The Shrinking Pool of Equities and What This Means for Investors
One major side effect of the M&A boom and a multi-year slowdown in Initial Public Offerings (IPOs): fewer public companies.
In fact, the number of U.S.-listed companies has fallen by more than 3,000 from a peak of 9,113 in 1997, according to the University of Chicago’s Center for Research in Security Prices.1 IPOs are down, too, with just 128 for all of 2016, the lowest number since the financial crisis, according to an article in Fortune Magazine earlier this year.
M&A activity is contributing to the decline as well, with nearly $600 billion in deals done in 4Q 2016, according to Dealogic. A KPMG study indicates that 84% of companies surveyed expect to initiate a deal through 2017, and 78% of those respondents are eyeing multiple deals.2 During this period, private financing has ballooned, creating opportunities for companies to raise capital without the need to tap the public markets – think Uber or Airbnb.
So, what does this mean for investors? Most of us don’t have a simple way to access the large pools of private capital that are going into these companies. But, that changes when it comes to those public companies being taken private by a private equity firm, or combining through a merger.
Trying to guess the next big takeover target is not usually a fruitful exercise, however. More effective – and more predictable – is a strategy that seeks to benefit from the gap that often opens up between the price an acquirer announces it will pay for a company and the cost of the shares of the target company in the open market. This strategy is known as “merger arbitrage.” Why would a company’s shares not move immediately to the proposed deal price when a takeover is announced? Sometimes, they do. In other instances, when the market judges the offer to be too low and another bidder is expected to appear, the shares might go to a premium to the offer.
But, in many cases, the shares of the target will trade at a discount to the proposed purchase price. There are lots of reasons why this might happen: concern over the buyer’s ability to fund the deal; the possibility of regulatory or anti-trust challenges delaying or preventing the deal from closing; or stock price fluctuations in a stock-for-stock transaction, to name a few. Generally speaking, this gap tends to narrow as the closing date nears, and disappears entirely when the deal is completed. The merger arbitrage investor looks to capture the return generated as the offer price and closing price come together, a relatively low-risk way of participating in M&A.
It’s an interesting time in the investing world – Bloomberg data reveal that there are now actually more market indexes in circulation than there are U.S. stocks. But, while the number of stocks in the public domain may be declining, the opportunities are still there. A merger arbitrage strategy is one approach that can help position an investor to take advantage of the prevailing trends.
1. Farrell, Maureen, “America’s Roster of Public Companies Is Shrinking Before Our Eyes” The Wall Street Journal, Jan. 6, 2017.
2. Tiemann, Daniel, “M&A Pulse: M&A experts weigh in on deals for 2017” KPMG LLP, 2017.
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Merger arbitrage involves simultaneously purchasing and selling the stocks of two merging companies to create “riskless” profits and is often considered a hedge fund strategy.
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