When Merger & Acquisition (“M&A”) Activity Slows Down

by: , Chief Investment Officer and Managing Director | IndexIQ; Mark Lacuesta, FRM, CAIA, CIPM, Director of Index Strategies, IndexIQ

Given that merger arbitrage deals are the core component of a merger arbitrage strategy, what happens when merger & acquisition deal volume declines?

For several years, we’ve been in the midst of an M&A boom. According to Dealogic, in 2018, U.S.-targeted M&A volume reached a total of $1.74 trillion and 7,791 deals. Q1 2019 was busy, too, as U.S.-targeted M&A broke historical first quarter records, reaching a total volume of $537.6 billion and 2,158 deals. So, while it may seem a little early to worry about running out of transactions, M&A is highly cyclical and the day will come when volume declines.

Two of the key metrics that drive the performance of a merger arbitrage strategy are deal premiums and completion rates. We raised the question, are either, or both of these key performance drivers impacted by a decline in the number of deals?

Our research revealed two significant findings. First, there appears to be a positive relationship between S&P 500 Index returns and the subsequent change in the number of deals that are announced. The chart below shows an increase in deal flows following positive market returns.

Deals vs. S&P 500 Index Returns

Source: Factset Mergers database, quarterly, from 1996 through 2018.

Second, there appears to be no statistical relationship between the changes in the S&P 500 Index and the merger premiums offered by acquiring companies.

Deal Premium vs. S&P 500 Index Returns

Source: Factset Mergers database, quarterly, from 1996 through 2018.

Examining merger deal premiums grouped by calendar year shows the annual average ranges from 20% to 47%, with the historical average at 31.2%. The data suggests that while the pipeline of transactions may correlate with the market (as proxied by the S&P 500 Index), acquirers are still offering a consistent premium for target companies. Therefore, the S&P return and number of announced deals (above a bare minimum needed to execute the strategy) should have little or no impact on the potential return of a merger arbitrage strategy, in our opinion.

Additionally, our research showed that in terms of completion rates, on average, 81% of deals successfully complete. These numbers are consistent across up and down markets, with regulatory and shareholder reaction having more of an impact than market direction. This consistent completion rate allows for enough turnover to occur within the strategy to introduce newer deals as they become announced.

Quarterly Completion Rates vs. Mean

Source: Factset Mergers database, quarterly, from 1996 through 2018.

The IQ Merger Arbitrage Index has historically demonstrated a low correlation to the broader market. The data on premiums provides one explanation as to why merger arbitrage strategies work to add diversification to a portfolio. Because the deal premiums remain largely consistent regardless of whether the S&P 500 Index is moving up or down, the returns may also be relatively consistent, assuming the deals get done. While the volume of deals may vary from year-to-year, other factors like the strategic importance of an acquisition mean that there should still be a sufficient quantity of quality transactions to choose from to add to a strategy.

The IQ Merger Arbitrage Index employs a systematic, rules-based process to identify deals for inclusion in the Index. The criteria include a listing in developed markets, a minimum percentage of the target company’s shares being sought, limiting the maximum deal age, and sufficient liquidity.

For now, there is no shortage of deals that meet these criteria, and the stock market, while it’s been more volatile lately, continues to be supportive of M&A. But when the cycle turns, our research suggests that there should be no major impact on a merger arbitrage strategy to continue to successfully execute on its strategy. Furthermore, a strategy with strong deal selection criteria could be especially effective in identifying more qualified opportunities in times of reduced deal flow.

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

Before considering an investment in the Fund, you should understand that you could lose money. Certain of the proposed takeover transactions in which the Fund invests may be renegotiated, terminated or involve a longer time frame than originally contemplated, which may negatively impact the Fund’s returns. The Fund’s investment strategy may result in high portfolio turnover, which, in turn, may result in increased transaction costs to the Fund and lower total returns. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Diversification does not eliminate the risk of experiencing investment losses. Stock prices of mid and small capitalization companies generally are more volatile than those of larger companies and also more vulnerable than those of larger capitalization companies to adverse economic developments. The Fund is non-diversified and is susceptible to greater losses if a single portfolio investment declines than would a diversified fund. The ETF should be considered a speculative investment with a high degree of risk, does not represent a complete investment program and is not suitable for all investors. The Fund may experience a portfolio turnover rate of over 100% that will increase transaction costs and may generate short-term capital gains which are taxable.

Liquid alternatives (liquid alts) are alternative investment strategies that are available through alternative investment vehicles such as mutual funds, ETFs, and closed-end funds that provide daily liquidity.

Deal premium is the difference between the actual price paid to acquire a company and the estimated real value of the acquired company before the acquisition. The size of the premium often depends on various factors such as competition within the industry, the presence of other bidders, and the motivations of the buyer and seller.

Deal completion rate is the rate of announced deals that complete the merger.

The IQ Merger Arbitrage Index seeks to achieve capital appreciation by investing in global companies for which there has been a public announcement of a takeover by an acquirer.

The IQ Merger Arbitrage Index is the exclusive property of IndexIQ which has contracted with Solactive to maintain and calculate the Index. IndexIQ® and IQ® are registered service marks of IndexIQ.

The S&P 500 Index is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE, NASDAQ, or the Cboe BZX Exchange.

Consider the Fund’s investment objectives, risks, and charges and expenses carefully before investing. The prospectus and the statement of additional information include this and

other relevant information about the Fund and are available by visiting nylinvestments.com/etfs or calling 888-474-7725. Read the prospectus carefully before investing.

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, located at 51 Madison Avenue, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. 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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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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Mark Lacuesta, FRM, CAIA, CIPM

Director of Index Strategies, IndexIQ

Mark is Director of Index Strategies at IndexIQ where he is responsible for overseeing IndexIQ’s proprietary and third-party indexes underlying the firm’s ETF offerings. In this role, Mark is involved with research, product development, trading, sales, and marketing

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