January 31, 2022 – According to Institutional Investor, “merger arbitrage may be the hottest ticket for solid returns this year.”
Their bullish outlook for the asset class is three-fold:
1. Record M&A activity – In 2021, global M&A set a new record, surging past $5.8 trillion. As a result, more mergers and acquisitions create a larger opportunity set for arbitrageurs. If capital employed (demand) remains constant, this larger opportunity set (supply) will lead to higher yields.
2. Fewer merger arbitrage specialists – Sizable arbitrage hedge funds, such as Perry Capital and York Capital, have shuttered in recent years. The reduction of market participants competing for attractive arbitrage spreads makes the market less efficient, leaving more attractive returns for the remaining players.
3. Higher yields – Post-Covid, merger spreads have been extraordinarily wide, as market participants who were burned during the Covid bear market take a less aggressive approach to arbitrage, choosing to allocate capital more carefully. In addition, the recent market volatility given the commencement of a Fed interest rate hiking cycle has caused further spread widening. Therefore, merger yields and their yield spreads above junk bonds have reached their highest level since spring 2020.
The recent equity market volatility, and the uptick in interest rates, should be on the radar of arbitrageurs.
Thus far, the volatility has not translated to stress in the bond market, and therefore deal financings are not at risk (yet).
In addition, the market volatility has not translated to economic weakness, and therefore not giving would-be acquirers ammunition to re-cut prices of definitive deals.
From a deal risk standpoint, the two most important factors aside from market volatility have been U.S. antitrust and Chinese regulatory approvals.
On the U.S. antitrust front, the FTC did sue to block Lockheed Martin’s acquisition of Aerojet Rocketdyne. This event was not a surprise, given the market was already pricing in high odds of regulatory action. However, there is widespread fear that more deals could be challenged. For example, Microsoft’s acquisition of Activision Blizzard has been ascribed a less than 50% odds of success according to the market, despite the companies having a limited combined market share in video games.
Conversely, the Chinese regulatory approval quagmire is looking more positive. China’s State Administration for Market Regulation (SAMR) finally approved AMD’s acquisition of Xilinx, allowing the market to breathe a sigh of relief on any deal requiring Chinese approval. SAMR’s deal clearance indicates that they are unlikely to irrationally block other outstanding deals.
In any event, allocators to merger arbitrage can be cautiously optimistic. Not only has merger arbitrage held up well during the recent S&P 500 market correction, but has created an opportunity to allocate capital at yields more than double that of “high yield” fixed income.
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.
