June 25, 2024 – In last month’s Merger Monitor, Hipster Antitrust, we discussed the FTC’s aggressive approach to antitrust regulations. We concluded that its actions have thus far not resulted in a demonstrably higher deal termination rate nor longer average deal timelines (at least not yet). So far, its bark has been louder than its bite.
Nevertheless, antitrust rhetoric can lead to deal drama and headline risk, resulting in excess volatility in targeted and tangential merger arbitrage spreads. Even though merging parties often include the chance of regulatory delays within the estimated closing guidance of their announced transaction, any whiff of antitrust authorities poking around can send a merger arbitrage spread into a tailspin. Arbitrageurs have the itchiest of trigger fingers, with a fire, ready, aim mentality. Elevated risk premia are rapidly priced into merger arbitrageur spreads, whether deserving or not.
That being said, regulatory affairs, be it antitrust or foreign direct investment related, and their resulting potential for deal drama or delays, are generally known upfront. These are what we call “known unknowns”.
Known unknowns are risks or uncertainties that investors are aware of but cannot accurately predict or measure. These are factors that are acknowledged as potential issues, but their outcomes or impacts are uncertain. Understanding and managing known unknowns, such as a regulatory challenge or quarterly financial performance below expectations, is crucial for risk management in investing.
Conversely, where analysis and risk management becomes trickier is with unknown unknowns.
Unknown unknowns are risks or uncertainties that investors are not aware of and cannot predict. These are factors that come as complete surprises because they are outside the realm of known possibilities. Unknown unknowns are the most challenging to prepare for because they are unforeseen and unprecedented. Investors often refer to these events as “black swans”.
There have been several unknown unknowns, or events that came entirely out of left field, that have led to mergers falling apart over the years.
- TD Bank’s $13.4 billion proposed acquisition of First Horizon was terminated in May 2023, 14 months after the deal was announced, after multiple U.S. regulators popped TD for significant money-laundering violations (unrelated to the merger).
- Vintage Capital’s $654 million deal for Rent-A-Center was terminated in December 2018, more than a year after striking the definitive agreement, after Vintage forgot to extend the deal’s outside date. You do not often see such a minor detail overlooked that resulted in such major implications. Nonetheless, arbitrageurs were generally ok on this trade, as the stock traded up after the target terminated the deal.
- Pfizer’s $120 billion planned merger and tax inversion (back when these were a thing) with Allergan, fell apart in November 2016. The deal terminated one year post announcement after the U.S. Government announced a new law specifically crafted to block the transaction.
Known unknowns are par for the course in merger arbitrage, with the major known risks including antitrust laws (i.e. FTC), foreign direct investment laws (i.e. CFIUS), shareholder votes, financing, industry specific regulatory approval (i.e. FERC), etc. In terms of odds of success, some are easier to handicap than others.
It is the unknown unknowns that can come out of the blue and burn arbitrageurs. A recent black swan deal event occurred with Chevron’s proposed acquisition of Hess.
In October 2023, Chevron announced a friendly acquisition of Hess in an all-stock merger valued at $60 billion. The deal came less than two weeks after Exxon Mobil announced its blockbuster $64.5 billion acquisition of Pioneer Natural Resources.
Historically, oil & gas mergers have been relatively straightforward, requiring basic antitrust approvals (which tend to be simple given they are commodity producers) and a shareholder vote.
In contrast to Exxon’s Pioneer deal, which closed within the companies’ initial guidance at under seven months, the Hess/Chevron merger is eight months in with little prospect of closing in the near term.
The unknown unknown with respect to the Hess/Chevron was an unprecedented event. Many oil & gas assets are subject to a “right of first refusal” (ROFR), a standard agreement that allows a partner in the ownership of an asset the right to acquire the stake if it is up for grabs. However, a ROFR does not apply in a corporation transaction, and dozens of oil companies are sold every year, never having an asset-level ROFR issue pop up.
Hess’ crown jewel asset is its stake in the Stabroek Block in Guyana, one of the biggest oil discoveries in recent history. Exxon is the operator of the asset.
While the merger was expected to go off without a hitch, with company closing guidance for the first half of 2024 (an expected 7 month closing timeline), Exxon had other plans. Even though the typical ROFR does not apply in a corporate transaction, five months after the Hess/Chevron merger was announced, Exxon unexpectedly decided to file for arbitration around the applicability of the ROFR.
Exxon’s attack on the merger was a headscratcher, not only because asset-level ROFRs do not apply to corporate transactions, but strategically, there was little in it for Exxon. If Exxon challenged the deal and lost, they’d be out of pocket the legal fees, while angering a partner. If Exxon won, Hess would return to business as usual with its stake in the Exxon-operated asset in Guyana. Exxon has no mechanism to acquire the asset, aside from bidding on Hess en bloc, which they decided against.
Besides opportunistically looking for a potential nuisance payout, the only other explanation for Exxon’s actions is solely to throw sand in the gears of a competitor’s deal. “Just for the lols” as the kids say.
While the Exxon arbitration against Hess/Chevron will likely fail, it will be successful in materially delaying the deal. What was originally a first half of 2024 closing date, the merger is now expected to close in late 2024 or early 2025. A delay like that reduces the merger arbitrage yield materially, making what looked like an attractive investment into one that’s fairly undesirable.
In any event, the lesson learned is that unknown unknowns can never be predicted. Therefore, the only way to fortify portfolios against these black swans events is to diversify sufficiently.
As they say, diversification is the only free lunch in investing. While that statement is true from an asset allocation perspective (we recommend allocating to at least 10 asset classes to be properly diversified), it is particularly true in merger arbitrage. An arbitrageur can protect from the unknown unknowns by running a well diversified portfolio of (ideally) uncorrelated arbitrage investments, such that it can confidently withstand any single black swan event without much issue (or negative P&L effect).
The AlphaRank.com Merger Monitor below represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized returns of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.
Each individual merger is assigned a risk rating:
- AA – a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
- A – a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
- BBB – a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
- BB – a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
- B – a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
- CCC – a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
- NR – a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.
The AlphaRank merger analytics database is utilized in running the Accelerate Arbitrage Fund (TSX: ARB), which may have positions in some of the securities mentioned.
