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© Copyright 2000 Rogers Media. The following article first appeared in the December 2000 edition of
BENEFITS CANADA magazine.
To have and not hold
Pension fund managers are taking advantage of corporate marriages with an alternative investment
strategy known as merger arbitrage that enables them to simultaneously buy and sell shares in companies
preparing to tie the knot. With relatively low risk and competitive returns, it's an investment proposal
worth looking at.
By Robert Parnell
Canadian institutions and institutional investors are now looking at hedge funds and other alternative
investments as a separate and legitimate asset class. And yet little is known of this sector beyond the
newspaper headlines and the industry's penchant for secrecy. One thing is certain: the hedge fund industry
is growing at a furious pace.
Hedge fund assets under management increased four-fold from January 1994 to June 2000, according to TASS
Investment Research Limited. Total hedge fund assets under management today are estimated to be more than
US$350 billion. One factor fuelling this growth is the defection of mutual fund managers to the hedge fund
world.
Merger arbitrage is a particular hedge fund strategy that is often considered by institutions as an
important component of a diversified hedge fund portfolio. It is one branch of hedge fund strategy known as
risk arbitrage. In addition to mergers, this broader category includes arbitrage of other corporate events
such as recapitalizations, cash tender bids, stock tender offers and spin-offs.
Many risk arbitrage hedge fund managers also invest in distressed securities. The category of risk
arbitrage and distressed securities is often described as event driven because the exploitation of a
corporate event drives the investment strategy.
The practice of risk arbitrage increased significantly during the corporate merger frenzy of the '60s and
'70s as giant conglomerates where cobbled together. The '70s saw an increase in the number of players
attracted to the risk arbitrage game. Among the most infamous was Ivan Boesky who established the first
hedge fund specializing in risk arbitrage in 1977. Unfortunately, Boesky's insider trading antics cast a
pall over the arbitrage community in 1987.
The '80s saw a dramatic in-crease in the number of hostile takeovers. Acquisitions during this period were
characterized as financial rather than strategic in nature. The acquirer in a financially driven takeover
is motivated by the prospect of adding value through reorganization or asset stripping. Corporate raiders
such as Carl Ichan, T. Boone Pickens, and Sir James Goldsmith were legend for this aggressive approach.
There were fewer hostile takeovers in the '90s. So-called strategic mergers are now the fashion of the day.
Such mergers are often driven by the need to dominate an industry or achieve economies of scale. From the
arbitrageur's standpoint, strategically motivated mergers can be very appealing because they often attract
additional bidders and higher takeover premiums.
Over the past few years there has been a staggering increase in the volume of merger activity. Low interest
rates have made these deals easier to finance and high stock multiples have made stock-for-stock
transactions less dilutive. Mergers during the first six months of 2000 totalled a whopping US$1.88
trillion and comprised 17,777 separate transactions.
STOCK-FOR-STOCK MERGERS
In a typical stock-for-stock merger the acquiring company (often referred to as the groom) offers some
multiple of its stock in exchange for each share of the target company (the bride). Friendly mergers can be
thought of as harmonious marriages whereas hostile takeovers are something completely different, and can be
as acrimonious as the ugliest divorce.
Arbitrage opportunities arise when there is a material takeover premium in the value of the groom's offer
relative to the price of the bride's shares in the market. This takeover premium or spread will often exist
if there is a risk that the deal will not be consummated.
As the merger must receive assent from shareholders and other influential bodies--including the Department
of Justice, Federal Trade Commission and the European Competition Bureau--the merger spread can be
substantial and will often fluctuate over time as the market changes its opinion on the probability of
consummation. Herein lies the opportunity for the arbitrageur.
The merger of SBC Communications (SBC) with Ameritech (AIT) in the U.S. is a good example of a pure
stock-for-stock merger. In this telecommunications deal announced in May 1998, SBC offered 1.316 of its
shares for each AIT share.
On April 19, 1999 with SBC's shares trading at $52.94, the value of the offer was $69.67 (1.316 x $52.94).
With AIT's shares trading at $62.13, there is a $7.54 spread or premium in the offer ($69.67 - $62.13). The
arbitrageur seeks to lock in this merger spread by buying AIT and short selling 1.316 shares of SBC.
If the merger is consummated, the arbitrageur will earn the $7.54 spread along with a short sale rebate of
approximately $1.59 (interest earned on the proceeds of the short sale). Given a reasonable estimate of the
time until closing (5.75 months in this case) and a capital requirement of $65.90 (a leverage of 2:1 is
assumed). The annualized rate of return on capital employed is an attractive 31.07%. Dividends and
transaction costs are ignored for simplicity.
This transaction may at first appear more speculative than it actually is. Since AIT will ultimately
convert into SBC upon completion of the merger, buying AIT is actually an inexpensive way of acquiring
shares of SBC. Provided the merger is consummated, the investor is effectively long 1.316 shares of SBC and
short 1.316 shares of SBC, with no net exposure to SBC, the telecommunications industry or the stock market
for that matter.
When viewed in this light, it's evident why merger arbitrage is regarded as a compelling hedge fund
strategy. It offers an attractive inherent return with little or no market exposure.
A merger arbitrage differs from traditional investment management. While a traditional portfolio manager
may focus only on the subsequent profitability of the merged entity, arbitrageurs care only about the
probability of the deal being consummated, and how long it will take the deal to close.
The SBC-AIT transaction is more illuminating when the evolution of the deal is examined over time. The
value of SBC and AIT changed as shareholder and governing body approvals were obtained. The dollar spread
gradually trended to zero as AIT and the value of SBC's offer converge as consummation approaches.
Merger arbitrage is a classic example of a convergence trade. Correlation of the return of the bride and
groom also increases as consummation approaches.
More surprisingly, however, is the variability of the pro forma annualized return of the arbitrage trade
from each trade initiation date. Although the arbitrage rate of return clearly declines on the date the
merger is announced, it frequently exceeds 20% per annum and is occasionally in excess of 30% prior to
closing. This despite the deal receiving approval from both shareholders and government authorities. It is
clear that the stock market is not efficiently pricing merger companies.
The activity of traditional investors may explain the price dislocation of engaged companies. Despite the
fact that two companies have been linked by a merger announcement, many traditional investors will continue
to look at the individual securities in isolation. The merger spread may increase simply because
traditional investors are buying the groom without regarding its arbitrage value.
A compelling attribute of stock-for-stock merger arbitrage is its lack of market sensitivity. While not all
merger arbitrage trades are purely market-neutral, a simple stock-for-stock transaction tends to have a
market-neutral character.
When the daily returns for the SBC-Ameritech arbitrage are viewed against the Standard & Poor's 500
index (S&P 500), it becomes clear that this particular transaction has no relationship whatsoever with
the behaviour of the stock market in general (see "Independent performer," page 31). The correlation with
the S&P 500 is 0.03 and the beta is -0.03.
RISKS AND REWARDS
As the name suggests, risk arbitrage is not without risk. Although the vast majority of announced, friendly
mergers are consummated, the financial damage to an arbitrage position caused by a broken engagement can be
substantial.
Just as convergence of the bride and groom brings profit, divergence brings loss. A deal may fail because
shareholders do not approve, the bride may not be receptive to the groom's advances and use various
defensive strategies. Anti-trust agencies may also move to block the marriage.
As with any asset class, diversification is an important part of risk management. A well-diversified merger
arbitrage portfolio will have exposure to 30 or more deals. An attractive feature of merger arbitrage risk
is that it tends to diversify very effectively. One deal is not very closely correlated with any other. As
a result, the volatility of merger arbitrage portfolios is often surprisingly low. Merger arbitrageurs may
also reduce risk by avoiding hostile takeovers where the deal risk is unacceptable.
Risk arbitrage and event-driven hedge funds, in general, have produced attractive rates of return with
relatively low levels of volatility over the past seven years. From Jan. 1, 1994 to Sept. 30, 2000,
Tremont's Investment Management Inc.'s sub-index of risk arbitrage hedge funds produced a compound
annualized return of 17.87% while the Credit Suisse First Boston/Tremont Event Driven Index produced a
return of 12.42%.
Over the same period, the standard deviation of risk arbitrage and event-driven hedge funds has been 7.04%
and 6.69% respectively--approximately half the volatility of traditional equity markets.
TAKING THE PLUNGE
There are times when merger arbitrage and risk arbitrage are not attractive investment vehicles. For
instance, when too much capital is chasing too few deals, merger spreads can narrow across the board and
the return per unit of deal risk is unacceptable.
The past few years have seen a slight narrowing of deal spreads, but there has been sufficient flow of
deals to keep arbitrageurs fat and happy--for the moment. However, all arbitrage hedge fund strategies have
a value cycle and there are times when allocations to them should be reduced or avoided altogether.
Over the longer term, institutions considering alternative investments would benefit from looking at
merger/risk arbitrage and the entire event-driven category in the context of a more diversified
multi-strategy/multi-manager portfolio of hedge funds.
Thorough research should be conducted into the entire range of hedge fund strategies and merger/risk
arbitrage should compete with other strategies on its own merits. It is also best to work with a hedge fund
advisor to assist in strategy and manager selection.
Investing in a merger arbitrage transaction, a risk arbitrage or event-driven hedge fund is akin to
operating a business. Deals and capital are the raw material, and rates of return are the end result.
Analysis of hedge fund operations should therefore focus on the production process (trading) and the
quality of management.
With attractive risk-adjusted returns and low levels of correlation to traditional asset classes, merger
arbitrage and risk arbitrage are investment alternatives worth exploring. These investments along with
other hedge fund strategies need to be actively considered by pension funds and other institutional
investors as part of regular asset mix studies.
Robert Parnell is president and chief investment officer of Tremont Investment Management Inc. in Toronto.
rparnell@tremontinvestment. com.This article is the first in a series on alternative investments.
*** ***
Many happy returns
From Jan. 1, 1994 to Sept. 30, 2000, risk arbitrage hedge funds produced a compound annualized return of
17.87% while the Credit Suisse First Boston/Tremont Event Driven Index produced a return of 12.42%. Over
the same period, the standard deviation of risk arbitrage and event-driven hedge funds has been 7.04% and
6.69% respectively--approximately half the volatility of traditional equity.
Source: Tremont Investment Management, Inc.
Independent performer
Daily returns for the SBC-Ameritech arbitrage viewed in comparison to the S&P 500 Index illustrate that
the value of this transaction has no relationship to the behaviour of the stock market. The correlation
with the S&P 500 is 0.03 and the beta is -0.03.
Source: Tremont Investment Management, Inc.
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