September 28, 2024 – Merger arbitrage is an investment strategy that capitalizes on the spread between a company’s current share price and the consideration paid for its acquisition in light of an announced merger transaction. The merger risk premium— or the spread between the acquisition price and the trading price of a stock—compensates the arbitrageur for the risk of the acquisition failing to close. The merger arbitrageur’s goal is to “lock in” the spread earned upon deal closing and to profit from buying a takeover stock at a discount to its acquisition price.
In short, successful merger arbitrage is akin to buying a dollar for 95 cents.
The primary goal of merger arbitrage is to profit from the specific price movement of a stock involved in a merger rather than from the overall direction of the market, while the strategy’s success hinges on the completion of the deal rather than on broader market trends. If the merger goes through as planned, the target company’s stock price will converge to the acquisition price, regardless of whether the stock market goes up or down.
Because it doesn’t rely on the overall market direction, merger arbitrage can provide returns that are less correlated with the market. This lack of correlation makes it particularly attractive in times of market uncertainty or downturns, as well as an effective portfolio diversification tool.
Being market-neutral, merger arbitrage adds a layer of diversification to an investment portfolio, reducing overall portfolio risk by not being tied directly to market fluctuations. Given its lack of reliance on unpredictable stock market movements, arbitrage can produce consistent investment results and make for a compelling long-term portfolio allocation.
Over the past 25 years, the arbitrage index has returned 6.7% annually, with volatility of 3.2% and a Sharpe ratio (return per unit of risk) of 1.46. In comparison, the long-term Sharpe ratio of the S&P 500 is approximately 0.6, or less than half that of arbitrage.
The arbitrage index has only had two down years over the past quarter century.
Source: Bloomberg, Eurekahedge
Given its attractive risk-adjusted return metrics, along with its diversification benefits such as a limited beta and low correlation compared to stocks and bonds, arbitrage has served as an effective addition to a balanced portfolio.
Over the past 25 years (since the inception of the Eurekahedge Arbitrage Hedge Fund Index), a global 50% stock and 50% bond portfolio has returned 5.2% annually with a Sharpe ratio of 0.55. By adding a 20% arbitrage sleeve to the global balanced stock and bond portfolio, the annualized return over the past quarter century increased by 30bps per annum to 5.5%, while more importantly, the Sharpe ratio increased by 25.5% to 0.69.
In addition, during major equity drawdown events, including 2000, 2008, and 2022, the addition of arbitrage led to a meaningful reduction in portfolio drawdown. The performance of the global balanced portfolio (light blue line) compared to the 80% stock/bond + 20% arbitrage portfolio (dark blue line) is seen below.
Source: Accelerate, Bloomberg
Despite its track record of success in increasing portfolio returns while reducing portfolio risk, arbitrage is still widely underutilized by allocators. It is not a glamourous strategy that will make one rich quick, and its historically consistent high single-digit annualized returns are not necessarily exciting (although I personally find long-term Sharpe ratios above 1.0 quite intoxicating). However, some of the world’s top allocators have long been proponents of the strategy.
Many people do not realize that the greatest of all time arbitrageur is none other than Warren Buffett. While the famed Oracle of Omaha is celebrated for “buying great businesses at fair prices” for conglomerate Berkshire Hathaway, he has made his most significant investment returns (on a percentage basis) through arbitrage.
One of Buffett’s earliest documented arbitrage investments occurred 70 years ago. In the early 1950s, Warren Buffett worked for his mentor, Benjamin Graham, at Graham-Newman Corp., an investment partnership. During this time, Graham taught Buffett the principles of value investing, which included looking for undervalued assets and arbitrage situations where market prices deviated from intrinsic value.
Around 1954, Buffett came across an opportunity with Rockwood & Company, a Brooklyn-based chocolate manufacturer. The company was controlled by Jay Pritzker, who later became known for his business empire including the Hyatt Hotels. Rockwood was sitting on a large inventory of cocoa beans when the price of cocoa had skyrocketed due to a temporary shortage, from about 5 cents per pound to over 60 cents.
Jay Pritzker devised an ingenious plan to capitalize on this price surge without incurring hefty taxes. An arcane provision in the tax code allowed a company to avoid taxes on inventory profits if the inventory was distributed to shareholders as part of narrowing the company’s business scope. Rockwood decided to use this loophole by initiating a share repurchase program where shareholders could exchange their shares for cocoa beans.
Buffett recognized that by buying Rockwood shares, exchanging them for cocoa beans, and then selling these beans, he could make an arbitrage profit. The shares were trading at a price that, when exchanged for beans, offered the beans at a discount compared to the market price for cocoa.
He spent several weeks buying Rockwood’s shares, trading them for warehouse receipts representing the cocoa beans, and then selling these beans in the commodities market. This type of trading was arbitrage in its classic form: profiting from price discrepancies in different markets.
Buffett’s cocoa bean arbitrage is a lesser-known but classic example of his early arbitrage investment strategies. He continued to execute arbitrage strategies over the next several decades that helped him compile the greatest investment track record the world has ever known.
For example, in Berkshire Hathaway’s 1988 Chairman’s Letter, Buffett detailed how “we made unusually large profits from arbitrage, measured both by absolute dollars and rate of return. Our pre-tax gain was about $78 million on average invested funds of about $147 million.” This performance resulted in a 53% return for Berkshire Hathaway through arbitrage for the year.
In his 1988 annual letter, Buffett described arbitrage as “the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market,” detailing several successful arbitrage investments that year, including in the buyouts of Arcata and RJR Nabisco by private equity firm KKR.
It was during the period that Buffett was heavily focused on arbitrage that he produced his best investment returns. However, he became a victim of his own success, and Berkshire grew so big that its investible universe shrank significantly. Berkshire’s current $1 trillion market capitalization limits Buffett’s investment activities to buyouts and large cap stocks. For reference, the entire U.S. merger arbitrage market is currently approximately half of Berkshire’s market cap.
Nonetheless, assuming one runs a portfolio smaller than Warren Buffett, adding merger arbitrage to an investment portfolio can enhance diversification, providing a hedge against market volatility while offering a steady source of returns. Its low-risk, event-driven nature makes it an attractive option for investors seeking to balance risk with reward, particularly in portfolios that aim for steady growth with minimized exposure to market swings.
As for recent deal activity, in September there were 12 public mergers announced in the U.S. and Canada, representing an aggregate value of more than $30 billion. Notable deals announced include Verizon Communications’ $20 billion merger with pure-play fiber provider Frontier Communications, Blackstone and Vista Equity Partners’ $8.4 billion buyout of enterprise software company Smartsheet, and Anglogold Ashanti’s $3.2 billion acquisition of Egyptian gold miner Centamin (Disclosure: Accelerate Arbitrage Fund (TSX: ARB) holds several of these securities). Nine deals worth a total of $26 billion closed during the month, while one transaction, WillScot’s proposed merger with McGrath RentCorp, was terminated after facing pushback from the FTC.
A notable event affecting the merger arbitrage market was the Federal Reserve’s recent 50bps cut in the benchmark interest rate. We believe that lower interest rates may spur increased M&A activity with reduced financing costs allowing acquirors to step back into the merger market (particularly private equity firms, who have an estimated $1 trillion of dry powder to put to work).
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.
