Shrinking Merger Arbitrage Post Crisis; Why Now?


This study is being conducted on the evolution of merger arbitrage spread post the financial meltdown of 2008 that is considered by many economists as the worst financial crisis after the Great Depression of the 1930s. Considering how cautious investors have become now, putting money in merger arbitrage investment strategy that seeks to profit from an arbitrage opportunity arising due to a discrepancy between the acquisition price offered by the acquiring firm and the price at which the target firm’s stocks trade before completion of a merger seems like a viable option in order to seek protection from an extremely volatile market. Both bond and equity markets are failing to provide security in the face of rising volatility and interest rates respectively. Merger arbitrage holdings thus come handy as an alternative source of investment. Following the path undertaken by Jetley and Ji in their paper, ‘The Shrinking Merger Arbitrage Spread: Reasons and Implications’ (2010), this report demonstrates that merger arbitrage has in fact shrunken even further in the recent years which can be attributed to a wide range of factors, ranging from reduction in transaction costs to an increase in trading of the target’s stock following the merger announcement. Particularly, the findings confirm the impact of changes in risk on arbitrage spread. Also, the study tries to show how economic factors of demand and supply are able to explain this decline in arbitrage spread.

Part 1: Introduction

In the face of a low yield environment and relatively expensive bond and equity markets, risk diversification with conventional assets is clearly becoming difficult. On one hand, bonds are unable to provide security in light of rising interest rates and on the other hand, equity markets are failing due to extreme market volatility. Investors are thus looking towards unconventional but liquid risk premiums, such as the M&A arbitrage spread as a tool to buffer portfolio volatility and to preserve wealth. Merger arbitrage can be defined as an investment strategy that involves simultaneous buying and selling of shares of the target and acquiring companies respectively. This is so because normally when such a deal is announced, stock price of the target rises and that of the acquirer declines but stock price of the target still remains below the acquisition price which reflects uncertainty in the market regarding completion of the deal. Merger arbitrage spread seeks to capture this very difference in target stock price. Bloomberg, as on April 27 this year announced a first quarter return of 1.3% for merger arbitrage in light of a decline in the overall industry performance. Thus, in order to alleviate risk, provide downside protection and most importantly diversify returns in investor portfolios, the M&A arbitrage strategy is perhaps more important today than ever before.

It is also called risk arbitrage as it is not exactly risk-free which arises from the possibility of the deals failing to go through. There could be various reasons for this to happen which include, negotiation errors, cultural integration issues, miscommunication or no communication at all and difficulty in the execution process. Such possibilities add the risk in the term risk arbitrage. However, it has lately become a very popular investment strategy as an alternative to falling bond and equity markets post the crisis due to low interest rates and increased market liquidity. Due to the presence of high degree of complications and risks, only large institutional investors having the required expertise can adopt merger arbitrage as a worthwhile investment strategy. Thus, the major users of merger arbitrage are hedge funds, private equity firms and investment banks. As of 2016, the assets under management of merger arbitrage hedge funds are valued at $63.8 billion growing by almost three times from 2007 when they were valued at just $28 billion. This shows the growing popularity of alternative investments, particularly merger arbitrage strategy.

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This report is based on various studies conducted on declining merger arbitrage with special reference to Jetley and Ji’s paper, ‘The Shrinking Merger Arbitrage Spread: Reasons and Implications ‘(2010). The findings are in line with theirs as the shrinking arbitrage is explained by lower bid premiums in recent times which can be defined as a fairly good proxy to explain the amount of risk a deal carries along. In addition to bid premium, another one of my determinant variables is the dollar value of deals announced from January 2009 to April 2016 which can be described as a proxy for the demand of merger arbitrage capital, as proposed by Rzakhanov and Jetley (2013). Also explained is the impact of supply side of the M&A market that is limited by the volume of M&A deals at any point in time.

Part 2: Evolution of the spread

Profitability from merger arbitrage can be better explained by dividing M&A deals into its two most common forms which have strictly been used in this report namely: Cash Mergers and Stock Mergers.

1. Cash Mergers:
Cash mergers simply involve the acquiring company buying shares of the target with cash. In a cash merger, the acquiring firm usually makes a tender offer at a price that is acceptable to shareholders of the target firm who then approve the offer. It needs to be noted that until the deal is complete, stock price of the target trades at below the acquisition price. Thus the strategy involves buying target shares before the acquisition and making a profit if it goes through.

2. Stock Mergers:
In a stock merger the acquiring company exchanges its own stock for that of the target. A key term in a typical stock merger is the conversion ratio which can be defined as the ratio that converts the target firm’s shares into shares of the acquiring firm. An arbitrageur in this case can seek to profit by purchasing stock of the target company and going short with stock of the acquirer. The short position is thus covered when target stock gets converted to that of the acquiring company as the deal gets completed.

Cash deals and stock deals tend to have very different effects on shareholders of both the acquirer and the target. A cash deal is easy to implement in the sense that the exchange of money for shares completes a simple transfer of ownership. But, stock deals can lead to complications with no clear-cut distinctions between the acquirer and target. Another difference between the two types of merger deals is that in a cash transaction, shareholders of the acquiring firm bear the entire risk that expected synergies will not be realized. On the contrary, in stock transactions the risk is shared with shareholders of the target firm. Also, it has been observed by many researchers that at the time of announcement, shareholders of acquiring companies fare worse in stock transactions as compared to their returns from cash transactions, with the difference becoming much greater over time. This is because market reaction to announcement of cash deals is more favorable than stock deals as an acquirer is conceived to be more confident if he decides to pay for the acquisition with cash. Thus, over time it has been witnessed that cash deals have been consistently performing better than stock deals.

Following the collection method of Jetley and Ji, data for this analysis was obtained from Thomson ONE by collating a dataset of all Mergers and Acquisitions from January 2009 to April 2016 for all successful deals in USA involving publicly listed companies. The number of bidders was also fixed at one and I made a point to consider only deals with disclosed deal values in order to get the desired data for the determinant variable i.e. transaction value. As mentioned above, data has been collected for pure cash- only deals and pure stock-only deals. All other forms of considerations have been ignored for simplicity. Lastly, I used the Thomson DataStream to obtain daily price data for my sample of 613 deals.

Table 1: Summary of Successful M&A Deals, 2009-2016
Y Year N Number of deals in s Sample Median Arbitrage
2 2009 4 47 2 2.83%
2 2010 9 93 1 1.50%
2 2011 5 55 2 2.27%
2 2012 8 81 0 0.97%
2 2013 8 83 1 1.05%
2 2014 1 105 2 2.04%
2 2015 1 127 1 1.67%
2 2016 2 22 2 2.04%
The formulas used to calculate the arbitrage spread (as provided by Jetley and Ji) are as follows:

a) Cash Deals

Scash,t = (Poffer ‘ Ptarget,t) / Ptarget,t

Scash,t = Arbitrage spread for cash deal on trading day t

Poffer = Price in cash that an acquiring company offers to pay for each share of the target company’s common stock

Ptarget,t = Closing price of the target company’s common stock on trading day t
b) Stock Deals

Sstock,t = [(Pacquirer,t ) (ER) ‘ Ptarget,t ] / Ptarget,t

Sstock,t = Arbitrage spread for a stock deal on trading day t

Pacquirer,,t = Closing price of the acquiring company’s common stock on trading day t

ER = Deal exchange ratio (i.e., the number of shares of the acquiring company’s common stock offered to the target company’s shareholders in exchange for one share of the target company’s common stock)

Ptarget,t = Closing price of the target company’s common stock on trading day t

A point to be noted is that the arbitrage spread for all deals was computed from the day after the merger was announced to the date of resolution in order to avoid impact of any preannouncement information for deals that were announced after the markets closed.
Figure 1: Median Arbitrage Spreads for Successful M&A Deals,

Previous studies by Mitchell and Pulvino (2001) and Jetley and Ji (2010) found that the spread for successful deals gradually declined over the deal period. Results obtained from this study are thus in-line with previous literature as observed in the figure above. The arbitrage spread, for my sample of 613 companies starts with a median first-day arbitrage spread of 1.48% and goes down to 0.80% within the first 100 days of deal announcement. Thus, it is safe to say that the arbitrage spread for successful deals has shrunken even further from 2009 onwards, from a first day starting point of 1.19% in 2007 to 1.48% as of now.
Part 3: Reasons for Shrinking Arbitrage Spread (Regression Results)

The following section looks for possible reasons to explain the observed decline in the arbitrage spread over the last seven years. This is first analyzed by running a regression to study the impact of bid premia and transaction value on monthly values of arbitrage spread followed by an economic interpretation of the regression results obtained to explain the shrinking spread.

Table 2: Regression Results for Impact of Bid Premium and
Deal Value on Arbitrage Spread (2009 ‘ 2016)
E Explanatory Variable E Estimate
(t (t-statistic)
C Constant 0. 0.051724
( (7.294666)
B Bid premium first day after n announcement 0. 0.009990
(( (2.554322)*
L Log of deal value – 0.004629
(- (-4.689282)*
*Significant at 5 percent level

Risk Reduction; Bid premium

Bid premium can be defined as the difference between actual price paid to acquire target and the estimated real value of it before acquisition. The regression shows a statistically significant coefficient for bid premium at the 5% level. Its coefficient value (0.009990) however is very low as in reality size of the premium is not necessarily correlated with the success of a deal. Thus it is immaterial whether the deal was successful or not. However, the point to be noted is that bid premia can explain evolution of the arbitrage spread and is in fact positively related to it. This implies that the gradual shrink in the arbitrage spread can be attributed to a similar decline in bid premia over the years which in turn suggests a reduction in risk associated with risk arbitrage. With the advent of continuous technological advancement over the years, hedge fund specialists have been able to enhance their knowledge and skill in evaluating the likelihood of the merger actually occurring successfully. Therefore, it has led to a continuous decline in the amount of risk an investment strategy involving merger arbitrage carries. The reduction in bid premia can thus be attributed to this fall in risk levels carried by M&A deals. Completion risk, i.e. risk that a deal may not be completed has not been considered as my sample only consists of M&A deals that have been successfully completed.

Figure 2: Relationship between Bid Premium and Deal Value
According to Alexandridis, Fuller, Terhaar and Travlos in their paper, ‘ Deal Size, Acquisition Premia and Shareholder Gains’ (2011), deal value and bid premium are inversely related to each other, thus having opposite impact on arbitrage spread, where deal value is a proxy for size of the deal. This can be attributed to factors such as, managers’ reluctance to offer hefty premiums when the value at stake is very high. Another reason is that integration complexity increases with the attempted union of large firms which thereby enhances the uncertainty about expected synergies to be achieved from the combination of the two. This could therefore lead to a lower premium to be observed. We can thus say that acquirers, on an average pay significantly lower premium for large deals.

This inverse relationship between deal size and bid premia (see Figure 2) can also be used to explain why the decline in both the premia and arbitrage spread go hand in hand. Acquirer firms are reluctant to offer an exorbitant price for the target firm if the deal value is very large as larger deals tend to destroy more value for acquirer firms both in the short run and long run, which keeps the premia low. Moeller et al. (2004) presented the reasoning that larger acquirers tend to overpay as managerial hubris is a more common problem in large firms. Overall, the complex nature of large deals makes them associated with lower premiums. Since this is the case observed in my sample, it is fair to say that a fall in the bid premia has led to consequent diminishing of the arbitrage spread.

Demand for Merger Arbitrage Capital; Deal value

On the other hand, regression results for deal value as an explanatory variable for arbitrage spread are also statistically significant at the 5% level but are inversely related to it with a coefficient value of -0.004629. In simpler terms, arbitrage spread contracts for large-sized deals. This can be due to the availability of more public information about the deal taking place between two well-renowned firms. Investors will be more updated about deal progress involving large companies through media and other sources. As a result, demand for target firm stocks will rise post the announcement date, leading to an increase in its stock price. This increase will in-turn cause the arbitrage spread to shrink. Also, in acquiring a large firm the mean acquirer will have more reliable information about the target such that it can formulate its action plan easily. This will also lead to more public information to be released giving investors a clearer picture to work out their investment decisions accordingly. Studies by Jindra and Walking (2004) and Walking (2007) confirm that large-sized deals carry lower transaction costs which increase liquidity and thus there is more readily available information for investors. Thus, negative relation between the arbitrage spread and natural log of bid value shows that arbitrage spread decreases as we increase the value of the transaction.

Therefore, the first set of regression results indicate that a decline in merger arbitrage spread and subsequently in the aggregate alphas of merger arbitrage hedge funds (measure of arbitrage returns) can be partly attributed to a reduction in risk associated with the mergers along with a gradual increase in the demand for arbitrage capital, Rzakhanov and Jetley (2013). Going by the trend proposed by Jetley and Ji (2010) there is however no reason to believe that future deals will continue to be less risky than the deals that have already been announced. Nonetheless, it seems to be the case considering the widespread development of the hedge fund industry.
The regression that follows tries to explain the effect of number of monthly M&A deals taking place on the median arbitrage spread. The regression coefficient is statistically significant implying that volume of deals taking place in a month has an impact on the arbitrage spread. The coefficient however, is negative (-0.001036) leading to an inverse relation between the two variables. Thus, it shows that part of the decline in arbitrage spread and consequently the aggregate alphas of merger arbitrage hedge funds can be explained by an increase in the volume of M&A deals that have been initiated in the recent past. This measure can also be used to examine the impact of an increased supply in the market for mergers and acquisitions, which is clearly negative.

Table 3: Regression Results for Impact of Volume of Deals on
Arbitrage Spread (2009-2016)
E Explanatory Variable E Estimate
( (t-statistic)
C Constant 0. 0.027531
( (7.643371)
V Volume of Deals — -0.001036
(- (2.252973)*
*Significant at the 5 percent level
Monthly volume of deals

World economy has been consistently healthy post the global economic crisis of 2008 and has as a matter of fact been gaining momentum like never before. Companies have thus been able to generate decent amounts of cash reserves, have been able to issue debt to finance deals and the stock markets have been bullish making merger transactions easier to initiate. R&D dependent sectors have been significantly gaining pace in the world of M&A activity and have thus contributed immensely to an increase in the number of deals taking place. Complimentary to this is the subsequent decline in the arbitrage spread.

Constructing diversified portfolios of a number of different target firms can considerably reduce the likelihood of deal failure as well as the impact of one failed transaction on the profitability of merger arbitrage strategies. Thus, as compared to other asset classes they display attractive diversification potential that investors can explore.

Historically, it has been observed that return distributions for the merger arbitrage strategy typically exhibit a large degree of kurtosis, which suggests an excessive exposure to event risk. As a result, many managers set position limits within their funds to avoid a concentration of assets in any one deal. A failure to adequately diversify a portfolio of merger arbitrage deals may expose the investor to undue event risk. Applying the same ideology to hedge fund strategy we can observe that with a greater number of deals available to invest in, the demand for target shares amongst investors has been increasing which is causing target stock prices to rise and thus leading to a contracting arbitrage spread. This is in line with the result on bid premium obtained previously. Both these factors can be used to explain a reduction in risk carried by an acquisition. It is thus not incorrect to say that these three variables are intimately connected with each other. With an ever-increasing capacity of the merger market, risk involved in investing in arbitrage returns has gone down considerably, together causing merger arbitrage spread to shrink even further than observed previously. The spread has thus attained an all-time low of 0.80 % as witnessed on the 100th day of an average deal.

Part 4: Conclusion

It was observed that the arbitrage spread declined even further post the crisis of 2008. This decline is seen to be induced by an increase in the number of M&A deals that have been taking place over the years. This pattern was also observed in the study conducted by Jetley and Ji and other academicians and has been showing a consistent trend ever since, i.e. as the US is strengthening and the global economy is gaining momentum, boardroom confidence all around the world is growing. This is resulting in more merger transactions across a wider set of industries, leading to a broader opportunity set of attractive, high-quality M&A situations from which arbitrageurs can exploit.

In addition to this, the gradual decline in arbitrage spread can also be attributed to a reduction in deal premium as well as an increase in the value of the transaction. My findings also support the conclusions of other studies which focused on realizing bid premium as an important factor to explain a decline in the spread. I have also been able to shed some light on another important factor that comes into the picture that is the transaction value or simply the size of the deal. As concluded by Moeller et al. (2004), there is consistent evidence that large firms offer larger bid premiums than small firms implying that larger deals are riskier. The evidence is thus consistent with managerial hubris playing a role in decision-making for large firms. The trend has not reversed over time.

Merger arbitrage as an alternative investment strategy thus comes out to be very fruitful as due to the financial crisis of 2008, investors have been speculative in putting their money in bond and equity markets which has thus increased investment opportunities around the world of M&A arbitrage. Such investment opportunities are able to fight the rising volatility in markets as well as interest rates which makes them a viable option. Also, with the advent of better technology and sources an arbitrageur is able to track market movements better and thus efficiently plan investment decisions.

Overall, hedge fund returns from merger arbitrage seem to be declining even further. Fung et all (2007) conducted their study from 1998 to 2004 and found this to be true along with declining alphas for event-driven merger arbitrage funds. The reason they site is very simple and logical which is that as the capital in the hedge fund industry has been increasing at a constant rate, it is adversely effecting the funds’ ability to generate excess returns.

The results also confirm that some of the decline in the spread is indeed permanent and investors planning to invest in hedge funds should try to interpret results post 2002 rather than over a long period as they seem to be giving a clearer portrayal of the M&A market and the investment opportunities that exist in it, Jetley and Ji (2010). This is so because all the recent studies have been able to capture a large amount of economic factors that maybe affecting the arbitrage returns for investors and so are able to provide an excellent source of guidance.

However, it needs to be noted that until recently it was almost impossible for individual investors to invest in the hedge fund industry and gain significant results out of merger arbitrage strategy as it is a very complex form of investment and requires a significant amount of expertise. But, with the introduction of a recent class of ETFs that focuses on tracking a set of acquisition deals that meet their requirements, it has become a lot easier for individual investors to put money in merger arbitrage strategies. For instance, S&P Merger Arbitrage Index has 53 constituents currently and it tracks both cash and stock deals taking place in various sectors. Individual investors thus need to find just the right ETF that tracks their desired index to invest in merger arbitrage. The hedge fund market is thus flourishing like never before with investment opportunities waiting to be exploited by investors.

Lastly, as bonds are potentially failing to provide security in the face of rising interest rates and equities are becoming more volatile, it is essential for investors to consider alternative investment strategies as a potential tool to buffer volatility and to preserve wealth. Merger arbitrage has historically been able to provide protection and deliver positive returns during periods of market stress and it is safe to say that investors can adopt this investment strategy.


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