Guide to Merger Arbitrage

Merger arbitrage has become a popular investment strategy used both by professional capital allocators and retail investors alike. In fact, the combined assets under management of M&A hedge funds has increased 5x over the last decade (to $72bn in 2019), while the combined value of all the deals done in 2019 in North America reaches $2 trillion dollars. But with all those numbers and big players, are there any crumbs left in M&A for the small retail investors?

We believe there are - even this year we've posted a number of arbitrage cases with triple-digit IRRs (SKYS +100% in one month, BREW +45% in 5 months, LWB +35% in 1.5 months, SORL +14% in one month, etc.). However, in order to not get lost in the vast sea of mergers that are always available in the market and to spot these stand-out cases, one really needs to know what to look for.

Therefore, in this article, we present general guidelines for investing in merger arbitrage. We mostly cover the specifics of the US market, however, the majority of the discussed issues are related to the concept of the merger arbitrage investment itself and therefore are applicable to other markets as well. At the end of the article, you can also find our short synopsis note for a quick check when researching your next merger arbitrage case.

 

MERGER ARBITRAGE

In a merger, one company takes over another one by paying a certain sum in cash, stock, or a mix of both. If a target company is publicly listed, there might be an opportunity for the arbitrage.

Usually, in order to incentivize management and shareholders of the target to take the deal, a buyer offers a premium (sometimes even multiples) to the pre-announcement price of the target's shares. As a result, after the merger proposal is announced, target's shares jump up. However, often due to numerous uncertainties still outstanding, they usually settle somewhat below the offer price. This spread reflects the uncertainty and riskiness of transaction as perceived by the market. Eventually, if the deal goes through and closes successfully (or the risks are resolved), the spread gets eliminated and the share price of the target company reaches the offer price. If the deal fails, however, the share price of the target company is likely to fall to pre-announcement levels.

In essence, and this is crucial, opportunities to profit from merger arbitrage arise from investor's assessment that the market is overestimating/incorrectly pricing the risks of potential failure, and then betting on the successful closure of the merger (or from pure luck - by guessing correctly which mergers will close successfully).

Therefore, the first question to be asked upon stumbling across a seemingly attractive merger arbitrage case is - why does this spread exist? All cases are different, but several of the most prominent risks could be shareholder approval, regulatory consent, reputation, and the true intentions of the bidder (e.g. the risk of an offer being fake), hedging availability, and so on. Therefore, the most important job for merger arbitrageur is to analyze these risks alongside the basic transactional information and put all of the pieces into one big picture, which will then help him/her to decide whether the particular arbitrage case is worth a bet or not.

Thus the attractiveness of a particular transaction lies in the difference between the market's and investor's personal assessments of what would be an appropriate spread given the risks. Of course, in the ideal world (fully efficient markets), the spread should represent the available information perfectly and should be the same for everyone. This is more or less the case with large-cap deals (+$1bn) where a high number of sophisticated investors are involved, the transactions are well analyzed from all possible angles, and the spread (if any is left) reflects caveats quite well. However, this is quite often not the case with small/micro-cap transactions - due to various liquidity/size constraints, institutional money (hedge funds, investment banks, asset management firms) can't or do not want to analyze and participate in smaller merger arbitrage opportunities and the spread might be significantly wider than would be expected given the circumstances.

As for the average time it takes for the merger arbitrage situations to play out, the distinction should be made between the period till the merger itself closes and the period till the spread gets eliminated or narrows materially. Sometimes, in cases where the market's perceived risks last for the whole duration of the merger, the two timelines coincide, however, often the spread gets eliminated or narrows down significantly in advance of the merger closure.

Smaller mergers usually take 4-5 months to close, while larger cases might take 1 year or more. In comparison, since 2017, the average time it took to close a merger arbitrage idea that was posted on SSI stands at 2.6 months.

The entry/exit timing differs case by case.  During the merger process, the spread can be quite volatile and driven by the flow of news/rumors. This might present more than one opportunity to enter/exit the trade. Here is an example of a rather "eventful" large-cap merger arbitrage case - notice how each event impacts the share price of the target company and in turn the spread (full write-up can be found here):

TIF EXAMPLE

  1. 28th Oct'19 - LVMH makes an unsolicited, preliminary offer at $120/share cash offer for jewelry retailer Tiffany ($TIF). Apparently, the market expects a higher bid, and $TIF shares jump 8% above the offer price and continues to trade at a premium.
  2. 20th Nov'19 - reportedly, LVMH raises the bid to $130/share. $TIF share price reacts mildly but then several days later both parties reach an agreement for LVMH to acquire $TIF for $135/share. The definitive (binding) agreement is signed. The remaining spread stands at 1%, so apparently, the market views the chances of the deal closing successfully as very high.
  3. End of Feb/early Mar'20 - fears over COVID-19 outbreak ramps up and market sell-off starts. Spread gradually increases.
  4. 18th March'20. The pear of market panic. TIF temporarily shuts down all of its US and Canadian stores. Spread increases to 22%. The next day rumors come out that the merger is still on and that LVMH might buy shares on the open market to smoothly digest the transaction. $TIF shares soar from $111/share (22% spread) to $126/share (7% spread).
  5. 20th Mar'20 - $TIF issues annual report in line with expectations (although revenues shrunk by 8% YoY). The share price tumbles initially but then jumps back up and settles at 5%-6% spread to the offer price.
  6. 22nd Apr'20 - $TIF tumbles on news that Sycamore Partners is trying to wiggle out of L Brands acquisition (one of the first attempts to break the merger agreement post-COVID). Spread increases from 4% to 8%, but then eventually narrows down to 4-5% again in the two upcoming weeks.
  7. 2nd Jun'20 - rumors appear that LVMH is concerned about the transaction and that the closing is uncertain. Spread increases from 5% to 18%.
  8. 3rd Jun'20 - reports come out saying that Bernard Arnault (CEO of LVMH) is talking with advisers to find ways to pressure the target company and cut the proposed price. Meanwhile, it is also stated that Tiffany is still in compliance with the financial covenants under the merger agreement as sees no basis for the price renegotiation.
  9. 5th Jun'20 - after considering the legal issues, LVMH is not looking to cut the price anymore but continues to closely monitor $TIF. Spread shrinks from 18% to 11%.
  10. 27th Jul'20. LVMH CEO states that despite the impact of COVID-19, they will respect the merger agreement. $TIF jumps up and the spread shrinks from 11% to 8%.
  11. 24th Aug'20. Both parties moved the initial closing deadline by 3 months to the 24th of November (ultimate deadline). The merger has still to acquire certain regulatory approvals including one from EU regulators. The market has viewed this as a substantial increase in the uncertainty and the spread widened from 6% to 11%.
  12. 9th Sep'20 - LVMH wrote a letter trying to wiggle out of the merger. Both parties went to court. Spread has increased from 11% to 19%.

 

TRANSACTION DETAILS

To assess the attractiveness of a specific merger arbitrage opportunity, it is important to thoroughly review all details of the transaction (press releases, presentations, the actual merger agreement and etc). The most detailed information is usually contained in the proxy statement which is filed under PREM14A (preliminary proxy) or DEF 14A (definitive proxy) forms some time after the initial merger announcement and before the shareholder's meeting to vote on the transaction. The proxy statement is meant to provide shareholders with extensive information in order to allow them to make an informed decision on whether to approve or reject the transaction.

Offer Type

Firstly, it is important to make a distinction between binding and non-binding offers as these indicate very different stages of the merger process.

  • Non-binding proposal: also known as preliminary, indicative, indefinite offer. Essentially is an "early-stage" offer, when a buyer is only expressing its interest in a target company. Such an offer doesn't legally bind the two firms - the buyer may change its intention and walk away freely at any time. A preliminary proposal usually comes with a due diligence condition, which has to be conducted before a firm offer is made. Naturally, any merger arbitrage at the non-binding stage is much riskier vs. the binding proposal (in Australia, preliminary agreements are even called the graveyard of merger arbitrageurs).
  • Binding proposal: this is a final/definitive agreement between a buyer and a target, which is also legally binding. The break of the agreement may result in termination fees and legal action. In the US it is common to announce the merger only at the stage of the definitive offer - when all other matters (due diligence, etc.) have already been settled. For other geographies such as US-listed Chinese companies, Australia, UK, etc. it is also a standard practice to publicly announce a non-binding agreement.

Another distinction that has to be made is whether the proposal comes as a friendly takeover or hostile. The difference is that in a "hostile" scenario, target company's management rejects or is against the transaction. In the latter case, to bypass the management's consent and proceed with the offer, the buyer usually has two choices. The offeror can either go to the target company's shareholders directly and launch a tender offer (subject to certain tender acceptance threshold) or initiate a proxy war against the management in order to replace the board/management.

If the initial hostile offer gets rejected by target's management, the spread usually widens as the risk of buyer walking away increases. However, this might also provide an attractive entry point to initiate an arbitrage position. Also, there's a possibility that a hostile offer will incentivize the management to enter into discussions with the buyer (or at least start exploring the strategic alternatives and potential sale), which eventually may lead to a "friendly" merger agreement between the parties.

In Nov'17 after CanniMed rejected the acquisition proposal from Aurora Cannabis, the buyer immediately turned hostile. With the support of the 3 largest CanniMed shareholders (owned 38%, while 66.7% was required) the buyer launched tender offerto acquire all CanniMed shares. The spread stood at 14% at the time. Next month, CanniMed went to regulators for protection (asking to view it as an insider bid with different filing/timing requirements) and then in January, both companies settled for a friendly merger agreement with far higher consideration ($43/share) relative to the initial offer ($24/share). In March, the acquisition was closed succesfully and generating 80% return in 4 months for arbitrageurs.

Merger Consideration

Usually, the consideration comes in one of these forms:

  • All Cash - a buyer is offering a fixed sum in cash for each share of a target company. This consideration type is often viewed by arbitrageurs as the 'best' mainly because no hedging is required (in contrast to stock consideration). The merger arbitrage is played by simply buying shares of the target company and waiting for them to get exchanged for cash or for the spread to narrow.
  • All Stock - a buyer is offering a certain amount of its own shares in exchange for each share of a target company. Arbitrage with all-stock consideration is more tricky and could be played both hedged and unhedged. Hedging involves 'locking-in' the spread by shorting buyer's shares alongside buying shares of the target company. This way one eliminates exposure to buyer's share price fluctuation. However, this comes at a price (borrow fees for shorted positions) and involves other risks (availability of stock to borrow, forced buy-in, and double exposure in case the merger fails). The size of the borrow fees varies depending on the liquidity of the stock (the number of shares available to be borrowed) and large borrow fees could eat up a considerable portion of the total upside, especially, in transactions involving smaller/less liquid companies. In some cases the main reason for the spread in all-stock mergers might be the lack of available or very expensive borrow - i.e. spread reflects the risks of expected volatility in buyer's shares and in turn in merger consideration. Unhedged arbitrageurs avoid paying the borrow fees but are left exposed to the changes in buyer's share price.
  • Mixed - a combination of both cash and stock.
  • CVR - alongside the above-mentioned options merger parties might also agree on contingent value rights (CVRs) as part of the merger consideration. CVR offers additional payments for the target company's shareholders if certain CVR conditions related to the business performance of the target are met. At the same time, buyer pays less for the acquisition if the operations underperform expectations (i.e. condition thresholds are not achieved). CVRs are quite popular in the pharmacy/medical industry mergers and are often conditioned on receiving FDA approvals or other milestones. Often in such situations, the upside of the whole trade lies in the value of the CVR (i.e. target's shares are trading at a premium to the merger consideration excluding CVR), so the key is to evaluate the chances of CVRs getting paid out eventually.

In 2019 Bristol-Myers acquired Celgene for 1 BMY share + $50 in cash per each CELG share. Additionally, the consideration included one tradeable CVR ($BMY-R) contingent on 3 separate drug approvals by the FDA - so the CVR makes the owner eligible for a $9 payment if all 3 drugs receive the approval by the end of March'21. In such cases there are two main risks to consider - the likelihood of meeting the required conditions and the risk of the buyer not being able to pay out the required sum eventually. Statistics showed relatively high average rate of approvals for each type of the drug, while given the size of and financial strenght of the combined company, the second risk seemed negligible. Overall, with the CVR trading at $3.48/share (159% upside) the situation seemed interesting. Currently, all required filings have been made (barely fitting in the deadline) and are under review by the FDA. Due to the approval risk and uncertainty regarding BMY's conflict of interests, the CVR currently trades at around $2/share (suggesting less than 25% chance of the successfull payout.

Buyer 

Nobody wants to find oneself invested in a merger arbitrage opportunity where a buyer simply changes its mind and walks away or where it eventually appears that the offer was fake from the very beginning (made not with the intention to take over the target company, but rather to lift its share price or some other motive). To avoid such situations, at least very basic buyer's due-diligence is necessary. It is important to understand not only whether the offer itself is legitimate, but also whether the acquisition makes sense for the buyer from financial and strategic perspectives. The questions to be answered are:

  • Why is this merger happening and what is the rationale behind the offer? If the buyer is a purely financial investor who is mainly interested in generating returns on this investment (either through cashflow generation or later sale of assets/company) then the price paid vs the potential valuation of the company will be a key aspect to check here (see also the shareholder approval/price section below). However, if it is a strategic buyer, whose goal is to buy the company for certain strategic applications (business expansion/growth, synergies, scale, efficiency, etc.), then it is necessary to understand the businesses of both parties and what synergies + additional benefits will the buyer derive from this acquisition.

As an example, let's take a Zyla Life (ZCOR) acquisition by Assertio Pharma. The buyer was transitioning from the previous opioid business due to certain regulatory issues and litigations. So it seemed that it is highly incentivized to replace the revenues of the divested opioid business with new revenues to live up to its growth story. ZCOR, with its high growth anti-inflammatory business and complementary portfolio (Assertio also owned 2 anti-inflammatory drugs) seemed like a perfect fit, therefore it was highly unlikely that the buyer would walk away. Therefore, given these points, a 26% spread seemed completely unreasonable. In the end, the idea was closed with 26% profit in 1 month.

  • Does the buyer seem credible? There is no single aspect that makes a company "credible", however, certain points such as a track record of creating shareholders' value, history of successful previously made acquisitions, larger market capitalization/assets under management, good reputation of management show credibility and provide a higher chance of things running smoothly. However, if the background check shows that the company or the people behind it have a questionable history (fraud, litigations, canceled transactions and etc) it is highly recommended to be very cautious before investing in such a situation.
  • How does the buyer intend to finance the transaction? If the buyer intends to pay with the cash on hand - it is important to check whether it has enough funds to do that (latest financial statement). If a buyer intends to finance the merger by raising equity/debt, then one needs to check the details of that as well - when/how exactly does a buyer expects to secure the needed funds or if the funding has already secured.

Of course, every situation is different and it is hard to draw any generalizations. Even if a buyer is a small, private firm with limited information available, it doesn't necessarily mean that the offer is fake and you should run from such merger arbitrage opportunity. However, even if the information on the buyer's company is limited, there might be some info available on the actual people behind it - either management or controlling/largest shareholders. Sometimes, their background might give you plenty of information needed to form an opinion on the buyer itself.

A good example here might be the acquisition of Input Capital (INP.V) by Bridgeway National. At a first glance, all other aspects appeared to be quite attractive - the price, the strategic rationale, the risk of shareholders' approval all seemed to be in favor of the successful closing of the offer. However, deeper due diligence showed, that the current CEO/chairman of the buyer has a history of multiple fraud stories and litigations. Moreover, the financial position of the buyer showed a very questionable ability to finance the acquisition, so very quickly this seemingly attractive idea turned into a very risky one.

Downside

Even if the initial research indicates that a certain merger arbitrage situation has a high likelihood of successful closure, it is crucial to weigh the potential losses as well. There is no magical risk/reward ratio as everything depends on a specific case (what are the remaining risks, timeline, etc.). However, betting for a potential 35% gain, while risking 20% should in most cases be more worthwhile than a situation with 5% potential profit and 80% downside. An estimate of the potential downside also helps with position sizing.

It is quite common to use the pre-announcement share price as a downside scenario. This assumes that in case the merger fails, the share price will return to the same level where the company traded before the offer was made. However, if during the time between the offer announcement and the merger break, a target company makes any significant announcements (e.g. quarterly/annual earnings) it may change the market's perception of the company, and the potential downside might increase/decrease accordingly.

 

SHAREHOLDER APPROVAL

Shareholder approval risk is one of the two major risks in most merger arbitrage cases with attractive spreads (the other being regulatory approval risks, discussed in the next section). Shareholder approval condition often requires serious consideration. Several general points worth checking:

  • Which approvals are needed? More often than not, only approval from the target company's shareholders is required, however, in some cases the consent from the buyer's shareholders might be needed as well.
  • What is the required approval rate? It might differ depending on the company's bylaws, jurisdiction in which the company is incorporated, and the acquirer (whether its an insider/shareholder or an outside buyer).
  • How many shares are already in favor of the transaction? Sometimes, the buyer already holds a significant stake (e.g. 44% in WUBA) before launching the offer. In other cases, major shareholders (e.g. 25% in PSSL) might have signed the support agreements beforehand indicating their intent to vote in favor of the offer. Pre-agreed support acts strongly in favor of the eventual shareholder approval.
  • Who are the major shareholders and how are they likely to vote? Information on major shareholders can be found in the annual report and proxy fillings. It is also worth checking the price at which price major shareholders have acquired their takes. In the U.S. this information might be found in 13D and 13G filings. One can also try tracing the stock acquisition price based on the filing date.
  • Are there any activist shareholders involved? See the "Activism" section below.
  • Are there any objecting shareholders? Any shareholders, especially with larger stakes in a target company and with vocal objections, that are opposing the merger, create a substantial hurdle for passing the vote (risk is elevated). In some cases, it might also present an opportunity and lead to an increased price, especially if the objecting shareholder is indicating a willingness to sell, just at a more appropriate price.
  • Recommendations by proxy companies. In the United States, more passive shareholders (index funds and some mutual funds) tend to vote in line with recommendations of the proxy advisory firms such as ISS (Institutional Shareholder Services), Glass Lewis, Egan-Jones, etc. Proxy firms conduct research on merger offers (especially larger ones) and prior to shareholder vote issue reports with their recommendations (support the transaction or not) and arguments behind. Therefore it is quite important to follow these reports and take them into consideration.

Once these points are taken care of, there are two other major aspects that need to be assessed:

Strategic Rationale for the Merger

It is very important to review the background of the merging companies in order to understand their businesses and motives behind the decision to merge. The strategic rationale plays a major part not only for a buyer (see "Buyer" section above) but for a target company as well and could be a key factor in securing shareholder approval (for both parties). For example, if a target company is struggling with its operations or is in a weak financial condition, a merger proposal might appear as a "lifeboat" to target's shareholders.

Zijin Mining offered Guyana Goldfields (GUY) cash consideration at a 2.6x level to the pre-COVID trading price. It seemed fair to assume that shareholders are going to vote in favor of the proposal as besides the significant value destruction and operational problems in recent years, GUY mine was in a certain transition of the mining phases, which required significant additional capital to proceed with. Given the capital needs, the company was projecting cash flow deficiency in 2020, so if the merger was to break, a significant financing raise (dilutive for current shareholders) would be needed. In the end, shareholders have approved the transaction and the merger closed with no hurdles.

Offer Price Adequacy

It is crucial to check if the offer price can be considered as "fair". Target company's shareholders will make their judgment on the proposal based on the value they're getting in return for surrendering shares of the company. Whereas, buyer's shareholders (in case their vote is needed) will try to evaluate if they are not actually overpaying. Unfortunately, there is no ultimate way to measure the attractiveness of the offer price, however, there are several points that could help arbitrageurs get a better view.

  • Offer valuation relative to the valuation of the listed peer companies, i.e. checking whether based on certain valuation metrics used within a specific industry the offer price makes sense and what is the risk that shareholders might view it as inadequate. E.g., if the merger is taking place at a significantly higher valuation multiple compared to its peer average, while its actual performance comes off only as average, shareholders of a buying company might oppose the transaction.
  • Recently closed transactions. Similar to above, the offer is compared to the valuations of recently closed transactions within both public and private markets within the same/related industries.
  • Worth noting that quite often one can find numerous details on these matters (i.e. peer comparison and valuations) in the investor documents presented by management. But be aware - these might be biased. Also quite often the offer needs to be approved as adequate by an independent expert/evaluator and their valuation and comparisons can also be found in the proxy statement (quite likely to be biased as well).
  • Comparing offer price to the historical trading range might also provide some (even if limited) insight into the likelihood of shareholder approval. If the offer price stands at the premium to the all-time high (e.g. NIBC) or at least a several-year-high, shareholders are much more likely to view the offer favorably. The opposite goes for the offers below the recent trading levels even if the company's financial position has deteriorated in the meantime.

Melrose Bancorp (MELR) was subject to acquisition by Cambridge Financial Group. Although the price offered to MELR (1.42x TBV) appeared to be lower than the average peer acquisition multiple of 1.68x, the fact that MELR was a tiny/low profitability bank (ROE just above 1%) made the offered price look quite fair, especially as it was at a decent premium to historical trading levels. Shareholders quickly voiced their support for the merger.

 

REGULATORY RISK

Regulatory approval requirements are specific for each case and depend on the transaction size, industry, market power of the companies in question, etc. The regulatory risk is more prominent and hard to handicap in larger transactions, while for the smaller deals (<$100m) unless the companies are in highly regulated industries (defense, military, etc.) such risk is negligible (often assumed to be very low/unimportant). The most common types of the needed consents are from the competition watchdog and foreign investment regulatory body.

Antitrust

In the United States, in order to comply with the competition/antitrust regulators (DOJ or FTC), both companies have to make certain premerger notification filings under the HSR antitrust act. The filings only have to be made if a target company is larger than $94m or the combined company's value is above $376m (smaller deals don't need antitrust approval). The investigating agency then has 90 days to review the filings and make the decision. If the regulator doesn't find any issues with the transaction it can approve the merger straightaway (early termination of the review period) or simply allow the whole review period to pass (90 days). However, if it considers that the merger could potentially harm competition in an industry (the combined company will have significant market share, pricing power, etc.), the regulator can block the merger or request additional filings for further review. Once the second request has been made, the merging companies have to make the required filings, which will be reviewed by the agency in an additional 30 days period. In other countries (UK, Australia, Canada, etc.) the antitrust regulation process is quite similar.

Only a limited number of merger transactions get rejected by the competition authorities. In order to raise some serious concerns for the watchdog, the combined company should have a significant market share/dominance in a certain industry (e.g. the blocked combination of two pharma giants Anthem (ANTM) and Cigna (CI) valued at $54bn). Naturally, in such cases the merging companies and the size of the transaction are usually quite large, meaning that big players / institutional arbitrage money is in the game. For these large-cap mergers, the regulatory risks have already been reviewed by numerous professional analysts and the spread most likely reflects the uncertainties related to approval (i.e. markets are pricing the arbitrage efficiently). Small investors are quite unlikely to have an edge here (aside from being lucky).

In contrast, when we talk about much smaller transactions (<$1bn) the merging companies usually have a limited market share and the antitrust review doesn't raise a significant threat. However, as always, there are cases with exceptions. especially when the buyer is a large-cap company;

Anheuser-Busch (BUD) was acquiring Craft Brew Alliance (BREW). Due to a small transaction size ($320m) and the tiny (1%) spread size before the COVID outbreak it seemed that antitrust approval shouldn't be a threat here. However, due to a relatively small size of the craft beer industry in which the buyer had a significant enough share already, regulators found issues with a potentially concentrated market share in the Hawaii craft beer market. Even after the companies agreed to make certain divestitures (sell some assets to lower the market share), regulatory approval still remains outstanding, however, the rumors are that the decision is going to be favorable. This caused spread to narrow materially and the idea was closed with 45% profit in 5 months.

Foreign Investment Regulators

The approval of foreign investment authority is usually required when companies from two different countries are merging. In the US, this regulatory body is called CFIUS (The Committee of Foreign Investment in the United States). CFIUS evaluation is not dependent on the merger size, however, it reviews the transaction based on national security concerns, the nationality of the foreign investor (e.g. Chinese investments are seen as high risk), target's involvement in national security activities or critical infrastructure in the US, and how close target's assets are too sensitive US government locations (like military installations). The whole review (from filing to approval) process usually takes from 4 to 6+ months.

The initial review takes 30 days after which CFIUS can either approve/reject the transaction or ask to initiate a second-stage review for an additional 45 days. Apparently, a secondary review is quite common - about 70% of the cases get the request for additional information. The average blocking rate stands at around 9%, which is quite low, however, cases of heightened sensitivity (Chinese investors) are getting blocked much more frequently - 43% rejection rate.

In light of these numbers, it is obvious that thorough CFIUS approval risk needs to be addressed before jumping into a merger arbitrage trade.

US-based UQM Technologies (UQM) was subject to an acquisition by Danish buyer Danfoss Power in 2019. The transaction was already approved by shareholders and the market viewed CFIUS approval as likely to be received - transaction traded at a 2-3% spread. However, CFIUS has extended the review period and initiated a second-stage review, which possibly indicated a heightened risk of potential issues found by the regulator and the spread widened to 14%. Nonetheless, alongside other positive factors (Gabelli fund increasing its stake in UQM), the analysis showed that the CFIUS blocking risk is low as 1) the buyer was from a lower risk country (Denmark); 2) neither of the companies was involved in national defense or related activities; 3) UQM didn't seem to be involved in any critical infrastructure-related activities and did not generate any revenues from the US government; 4) being near the strategic (military) location also seemed to be not an issue as in such case, the transaction would likely get blocked straightaway; 5) the management was very positive regarding the eventual approval (it should be taken into consideration as the management is better informed - even if always biased - than any retail investor could strive to be). Taking all these factors into account, it seemed like an attractive opportunity and eventually, CFIUS approval was received resulting in a low-risk 6% profit in one month (72% IRR).

International mergers

International mergers, where the merging companies have operations in multiple countries, may be required to receive regulatory approvals from multiple countries at once. For example, the current Tiffany (TIF) acquisition by LVMH is subject to regulatory consents from Mexico, Russia, China, Taiwan, Korea, Europe as well as Australian foreign investment authority. Such mergers are always more complex, prone to delays, and involve a greater amount of risk, which is not always possible to handicap due to limited available information. A good starting point to look into would be the market share held by the merging companies in each country as well as the nature of their operations (involvement in sensitive industries). However, even then some nuances might be left in a rather blind spot:

Israeli satellite networking provider Gilat Satellite Networks (GILT) is subject to an acquisition by the US peer Comtech (CMTL). The merger has already collected all the required approvals except for the consent from Russian regulators, who have extended the review period for up to several months. On one hand, it seems that the market share matters should not be a problem as revenues from Russia would only make a small portion of the combined company revenues. However, both GILT and CMTL provide services to several different governments around the world, so there might be some political/strategic issues involved. What is more, due to confidentiallity concerns, neither of the companies disclose details about the nature of the services that are provided to the governments, making it very hard to estimate the potential outcome of such review. In such cases, an investor could look for other points that could help him paint a better picture. For example, in the GILT/CMTL situation favourable regulatory decision from Russia could be expected based on: 1) the already received approval from US regulators; 2) the way the Russian review extension was discussed on the CMTL conference call - making it seem more of the administrative issue than a serious threat; 3) small size of the initial spread (1-3%), showing that the market viewed an approval from Russian as very likely. Nonetheless, even then, and especially in countries with heightened risk (China, Russia, etc.) regulatory decisions might remain unpredictable and be based on policital environment bringing substantial uncertainty to the table.

 

ACTIVISM

The involvement and support of activist investors is usually a very positive point for merger arbitrageurs - it indicates higher chances of the situation developing favorably.

An activist investor is an individual or a group that usually has material ownership in a target company and tries to push the shareholder-value-favorable agenda. Sometimes, the activist himself wants to acquire the company but gets rejected by management (see Offer Type/proxy fight section above). In some cases, where no offer is put on the table yet, an activist campaign emphasizing the undervaluation of the company might raise market awareness of the situation and put the company on the table as a potential acquisition target. In other cases, activist shareholders might help target company to fight off an unwanted/undervaluing takeover offer or even raise the offer's price.

In Sep'18 Arclight made an takeover offer for O&G industry player American Midstream (MID) at $6.1/share. Then due to oil price crash in late 2018 and 30% drop in AMID price, the buyer amended the proposal to $4.5/share in Jan'19. However, the oil price dropped to only $50/share, while the amended offer price stood at the AMID trading levels of early 2016 when the oil price was at $30. This made Arclight's actions seem very opportunistic and as Arclight already controlled 51% of AMID, no shareholder approval was required for the transaction to close. However, activist shareholders have raised a lot of noise arguing that the offer is strongly undervaluing the company, encouraging the independent board committee to reject the proposal and even accuse Arclight of dirty plays (intentionally driving AMID into the lows to buy it out cheaply). As a result, a few months later the price got sweetened to $5.1/share resulting in 31% gain in short period for those who were betting on the success of the activist campaign.

In the United States, when an activist asserts an active role in shareholding, it is usually required to file Schedule 13D. This filing includes the "Purpose of this transaction" section, where more information can be found on the actual intents of the activist. Also, there are often numerous public exchanges between the activist and the company that might provide further valuable information on the situation as well as the potential valuation of the company in question.

 

COMPETING BIDS

The presence of other bidders (official or rumors only) shows the potential for the situation to develop into a bidding-war. Bidding-wars usually result in very lucrative situations for the target's shareholders as well as merger arbitrageurs. This is well illustrated (although could hardly have been predicted in the early stages) by the bidding-war between Visa and Mastercard for the payment processor Earthport:

On the 24th of Dec'18 Earthport's shares closed at £0.07/share. The next trading day Visa tabled a £0.30/share (300% premium). In January'19 Mastercard joined the bidding with £0.33/share proposal. Then next month, in February, Visa sweetened its offer to £0.37/share after which Mastercard withdrew its bid. Overall, Earthport shareholders saw the company's share price increased by 5x in a few months.

The whole history and involvement of other potentially interested parties in the early stages (i.e. pre-announcement) of the merger process can be found in the "Background" section of the proxy document. Interests from other parties in post-announcement stages are revealed through press-releases and rumors.

Aside from the larger potential upside, the presence of competing bidders also significantly reduces the downside in case the merger fails. If the proxy document (or other sources) indicates a high number of interested parties with whom the discussion progressed to preliminary offers, then in case the current buyer walks away from the transaction, another party might step in.

Some merger agreements (not all) might include a go-shop period, which is a time (usually 30 days) in which after signing a definitive agreement with a buyer, the target may still go and look for other potential acquirers (that may offer a better price). If other bidders step up during the go-shop period, the target company may break the merger agreement without penalty. This provision makes the situation more favorable from the upsized offer perspective, especially if some of the shareholders voice concerns that the current offer undervalues the company.

 

TERMINATION FEE

The termination fee is a pre-agreed penalty payment if one of the merging parties breaks the merger agreement - e.g. if the target company breaks the existing offer in order to pursue a higher one. In such case, it would have to pay the pre-agreed termination fee to the previous buyer. Sometimes (not often) the termination fee clauses even include failure to obtain shareholder approval or regulatory consent.

The usual size of the termination fee stands at around 3-5% of the merger consideration, thus lower or higher amounts might indicate the level of buyer's commitment to the merger. Worth noting that in certain cases, the termination fee size from the buyer's side could be large enough to even provide weighty downside protection.

 

DELAYS IN CLOSING

This is an important piece to consider from the perspective of potential "risks" as any delays in finalizing the merger may indicate potential problems and create a lot of additional uncertainty. There are multiple negative effects of the delays/extended timeline:

  • Delays quite often indicate that the risks of transaction not passing one of the hurdles is larger than initially expected - the delay usually comes a result of a prolonged regulatory review, problems with financing, due diligence, etc. This increases the uncertainty and impacts the share price of both companies.
  • Delays inflate hedging costs for all stock transactions;
  • Delays in spread elimination lower the IRR of the arbitrage;
  • Finally, any delay increases the risk of a merger getting terminated by one of the parties - commonly, a merger agreement comes with a certain "outside date" (also called as drop-dead date, termination date, end date, etc.), that is a deadline for the merger completion. If the merger process passes the outside date, both parties can (not must) terminate the transaction, usually, without any penalties. Of course, usually, both parties are incentivized to merge and continue to proceed with the process, in this case the outside date simply gets extended. However, given the fact that some strong hurdles may have already appeared, the penalty-free termination might make it easier for either side to decide to break the agreement.

An example here could be the merger of Qualcomm (QCOM) and NXP Semiconductors (NXPI) - both companies agreed to combine in Oct'16 and despite receiving all the other required approvals, both companies failed to acquire consent from Chinese regulators. The initial end date of Oct'17 was extended multiple times until QCOM (the buyer) finally decided to stop pursuing the merger and terminated the transaction. The market wasn't really surprised by the move and NXP shares fell only 7% post-announcement.

 

MERGER ARBITRAGE IN OVERHYPED INDUSTRIES

Worth noting that it might be a good idea to avoid merger arbitrage in risky/overhyped industries - cannabis, blockchain, lithium, etc. Risks in these industries are much harder to handicap and the outcome of merger arbitrage is often less predictable. It is also more difficult to evaluate the background of the transaction (motivation of both parties) and assess the "fairness" of the offer (the valuations of these industries tend to be exaggerated and driven by day traders). Worth noting that sometimes, the connection to a risky industry might be not as obvious on the first glance:

Summit Bancshares (SMAL) was subject to an acquisition by Faciam Holdings. At first glance, this could've looked like a standard small bank acquisition, and initially, all aspects seemed quite fine (the price, shareholder approval, valuation of the target company, etc.). However, digging deeper it appeared that the buyer is actually interested not in the bank itself, but rather in providing financial services to MRB (marijuana-related businesses). These intentions were included in the new plan for SMAL under the merger agreement and had to be approved by the regulators. Unfortunately, it appeared that regulators did not want to provide consent for such services officially eventhough numerous other banks were successfully providing services to MRB 'semi-officially'. This has materially complicated the whole situation and eventually, both firms have decided to terminate the merger.

 

SUMMARY GUIDELINE FOR MERGER ARBITRAGE

To conclude this article, here is a short summary note on what to look for and check when researching a merger arbitrage opportunity:

  • Why does the spread exist? What are the main risks and conditions (shareholder approval, regulatory consent, etc.)?
  • Is the spread appropriate given the risks or this the market mispricing this opportunity?
  • What is the downside if the transaction fails? How does the risk/reward look like? Collecting pennies in front of a steamroller might not be the best strategy for generating investment returns.
  • What kind of offer is this? Non-binding and hostile offers are more uncertain, but in certain cases might offer a larger upside.
  • What is the type of consideration offered? If this is an all-stock merger - are there enough shortable shares available for hedging? The payment of CVRs usually takes much longer than the closing of the merger itself.
  • What is the strategic rationale behind the offer for both parties?
  • Is the buyer credible? Will it be able to finance the transaction?
  • What is the estimated timeline? What are the chances of it being delayed? International mergers are prone to delays. Large-cap mergers have a higher risk of this as well.
  • Where there any other bidders? Is there a possibility of a bidding war? In case the current deal fails, how likely is it for another bidder to appear? Is there a go-shop period?
  • Are there any activist shareholders involved? What are their intentions/agenda?
  • How likely is the approval from shareholders? Does the offered price seem "fair" for both sides? What other aspects are present that could impact the decision of shareholders? Who are the major shareholders and how are they likely to vote?
  • Are there any objecting shareholders?
  • What regulatory approvals are required? What issues could regulators potentially find with the merger (competition, national security)? Regulatory risk is hard to handicap, however, small/micro-cap transactions usually get approvals easier.
  • What is the termination fee? And does it offer any downside protection?
  • Position sizing - can one stomach the downside the transaction fails, or add to the position if the spread increases?
  • In what industry the merger takes place? It might be good to avoid overhyped industries.
  • What are the chances one still missing something? For larger size transaction spreads almost always exist for a reason

5 COMMENTS

  1. Michael Lax

    Thanks, this is a very informative article. What are the statistics on percentage of deals which break, average returns etc?

    1. Zulu Investor

      Someone correct me if I am wrong…but mergers that have the S&P 500 as the acquirer 92% of the time the deal goes through. 8% of the time the deal does not. I read that in a book once. I think it was from Keith Moore’s book “Merger Arbitrage”

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