Introduction
On April 8 an article appeared in Hedgeweek entitled “Identifying a pure merger arbitrage strategy in the event-driven space”. It’s one of our favourite publications and was written by James Williams. One of our readers asks “could review this piece and if we had any thoughts?”. Never being one to shy away from a challenge, we thought we would give it a go.
Article text is indented and italicized. For reasons of brevity we have not included the entire article. Three dots implies article text has been omitted. Our analysis follows these indentations. Links to sources and references can be found at the end of the analysis.
Identifying a Pure Merger Arbitrage Strategy
A recent study by the Strategic Consulting team, Prime Services, Barclays Capital, found that since 2010, merger arbitrage was the highest performing alpha generating strategy, returning 2.6 per cent (annualised). But in Europe, this strategy, which used to be referred to as risk arbitrage, is less obviously well known to investors than in the US. Part of this is down to not knowing what the right questions are to ask, when seeking out a ‘pure play’ merger arbitrage manager in the wider event-driven category.
Merger arbitrage is the only yield strategy in the equity space and involves managers assessing the strengths and weaknesses of M&A deals, building long positions on the expectation that the target company’s stock price will rise, while borrowing shares of the acquiring company to go short.
A yield strategy implies a return is more or less known over the life of an investment. Also, you may not need to borrow shares in the acquirer if the deal is structured as cash only transaction.
Uncertainty over the deal being completed or not creates a price discrepancy between the two companies; trading this spread between the two companies is where the term arbitrage comes from.
It’s not really a “discrepancy”. The difference, or spread, is there for a logical reason. Hence the debate as to whether this strategy should still be referred to as “arbitrage”
The Event Driven Space & Identifying Pure Merger Arbitrage
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As investors look to de-risk their portfolios and reduce their exposure to directional strategies in 2019, in anticipation of a market correction, knowing what to look for in a merger arbitrage manager is perhaps timely.
What investors? Is there any evidence of a reduction in exposure to directional strategies in 2019? In any case, investment manager research is an extremely important point to make.
The tricky issue is that some managers will present themselves as event driven funds, but within the portfolio they might pivot to merger arbitrage when the right opportunities come along, as well as focus on event driven situations that naturally bring market correlation and take away the yield visibility from a merger arbitrage strategy. There is nothing wrong with this; it simply means the risk/return profile will differ to a pure merger arb fund and generate more market beta.
As one industry source commented to Hedgeweek, wishing to remain anonymous, the difference between event driven strategies more broadly, and merger arb specifically, “is that the latter focuses on an anchor of value, which is the announced bid price that someone is willing to pay. The M&A cycle within European mid-markets has been productive over the last few years and this has been a big focus of our portfolio.
Indeed, style drift is a problem when comparing managers and identifying pure merger arbitrage funds. As followers of merger arbitrage limited know, a lack of investment opportunities was recently experienced in the cash only merger arbitrage space. Managers keen to keep clients and with funds to employ need to deploy those funds somewhere. Correlation however, depends on how the “event driven” situation is traded and can be positive or negative. Why the request for anonymity for this comment? Whatever industry source it came from, it is bang on the money.
Lutetia Capital
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Jean-François Comte is the CIO of Lutetia Capital says: “In my view, there are some key questions for allocators to consider. The first should be, Does the manager only invest in announced deals? The second should be, If the manager only invests in announced deals, do they invest only in friendly deals or do they also invest in hostile situations?”
Hostile bids are more correlated to the market when a signed, friendly deal is arguably not. Unless something unforeseen happens, the buyer has already confirmed a bid to conclude the deal, whereas in a hostile bid, nothing is accepted or signed.
“Another sub-question for investors to consider,” says Comte, “is to ask the manager if they only invest in equities to play out situations or if they also use credit securities. You could do either in announced deals; if you think some bonds could be recalled because of the refinancing triggered by the deal, you might use credit securities. That’s fine, there’s no right or wrong way of trading an M&A situation, provided you are clear and transparent with investors. It’s just about knowing exactly what the manager does, and having a clear understanding of the strategy.”
Good analysis from Jean-Francois Comte. We do not consider “pre-arbing” as merger arbitrage. It’s basically just speculating on a rumour. The difference in risk between hostile and friendly deals can be substantial. The correlation of returns to the market is broadly correct. Returns are more correlated if deals have a lower deal closing probability (DCP). This is generally the case for a hostile takeover. The last paragraph is solid analysis from Comte.
Risk / Reward Payoff
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Speaking to Hedgeweek, the COO of a European event-driven hedge fund says that one point for investors to consider in merger arbitrage is to establish what analysis the manager dies around a deal.”
“A traditional merger arb strategy generally takes small spreads on announced deals and leverages those up to generate a relatively attractive annual return,” they say. “The problem with that is it is quite asymmetric. One in 20 times a deal may blow up, which if you’ve levered, can lead to a very asymmetric risk/reward where the downside ends up being quite large, which you weren’t being paid for in the expectation of making a 2 per cent return on the upside.
“Investors should therefore be careful of the risk/reward. It could lead to the manager potentially losing 20 or 30 per cent on the downside, while only potentially making 2 per cent on the upside.”
Over time, there is a risk that the manager ends up losing more money than he makes, if risk management is not robust.
We would hate to see a manager die (sic) around a deal. However, we would like to know what analysis a manager does. Investors should ALWAYS be careful of the risk reward. Many managers invest in deals across the whole spectrum of DCP’s and only use leverage in a restricted manner.
Why Diversify?
Comte emphasises that compounding returns should be the key feature of a pure merger arb fund. He says Lutetia Capital’s mission is to maximise the yield for investors while lowering the risk through diversification. “We do not believe in concentrated portfolios,” he says, confirming the portfolio holds 40 to 60 positions with an average deal duration of 80 to 120 days. The minimum deal size for consideration is USD500 million.
On the compounding point, he explains:
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“Regardless of whether or not you are using leverage, your correlation to the market is going to be extremely low. Over time, it should be below 0.1 (unlevered), if you compare it to the S&P 500, or any other equity index. The whole point of a merger arb strategy is yield generation and visibility. That’s why we insist on diversification in the portfolio and the mutualisation of risk.
“The enemy of merger arb is not the wider macro environment, or concerns there will be less M&A activity in the market. The enemy is a deal blow-up that nobody saw coming.”
Of course, the evil twin of diversification means an increased chance of investing in a deal that ultimately fails. 80-120 days is the average deal completion timeframe. Merger Arbitrage Limited also has a set of proprietary investability rules related to our T20 Portfolio spread tracker. Good common sense. Correlation, as mentioned previously is related to the DCP. Correlation evolves and dissipates as deals near completion to become less (almost “un”) correlated with the market. Diversification may also help reduce this correlation. At the same time it almost guarantees you will be hit by something from the “wider macro environment”. As all economic bases (regions, sectors etc.) have been covered, exposure to these risks is widened.
Due Diligence
Another question for investors to consider, as part of their investment due diligence, is to ask the custodian to show them the fund portfolio every few months or so, to check the manager is doing what they say they are doing.
Listen to the manager, ask the right questions, and then fact check by asking a very simple request to review the portfolio – then one can trust and verify the manager’s strategy.
Provided the manager communicates their strategy effectively, it should not matter if they engage in different M&A investment activities. If one invests with an event-driven manager, and they invest in special situations, pre-bid deals, announced deals, and use a variety of equity and credit instruments to express their views, that is fine. But if an investor expects to invest in a pure merger arb strategy, the last thing they want is to find out the manager has undergone style drift and generated a higher market correlated return.
More sound advice and applicable to all investing.
“Most investors, at some level, look for consistency in terms of what a manager does, the types of things they will and won’t invest in, expected returns and so on,” says the undisclosed source.
“A year in to investing, the investor can then evaluate and ask, ‘Did the manager do what they said they were going to do?’”
They should do, investors that is. But they probably won’t. If they’re in profit they’ll be happy, and if not, investors will probably bail.
Conclusion
As a final tool for assessing merger arb strategies, Comte feels it is advisable to look at specific periods when the market is stressed such as Q4 2018 to see how resilient so-called “market neutral” or “absolute return” equity strategies are.
“Alpha generation over time is key but I think you also need to demonstrate limited drawdowns when volatility increases. That’s what you’re paying an absolute return manager for – to protect money in volatile periods when the market is not doing well. Are you getting the protection you are paying for? And maybe even a positive return, when the market is not doing well?
Now this IS important. Most managers can make money when times are easy. That is, no economic turmoil, cheap financing, bull market etc…. But what happened to returns during volatile times? Were they positive, or correlated? What was the standard deviation or returns during this period? Great questions.
“Merger arb as a category doesn’t really exist. It’s a sub-category of event-driven, but this can cover so many different situations. You can go from activism on one end of the ED spectrum where the activist investor takes a significant stake in a publicly listed company to change its course, to merger arbitrage on the other end of the spectrum, which should be a pure yield strategy uncorrelated to the markets.
“That’s why you need to do your homework (when looking for a pure merger arbitrage strategy) and ask the above questions,” concludes Comte.
Great way to finish Jean-François. For the most part, we agree with this article dear reader. We especially like the analysis that Mr Comte offers. One or two explanations require a touch up but we believe the article is informative and of use to investors.
Resources
The full and original text is at https://www.hedgeweek.com/premium/identifying-pure-merger-arbitrage-strategy-event-driven-space
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