Warren Buffett, the legendary chairman and CEO of Berkshire Hathaway Inc., relied considerably on merger and acquisition (M&A) arbitrage in his early days to post great investment returns, as chronicled in his annual letters to shareholders.
There are ways the arbitrage approach may fit in with the portfolios of high-net-worth investors.
The opportunity for M&A arbitrage arises when a company’s shares are trading below a price at which another purchaser is prepared to buy. The classic situation occurs when a company receives a takeover offer and its shares trade at a discount, or spread, to the offer price while waiting for approvals from shareholders and regulators.
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For business mergers, the typical spread was 4 per cent before COVID-19 but it blew out to 8 per cent when the pandemic hit, says Eric Fritz, co-manager of the NexPoint Merger Arbitrage Fund. The spread has since drifted down and now hovers above 6 per cent.
With investment returns tied to M&A offers and not the direction of the stock market, it becomes possible to earn absolute (positive) returns in bull and bear phases. Spreads of 4 per cent to 6 per cent may seem small but M&A bids usually take just three to six months to finalize.
Moreover, volatility is quite low. So are correlations with other asset classes. This makes the method a useful way to diversify a portfolio.
In fact, the return is one of the best available relative to the degree of risk, as defined by variability in returns (measured by standard deviation). Indeed, this asset class easily beats global stocks and even global bonds on the basis of risk-adjusted returns.
“From 2009 to 2019, M&A arbitrage returned 4.1 per cent annually with a standard deviation of only 2.5 per cent, while global bonds returned just 2.5 per cent annually with a 5.6 per cent standard deviation,” points out Julian Klymochko, manager of the Accelerate Arbitrage Fund.
Key to the success of this approach is assessing the probability of proposals closing. Writing in the Journal of Financial Economics , Malcolm Baker and Serkan Savaşoglu conclude that the best signal of success is whether or not the offer is hostile (less than 40 per cent of hostile bids succeed). Many deals also fall apart because they increase market concentration to a level unacceptable to antitrust regulators.
Clearly, M&A arbitrage comes with execution risks, particularly concerning the evaluation of M&A announcements and large drop in a share price of the targeted company if a deal falls apart. A way to handle this risk, as many M&A funds do, is by maintaining a diversified portfolio that holds several dozen plays.
One of Canada’s newest arbitrage funds, an actively managed exchange-traded fund run by Klymochko under the name Accelerate Arbitrage Fund, has gotten off to a roaring start with a 39.4-per-cent gain in its first year – thanks to arbitraging opportunities in connection with businesses and special purpose acquisition companies (SPACs).
Klymochko has had experience with M&A arbitrage since 2012 and brought this expertise to bear on SPACs as hundreds of them poured onto stock exchanges in recent years. “There are hundreds of SPACs trading at a discount,” Klymochko says.
If one takes advantage of the opportunity to buy a SPAC below its IPO price of $10, “it is a very low risk investment,” he remarks. If the SPAC fails to find a suitable acquisition in time, then one can still make a profit selling at the redemption price of $10 plus interest (or $10.25 plus interest, at SPACs that overfunded their trust accounts).
If the SPAC makes an acceptable acquisition, one can capture a greater profit by selling in the market if the price has climbed above $10 (but hold on to the warrants). If the price does not rise to this point, units can be redeemed at $10 (or $10.25) plus interest.
There are, of course, several risks to be aware of when investing in SPACs.
Another Canadian fund, the Picton Mahoney Arbitrage Fund Class (B), also focuses on businesses and SPACs. The average annual return for clients was 5 per cent during the eight years since inception Oct. 31, 2013 – with 80 per cent of months recording positive gains. Its returns are leveraged 200 per cent in the Picton Mahoney Arbitrage Plus Fund.
One of Canada’s oldest arbitrage funds, Amethyst Arbitrage Fund allots “up to 45 per cent of its portfolio to M&A arbitrage, with the rest going to arbitrage on convertible debentures, fixed income and other situations,” says Albert Arazi, vice president of business development for Amethyst.
Over the 22 years since inception in 1998, Amethyst has achieved an average annual return of 7.4 per cent for clients, with just four down years – three of which were small drops under 2.5 per cent. Over the past 10 years, the average annual return was 4.1 per cent, still respectable for a low-volatility strategy capable of generating absolute returns.
Buffett was a fan of M&A arbitrage but not for every time and place. In the late 1980s, he pulled back for a period because the field had become too crowded and opportunities too scarce. In 2021, we don’t appear to be at that stage: as Craig Chilton and Tom Savage at Picton Mahoney wrote in a recent commentary: “The opportunity set, in terms of size of deals and spreads being offered, is as bountiful as we have seen in the last 5 years.”
Larry MacDonald is a retired economist who writes for national business publications and blogs at https://larrymacdon.substack.com
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