Are the Stars Still Aligned for Merger Arbitrage?
We’re witnessing a set of ideal conditions for the merger arbitrage space: High stock valuations are providing currency for transactions, companies are flush with cash and not making any money holding it, and even a rising rate environment has not historically put a damper on mergers & acquisitions.
Merger arbitrage strategies seek to profit from the price discrepancy between a stock’s price after the public announcement of a merger and the completion of the deal. The asset class is typically used as an alternative to equities; it uses market hedges (shorts1) to dampen portfolio volatility and reduce correlations to the equity markets.
Figure 1 is a hypothetical diagram of how arbitrage works. After the announcement of a merger, a target’s stock price initially pops in response to the offer. The resulting stock price will typically remain below the takeover price, as the discount accounts for the risk of the deal not closing. The resulting spread will narrow, as the deal moves closer to completion. The added bonus is that these returns are generally insulated from the direction of broader markets.
Figure 1: Hypothetical Price Activity from an Announced Merger
Source: IndexIQ. For illustrative purposes only, based on hypothetical events of an actual merger and acquisition.
According to Bloomberg2, M&A activity has picked up recently, with last year being a particularly strong year. In 2016, the deal count reached its highest level over the past ten years, while deal volume was at its second-highest level. This momentum has carried over into 2017, with the value of global M&A deals at $2.7 trillion year-to-date, which is over 40% higher than this point last year. Deal values are highest in North America, followed by Europe, which has seen a year-over-year increase of close to 150%. It is also positive that over 90% of the deals announced are under $500 million in size. Smaller deals tend to have higher probabilities of closure, as they encounter fewer regulatory hurdles.
Figure 2: Deal Activity Has Been Robust
10-Year History of Global M&A Deals
In addition to a strong available opportunity set, there are also several key benefits to investing in this type of strategy. The strategy’s low correlations to both equity and fixed-income markets can serve as a potent portfolio diversifier. The HFRI ED Merger Arbitrage Index has had a low correlation to equity markets and an inverse relationship to fixed income. Investors often look to merger arbitrage strategies to mitigate volatility, provide more constant returns over various market cycles and potentially enhance risk-adjusted returns (as measured by the Sharpe Ratio). By incorporating M&A into a traditional 60-40 portfolio, you can see how the portfolio’s risk profile improves, with a lower standard deviation and beta, increased Sharpe Ratio, as well as improved drawdown.
Figure 3: Merger Arbitrage Report Card
Five-Year Correlation and Risk Statistics (4/30/17)
Correlation of HFRI ED Merger Arbitrage Index to:
|Index/Portfolio||Standard Deviation3||Sharpe Ratio4||Beta (vs. S&P 500)||Max Drawndown5|
|S&P 500 Index||10.17||1.33||1.00||-8.36|
|BBgBarc US Agg Bond Index||2.86||0.74||-0.02||-3.67|
|HFRI ED Merger Arbitrage Index||2.17||1.47||0.11||-2.40|
(60% S&P 500/40% US Agg)
(50% S&P 500/30% US Agg/20% Merger)
Source: Morningstar 4/30/17, Past performance is not indicative of future results. An investment can’t be made in an index.
As seen above, both stock and bond allocations may benefit from the potential drawdown protection offered by M&A strategies. Figure 4 depicts how, on average, the HFRI ED Merger Arbitrage Index has generated positive calendar year returns during down years, impacting the equity and fixed-income markets.
Figure 4: Up When Equities and Fixed Income Have Been Down
Average Calendar Year Returns during Down Periods (1996-2016)
Source: Morningstar. Past performance is not indicative of future results. An investment can’t be made in an index.
While it may seem counterintuitive to venture into an M&A strategy just as financing costs would be increasing, M&A strategies have actually performed well during prior rising rate periods, providing strong absolute returns (Figure 5).
Figure 5: Rising Rate Periods Have Historically Been Good for M&A
Cumulative Performance during Prior Rising Rate Periods
With M&A activity at robust levels and the added potential benefits of drawdown protection, dampened volatility, and consistent returns across market cycles, suitable investors may want to consider diversifying into a merger arbitrage strategy. It is important to keep in mind that not all strategies are the same. One should look for a way to access the M&A space via lower-fee products that seek to offer stronger risk-adjusted performance and–since the asset class tends toward more turnover–better tax efficiency.
To Be Continued
Stay tuned for a follow-up to this post: Will the Real Min Vol Please Stand Up?
1. A short is an investment strategy where the investor sells shares of borrowed stock in the open market. The expectation of the investor is that the price of the stock will decrease over time, at which point the he will purchase the shares in the open market to make a profit.
2. Bloomberg data as of June 5, 2017.
3. Standard Deviation/Risk – Standard Deviation is a measure of the extent to which observations in a series vary from the arithmetic mean of the series. This measure of volatility or risk allows the estimation of a range of values for a manager’s returns. The wider the range, the more uncertainty, and therefore the riskier a manager is assumed to be.
4. Sharpe Ratio – A measure of a manager’s return per unit of risk. It is the ratio of a manager’s excess return over the risk free rate over the standard deviation. A higher Sharpe Ratio implies greater manager efficiency.
5. Max Drawdown – Is the maximum loss incurred by a portfolio during a specified time period. It is used to measure the ‘worst case scenario’ of investing in a portfolio at the
worst possible time.
Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based index that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasurys, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities, with maturities of at least one year.
The HFRI ED Merger Arbitrage Index is designed to be representative of the overall composition of the hedge fund universe implementing a merger arbitrage strategy.
The S&P 500® Index is widely regarded as the standard index for measuring large-cap U.S. stock market performance.
Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services.
Securities are distributed by NYLIFE Distributors LLC, located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.