December 27, 2024 – The “risk” in risk arbitrage symbolizes the need for a cautious and attentive approach by experienced investors when managing merger arbitrage portfolios.

The term risk arbitrage emphasizes that while the investment strategy seeks to capitalize on arbitrage-like opportunities in pricing, the arbitrage profits are not guaranteed because the outcome of mergers and acquisitions carries uncertainty. Risk arbitrage highlights the interplay of reward and uncertainty that defines the merger arbitrage investment approach. Potential deal risks include regulatory approval delays or roadblocks, and financing or shareholder approval challenges, all of which may result in the failure of the deal, which can cause the arbitrageur to lose money.

“If you take care of the downside, the upside takes care of itself,” is a phrase that embodies the principle of risk management and prudent decision-making. While applicable to many asset classes and strategies, the phrase is perhaps no more appropriate than for the meticulous management of a merger arbitrage strategy.

Success in merger arbitrage depends more on what you do not own than what you own. Dodging landmines of deals that run into problems and not making the mistake of investing in deals that fall apart is key to harvesting the attractive yields offered by the arbitrage universe. While the average merger arbitrage yield of 11.9% looks enticing, deal delays and terminations make capturing most of this yield challenging.

Nevertheless, mitigating risk by evading the money-losing deal terminations, while participating in the upside by owning the successful mergers that close in line with expectations, requires skill and experience. This dynamic was well exemplified in December, which featured a higher than average number of deal terminations, along with several transactions that experienced turbulence, a sign of a future potential merger termination.

It is helpful to look at the data and events to analyze why the terminated mergers were problematic or presented an unattractive risk-reward profile, and the reasons why the Accelerate Arbitrage team avoided investing in them in our review of December’s deal debacles:

1. Poor antitrust fundamentals – The Biden administration has faced significant pressure from the adverse effects of inflation, particularly regarding the rising prices of food. This sensitivity explains why the proposed $25 billion merger of America’s top two largest grocery store operators, Albertsons and Kroger, announced in October 2022, was doomed from the start. The companies’ strategy behind the merger was to better compete with retail giants Walmart and Costco. In order to quell concerns of antitrust regulators, they presented a modest divestiture package. Nevertheless, we believed the proposed combination was a bridge too far amidst perhaps the most litigious antitrust cops in modern history. As expected, in February of this year, the FTC sued to block Kroger’s acquisition of Albertsons. As we believed was probable, on December 10th, a U.S. judge blocked the merger. The merger of the #1 and #2 players in an industry facing significant government scrutiny amidst an extremely combative antitrust regulator should be avoided by arbitrageurs.

2. Lack of buyer credibility – One of the major considerations when judging the probability of a merger closing is the acquiror’s credibility. Specifically, one must judge whether the buyer has the means and ability to consummate a transaction. In an all-cash deal, one simple question to ask is – does the buyer have the money? In the case of Fury Resources proposed $450 million acquisition of Battalion Oil Corporation announced in December 2023, it appeared clear from the start that the acquiror did not have the financial resources necessary to complete the transaction. Despite the proposed deal dragging on for more than a year, along with getting repriced -29% lower, it ultimately faced a financing failure, and as a result, was terminated last week. Transactions featuring an acquiror with no track record of acquisitions and no highly certain access to sufficient capital, such as a private equity fund or cash on hand as evidenced through public financial statements, should be avoided by arbitrageurs.

3. Unattractive risk-reward dynamic – The most straightforward deals to avoid are those that offer little, or negative, return for substantial risk. This unattractive risk-reward dynamic emerged in ARC Financial’s proposed $459 million take-private of STEP Energy Services announced last month. While the private equity buyer was credible and had sufficient funds, and the deal presented effectively zero antitrust risk, the main issue was the market price relative to the downside risk. Upon deal announcement, the share price of STEP quickly escalated to levels that presented a negative expected return for arbitrageurs as overzealous traders priced in overbid potential. The buyer already owned 57% of the target’s shares, making an overbid all but impossible, and made it clear that ARC Financial would not increase the consideration paid under any circumstances. The hedge funds that bought the target’s shares above the consideration, only to vote down the deal, faced steep losses after the transaction was terminated last week due to shareholder vote failure. It is straightforward that merger investments with a low (or negative) return, combined with significant downside risk, should be avoided by arbitrageurs.

2024 Review

For merger arbitrageurs, aside from the arbitrage yields offered by the market, three deal universe characteristics of the asset class matter most for returns: Number of deals, termination rate, and overbid rate.

Source: Accelerate

In the context of these three metrics, North American merger arbitrage in 2024 was more demanding compared to 2023. The number of public M&A transactions in North America declined by -13.6%, generating fewer opportunities for arbitrageurs to put money to work. The deal termination rate increased from 5.6% to 5.9%, slightly higher than the 5.5% merger termination rate since 2011. Meanwhile, the percentage of deals featuring an overbid, in which the consideration received by an arbitrageur is increased, fell from 1.9% to just 1.1%, significantly lower than the 4.4% overbid rate since 2011.

All three metrics deteriorated since last year, making a more challenging environment for merger arbitrage.

That said, if an arbitrageur was able to successfully navigate an environment fraught with risk, they were able to capitalize on high arbitrage yields and generate attractive risk-adjusted returns for clients this year.

As for what’s next, an upcoming change in administration in both the U.S. and Canada should create a more generous environment for M&A, with reduced regulatory scrutiny expected to lower deal termination rates while supporting attractive merger arbitrage yields through fewer deal delays and hurdles. Increased animal spirits, lifted by a friendlier regulatory and capital markets environment, may lift the fortunes of merger arbitrageurs next year.

Here’s to navigating the financial landscape with confidence in 2025 and making it a year of tremendous investing success.

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.