August 31, 2024 – The phrase, “picking up pennies in front of a steamroller,” is often used on Wall Street to describe an investment strategy offering small, consistent gains but involves taking on significant risk. The idea is that while you might be able to pick up some pennies (small profits) most of the time, the rare but large potential downside (getting crushed by the steamroller) could be catastrophic. The underlying risks are often overlooked or underestimated, and when these risks materialize, they can lead to significant losses.
There is a myriad of investment strategies that generate steady, albeit modest, returns, while occasionally experiencing a substantial downside event that can crush an investor. Selling naked put options, or selling volatility in general, is one. Speculators who owned inverse VIX exchange traded products, a short volatility strategy, earned consistent returns for a while before a spike in volatility led to a complete wipe-out.
Tried-and-true fixed income investing, in which the best-case scenario an investor gets back their principal plus interest, and in the worst-case scenario, suffers a total loss, also qualifies as picking up pennies in front of a steamroller. However, wildly speculative bond issues with massive duration provide sufficient upside (along with the crushing downside) to be exempt from this rule. Take, for example, Austria’s infamous 100-year bond, which initially rallied to more than 220 cents on the dollar as Treasury yields declined to record lows, only to crash to below 50 cents on the dollar after interest rates normalized.
In any event, traditional fixed income is an investment strategy that generates fairly consistent positive returns, while suffering the occasional steep loss. However, a well-diversified fixed income portfolio can generally eliminate any potential for catastrophic events (although 2022 was no fun for bond investors).
Critics have mistakenly branded merger arbitrage as an investment strategy akin to picking up pennies in front of a steamroller. Merger arbitrage involves buying the stock of a company that is the target of an acquisition, with the expectation that the deal will go through, and the stock price will converge to the acquisition price.
If a deal completes, one gets limited upside, or an “arbitrage yield” similar to the yield on a bond, while being exposed to significant downside in the event of a deal termination, analogous to a bond default in which an investor can lose 50% or more on the position.
In this context, the “pennies” are the modest arbitrage profits that can be made if the deal closes successfully at the proposed terms. The “steamroller” is the potential for the deal to collapse, resulting in substantial losses that far outweigh the small potential gains.
The steamroller aspect of merger arbitrage is valid. Let’s face it, there is a risk of loss on an investment with most strategies. Typically, an arbitrageur loses money when a merger terminates (although, not always), which makes for a bad day.
While the average merger arbitrage investment offers limited upside or “pennies”, such as a single-digit return, every now and then a merger investment can offer exceptional upside through an increased bid, akin to picking up a big, fat bag of money in front of the steamroller. This upside potential of merger arbitrage, in which an investor can earn an additional reward that is multiples of the expected return (i.e. 50% instead of 5%), is a feature not found in a pennies-in-front-of-a-steamroller strategy like fixed income investing. When a bond gets paid off at par, they never hand you over 150 cents on the dollar.
Historically, 95% of U.S. definitive merger transactions have closed successfully, while 5% have terminated. Offsetting the 5% terminations is the 5% of deals which have benefitted from an increased consideration (while just 1% have been revised downward).
Source: Accelerate
In M&A parlance, an increased merger consideration comes in two forms. When the initial bidder is forced to increase their initial consideration, due to shareholders demanding more or an interloper submitting a higher bid, this is known as a “bump”. When an interloper successfully outbids the initial friendly acquiror, this is known as an “overbid”.
Two recent examples this year, of which the Accelerate Arbitrage Fund (TSX: ARB) was long of both, showcase this phenomenon.
On December 18th, 2023, Dundee Precious Metals Inc. announced the friendly acquisition of Osino Resources Corp. in a cash and stock deal worth $1.55 per share, representing a 37.8% premium. On February 20th, 2024, interloper Shanjin International Gold Co., Ltd. (formerly known as Yintai Gold Co., Ltd.) submitted a superior proposal at $1.90 cash per share, representing a 68.1% premium and an overbid that was 22.6% greater than Dundee’s initial deal price. Ultimately, Dundee passed on the opportunity to match and Shanjin closed the acquisition of Osino at $1.90 per share this month.
Source: Accelerate, Bloomberg
Arbitrageurs who bought Osino shares after the Dundee transaction was announced expected a 7% gross, or 15% annualized, return if the deal closed as expected. Due to the overbid from Shanjin, arbitrageurs ultimately enjoyed a more significant 31% gross, or 47% annualized, return.
Another example of the upside potential in merger arbitrage was the case of Everbridge Inc. On February 5th, 2024, private equity firm Thoma Bravo announced the friendly buyout of Everbridge for $28.60 cash per share, representing a 20.2% premium to the company’s unaffected price. On March 1st, 2024, an unnamed interloper submitted a superior proposal, and Thoma Bravo bumped its bid by 22.4% to $35.00 cash per share, not wanting to lose the deal.
Source: Accelerate, Bloomberg
Arbitrageurs who bought Everbridge shares on the day Thoma Bravo announced its buyout expected a 1.6% gross, or 6.4% annualized, return. After Thoma Bravo bumped its bid to $35.00, arbitrageurs were blessed with a 24.3% gross, or 60% annualized, return.
In the above two examples, the original consideration was increased by more than 20%, and the annualized return went up by 3x-10x. Pennies were turned into big fat bags of money, a dynamic that is unobtainable from traditional pennies-in-front-of-steamroller strategies such as bond investing or volatility selling. Moreover, the occasional overbid or bump in consideration can help offset the odd money-losing transaction that terminates for the diversified merger arbitrage investor.
August was another busy month for merger arbitrage, with 15 public transactions announced in the U.S. worth an aggregate of $58.1 billion, and 4 announced in Canada (including one subscription receipt deal), worth a total of $3.5 billion. Across North America, 10 mergers worth $17 billion closed. No deals were terminated.
The North American merger arbitrage universe currently consists of 92 M&A deals totalling nearly $550 billion. The average merger arbitrage spread yields approximately 11.3%.
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.