February 28, 2022 – With a madman on the loose in Russia, investors have a heightened sense of anxiety in the market, and rightfully so.
We have not seen war in Europe for over 70 years, so the current geopolitical drama and accompanying capital markets volatility are foreign to most. Nonetheless, there are parallels to be found.
Merger arbitrageurs have a keen nose for risk management. We constantly monitor financial conditions, volatility, arbitrage spreads, credit spreads, and numerous other indicators to inform us of lurking deal risks.
Since Russia invaded Ukraine last week, merger yields have increased 900bps, rising from 11.4% to 12.3%. This rise in yields indicates a higher risk premium demanded by investors to account for a riskier merger market.
Is this rise in yields, and accompanying perception of increased deal risks, justified?
If a merger involves an eastern European acquiror or target, then the war would absolutely put the deal in jeopardy.
From an exposure standpoint, the current North American merger opportunity set has little exposure to Russia or Ukraine. The odd deal is contingent upon Russian antitrust approval, however, it is generally a minor player in the antitrust space, usually following the lead of the U.S., Europe and China. Corporations currently active in North American public M&A have little operational exposure to eastern Europe.
Aside from direct deal risks (asset exposure and to a lesser extent, regulatory exposure), which appear to be minimal, our ears perk up to the potential indirect deal risks caused by the war.
Specifically, the three main indirect risks are:
1. Credit risk – If credit spreads blow out and debt markets seize, then deals reliant on financing may hit some turbulence. Thus far, we have not seen a material effect on credit availability or credit spreads.
2. Price risk – If markets fall precipitously, this may give some buyers (specifically, non-strategic buyers – i.e. private equity) a reason to try to walk from the deal. What the Covid-19 bear market in 2020 proved to us, yet again, is that walking from a definitive deal is exceptionally difficult. Nonetheless, the S&P 500 falling -12% is not sufficient to cause concern regarding price risks.
3. Deal activity risk – Market volatility and geopolitical conflict can give some would-be acquirors cold feet concerning deal execution, slowing down deal activity. There has not been any slowdown in deal activity, with 5 deals announced this morning worth nearly $28 billion, and 10 transactions announced since February 22nd, worth an aggregate of $58 billion. Over the same period, there have been 5 mergers closed worth $54 billion in total. M&A is as busy as ever.
Consequently, the main risks facing a merger arbitrageur, in order of importance, are U.S. regulators, China’s antitrust watchdogs and finally, Russian market risk.
Last month, Lockheed abandoned its friendly takeover of Aerojet Rocketdyne because the FTC sued to block the deal. Also, UnitedHealth’s acquisition of Change Healthcare is on the ropes after the DoJ recently sued to block the deal. Both of these vertical mergers were pricing in a high probability of regulatory action, therefore the merger market turbulence on those two specific transactions was not necessarily unexpected by the market. With the current administration’s “trust-busting” stance on mergers, thus far, we have not seen any deals blocked that came as a surprise to the market.
In any event, heightened vigilance is warranted, given the risks in the market. Nonetheless, with the average merger arbitrage yield of 12.4% and the market pricing in that 13% of deals will break (compared with 6% deal break frequency historically), we believe allocators to merger arbitrage are getting more than compensated for the risk.
The AlphaRank 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 AccelerateShares.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.
