March 25, 2023 – Increased regulatory scrutiny, particularly the probing by antitrust regulators, can make mergers and acquisitions more challenging to consummate and require a longer duration to complete.
Antitrust laws aim to promote competition and prevent anti-competitive behaviour, such as monopolies, in the marketplace. When companies propose to merge, regulatory agencies (particularly in the U.S.) examine the deal to ensure it does not violate antitrust laws. In addition, large M&A deals may present timely PR opportunities for silver-tongued demagogues seeking to score political points by opposing corporate consolidation.
The regulatory process can involve extensive analysis of market dynamics, competitive landscape, and potential impact on consumers. Regulators may request documents, data, and interviews with key stakeholders to assess the proposed transaction’s impact on competition. This investigation can consume a significant amount of time and resources, potentially delaying the deal’s closing.
Regulatory and timing uncertainty can create several issues for investors. First, the uncertainty surrounding regulatory approval can lead to increased volatility in the stock price of the target company. This volatility can make portfolio management decisions, including sizing of a position and volatility management, more complex.
Second, the delay in the closing of deals can lead to increased costs and reduced yields for the arbitrageur. The longer the process takes, the more interest the arbitrageur will pay on their (typically) leveraged merger arbitrage investments. Generally, the longer the deal drags, the lower the yield.
Finally, additional downside share volatility could make it more likely that the acquiror seeks a price cut and the target agrees to one. For example, it is much easier to restrike a $25.00 deal down to $20.00 when the target share price has reduced to $15.00 in a bear market.
Merger arbitrageurs have taken these considerations into account and have adjusted deal probabilities accordingly (manifested via the share price of M&A targets).
Historically, 94% of public U.S. mergers and acquisitions have closed successfully. As a result, merger arbitrageurs generate attractive returns by capitalizing on the merger risk premium and investing in deals with average implied closing probabilities below the historical rate.
For example, pre-Covid, the average implied deal completion probability, as indicated by the spread of a merger target compared to the merger consideration, implied an average 91% merger completion rate.
Given the current politicized regulatory environment, the average implied deal completion has dropped to below 82%, well under the historical M&A closing rate of 94%.
Pre-Covid, the spread between the market implied closing rate and the actual closing rate was just 3%. Now, that spread has expanded to 12%.
While the widening differential between the actual closing rate and that implied by the market (caused by wider merger spreads) has created an opportunity for merger arbitrageurs, the consternation in the market caused by regulatory uncertainty has created an interesting dichotomy in the market.
Relatively low-risk deals with minimal regulatory concerns can trade at tight spreads, while “hairy” deals with antitrust concerns generally trade at extremely wide spreads.
The percentage of M&A transactions that we classify as “distressed”, defined as trading below an 85% implied probability of success, has surged from under 10% in 2019 to approximately one-third currently.
In the current market environment, one’s success as an arbitrageur is more related to the deals one did not invest in than the ones that were.
The current suite of distressed mergers is a venerable murderer’s row of large-cap consolidation. The currently highly politicized and treacherous regulatory environment means that any strategic acquisition above $10 billion will face issues, leading to delays and volatility at best and deal termination at worst.
One factor on the investors’ side is that any challenge from antitrust regulators must stand in court. However, even if the regulators lose in court, as has been happening more often than not, the significant delay in the timing of closing that they cause can damage investors’ returns. Ultimately, these delays, and the related volatility of an antitrust challenge, must be accounted for when entering a merger arbitrage investment. Therefore, the yield must compensate investors for these risks.
Reflecting on this dynamic, the higher the yield to arbitrageurs, the better.
Source: Accelerate, Bloomberg
After dipping to a frustratingly low level in February and early March, merger arbitrage yields of 11% are again attractive compared to other fixed-income investments such as junk bonds. The current double-digit expected yield from merger arbitrage is (hopefully) sufficient to compensate investors for the outstanding risks.
In any event, it makes for a smoother ride in merger arbitrage to stay away from the problematic, although high-yielding, deals. What this means for investors is to stick with small and medium-cap mergers and acquisitions along with private equity buyouts where there’s no competitive overlap. Picking these spots will likely provide the highest risk-adjusted returns, and most certainly, the best return on brain damage.
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.
* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit Alpharank.com for more information. Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Accelerate may have positions in securities mentioned. Past performance is not indicative of future results.