Hedging your bets in the M&A market

by: , Director, Product Management

Merger and acquisition (M&A) activity continues to be robust and is expected to remain elevated, as the year progresses. That being said, not all M&As are alike. As such, it can be beneficial to have a disciplined strategy to evaluate these opportunities, as well as implementing the proper hedging techniques to reduce one’s risk exposure. Following are a number of strategies to consider when it comes to individual M&A deals:

When to take the leap

A key element of an M&A strategy is when to establish a position in a particular company. One option is to seek out organizations that are potential candidates for an acquisition and establish a position in their stock. While this approach could result in meaningful upside, it also presents numerous risks, including significant broad-market correlation, not the least of which is the deal never being announced. A lower-risk approach is to only purchase companies being acquired, and to do so below the target price, realizing the difference when the deal is finalized. Importantly, having a portfolio of many deals reduces the impact of an individual deal failing.

Share price of National Semiconductor Corp. (NSM)

4/1/11 TI offers $25.00 per share cash

Source: National Semiconductor Corp, as of 9/23/11.

Hold ‘em or fold ‘em?

On average, it takes 120 days from a deal being announced until it is finalized. But, what happens if there’s a delay? This may be a sign that there are issues that could result in the deal being cancelled. When the timing of an acquisition is delayed, it makes sense to revisit the deal to determine the cause. If the deal is going through regulatory scrutiny or issues, such as securing financing or shareholder approval, the risk of successfully completing the deal may start to rise, resulting in the price of the target company to fall away from the target price. One general rule of thumb may be to stick with the position if the target company is still priced between its pre-announcement price and target price, and either take the gains if it has increased above the target price, or cut losses if it has fallen below the pre-offer price.

Hedging the downside risk

On the surface, a merger arbitrage strategy appears relatively cut and dry, with fairly well-defined risks. But, what happens when the acquiring firm is offering shares of their stock as part of the target price? There is the potential that the acquiring firm’s share price falls in value, resulting in a loss to the merger investor, even though the deal successfully closes. One opportunity to reduce this risk is with a hedging strategy that entails shorting the acquiring company. Consider this hypothetical example. Company A offers to buy Company B with a $50 equity/$50 cash bid—a total offer of $100 per share. If Company B was trading at $70 a share prior to the announcement and its price rallies to $95 post-announcement, there’s a $5 per share premium when the deal is finalized. With an unhedged strategy, if Company A’s share price rises to $60, the spread would rise to $15 a share (the initial spread of $5 a share + the $10 per share appreciation in Company A’s share price). But, what if Company A’s share price falls to $40 when the deal finalizes? With an unhedged approach, the spread would be -$5 per share ($40 + $50 versus the $95 purchase price).

Now, let’s look at two scenarios to see how hedging can be used to lock in the spread. If you short Company A and its share price rises to $60, it works out to $60 per share + $50 cash – $10 (loss from the short) = $100, thus maintaining the $5 spread. If Company A’s share price falls to $40, it works out to $40 per share + $50 cash + $10 (gain from the short) = $100. As you can see, the hedging strategy protects the investor if the acquiring company’s share price declines prior to the deal being completed.

Source: The above is for illustrative purposes only, based on hypothetical events of an actual merger and acquisition.

Summary

The increase in M&A activity has opened the door to numerous investment opportunities. Having a well-defined strategy, coupled with the use of hedging strategies, may help investors capitalize on the potential upside, while seeking to reduce some of the risks typically associated with merger arbitrage. Gaining access to an investment manager with specialized expertise in merger arbitrage may also help investors maximize the potential in this segment of the market.

All investments are subject to market risk and will fluctuate in value. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the federal government, as to the timely payment of principal and interest.

Correlation is a statistic that measures the degree to which two securities move in relation to each other.

Risk exposure is a quantified loss potential of business. Risk exposure is usually calculated by multiplying the probability of an incident occurring by its potential losses.

The information and opinions contained herein are for general information use only. IndexIQ does not guarantee their accuracy or completeness, nor does IndexIQ assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report and are subject to change without notice. Past performance is no guarantee of future results.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, New York 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs, and NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Dan Petersen, CAIA®

Director, Product Management

Dan Petersen is a Product Manager at IndexIQ, responsible for developing actionable content as it pertains to the competitive landscape, analyzing fund usage in the latest market environment, and portfolio positioning for both individual portfolios and broader-based applications

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