Mergers and acquisitions to diversify your portfolio

Can you explain your approach to the merger arbitrage strategy?

Let's start by defining what a "merger arbitrage" strategy is: it essentially consists of investing in companies already involved in M&A transactions, and aims to profit from the differential between the price offered for the buyout and that currently priced in by the market. The investment universe for merger arbitrage therefore comprises all M&A transactions involving listed companies. When a confirmed transaction is announced, the acquirer communicates to the markets its intention to acquire the target company at a price agreed between the parties. The target's share price naturally tends to approach this offer price, although it does not always reach it completely.

In order for the transaction to be completed and for the target's shareholders to obtain the proposed price, various conditions specific to each operation must be met. The manager's role is therefore to understand the risks and timeframes associated with these conditions, and then to determine the appropriate remuneration based on these elements. This remuneration will take the form of the difference, known as the "spread", between the announced transaction price and the target's actual market price. The higher the risk of transaction failure for example lack of regulatory approval, the wider the spread.

By adopting an approach based on a strategic understanding of transactions and their valuations, we select quality transactions and identify targets likely to become the focus of stock market battles or bid improvements, which is a key driver of potential outperformance for our strategy.

What are the advantages of investing in this strategy?

When a company is about to be acquired or merged, its share price is virtually no longer determined by its fundamentals, i.e. its financial performance, but rather by news about the operation in question. As a result, stocks involved in mergers and acquisitions tend to evolve independently of the market as a whole and of each other.

An M&A arbitrage strategy can offer advantages such as low exposure to market trends, given the historically low transaction failure rate (5%)[2] , which means controlled volatility and stable returns. This can make this strategy a good portfolio diversifier.

However, it's important to note that this strategy also entails risks, such as the risk that the transaction will fail, resulting in a price correction on the target issuer's stock. It is therefore essential to understand these risks before investing in an M&A arbitrage strategy.

How do you implement your strategy?

We apply our arbitrage strategy by studying each transaction from a corporate and market finance perspective. This analysis, combining fundamental and quantitative approaches, aims to enable us to select the transactions most likely to close successfully at the offer price. Our aim is to understand the logic behind each operation and identify the associated risks.

First, we evaluate the offer price of the merger or acquisition using comparative valuation methods in relation to similar companies and past transactions. We then examine the terms of the offer to identify any conditions that could potentially jeopardize the success of the operation. These conditions are classified into six categories:

• approval by the Board of Directors,
• the approval of the target's and the acquirer's shareholders,
• the approval of the competition authorities,
• regulatory approval,
• financing the operation,
• significant adverse events.

This analysis also enables us to estimate the time needed to complete the operation.

Once this analysis phase is complete, we monitor the spread on the market, and if we judge that the risk/return ratio of the transaction is favorable in relation to the available return on our money market cash, we invest.

We then monitor the transaction on a daily basis and adjust our position according to spread fluctuations. Portfolio construction takes into account risk, duration[3] and diversification. To manage the downside risk of a failed trade, we've designed a dynamic tool that evaluates the downside potential (the price at which the stock would fall in the event of failure). In addition, we have set up stop-loss[4] systems to limit the maximum potential loss[5].

We therefore favour an investment approach focused on a solid, low-risk core, which helps us achieve our management objectives. To this, we selectively add transactions with a slightly higher level of risk, such as those likely to feature stock market battles resulting in higher expected returns.

What are the performance drivers of the strategy?

The success of arbitrage strategies depends on two main factors: the volume of transactions and the level of spreads. A large number of announced transactions offers multiple investment opportunities, while a satisfactory average spread in relation to management objectives is crucial to profitability. These items have volume and margin effects on performance, respectively.

The level of spreads can be thought of as three categories of transactions:

• Transactions perceived as low-risk by the market, offering an expected return slightly higher than the risk-free rate.
• Transactions deemed risky by the market, with an expected return substantially above the risk-free rate.
• Transactions where the market anticipates, and prices in, an improvement in the terms of the offer, resulting in a negative expected return if the terms of the offer are met.

To be fully successful in implementing a merger arbitrage strategy, it is crucial to avoid failed deals as much as possible, and to maintain a high level of diversification to mitigate the impact of any failure. Thus, a well-constructed merger arbitrage portfolio will consist mainly comprise of low-risk transactions, ensuring a potential return slightly higher than the risk-free rate. It will also include a cautious selection of risky transactions - for instance , through an understanding of shareholder voting, regulatory approvals - to seek to increase this return, as well as a component of transactions offering the potential to improve the terms of the offer, which is a significant driver of outperformance for a merger arbitrage strategy.  

When is the right time to invest in merger arbitrage ?

As far as transaction volumes are concerned, an environment characterized by stable or falling interest rates offers the visibility buyers need to sustain dynamic M&A activity. In particular, financial buyers such as Private Equity funds will also be more active if financing costs are moderate.

As for spread, or expected return, the regulatory environment plays a decisive role. Thus, a liberal policy in terms of competition tends to be favorable. Although the level of interest rates has no net impact on spreads, a fall in interest rates is beneficial for arbitrage managers who have embedded duration[6] in their portfolios. In an environment of normalized interest rates, where valuation levels of traditional asset classes can be considered high, this strategy aims to offer an attractive investment solution.

Source: Candriam