ.
