Thursday, June 18, 2015

The Merger Fund

I've been an investor in the Merger Fund for a long time both for the risk adjusted returns it produces and for the wonderful discussions about merger activity in the most recent quarter.

The Merger Fund engages in merger arbitrage - betting on the outcome of deals.  Sound risky?  Not so fast.  The Merger Fund, like most arbs in mergers, hedges its bets, trying to lock in returns while minimizing risk.  The strategies that can be employed to do this can be complex, but let's just consider a simple example:

A target is trading for 30 euros and a bidder offers a stock deal suggesting a 40 euro bid price.  Right after the deal announcement, the price of the target rises to 38 euros, while the price of the acquiring firm settles at 60 euros.

We've talked elsewhere about the fact that the information above implies that, under simplifying assumptions, the probability of the deal being completed at 40 euros can be estimated to be about 80 percent.  But that is beside the point here.  A simple arbitrage strategy would be to short the appropriate amount of the bidder's stock and go long the target.  Assuming both stocks face similar market risks, this effectively hedges against market movements.

The hedge described is quite simple and not foolproof.  If the bid is abandoned and the target price returns to 30, the investor faces a substantial loss.  (There are other ways to hedge this, but we'll keep things simple here.)  More than likely, if this bidder loses, another bidder completes the deal at a higher price producing an even larger gain on the target than the 2 euro spread.  The original bidder would probably also experience price adjustments, perhaps gaining a bit and producing a slight loss for the investor.

But consider the returns if the deal is completed in, say,  two months: a 2 euro gain with little investment - in just a two month period.  

Now to be sure, many risks remain, but you get the idea. If you study the Merger Fund, you'll note that while its historical performance is below the S&P 500, so is it's volatility (and Beta).  It's Sharpe ratio is high.

Regardless, I offer the Merger Fund to you for the interesting commentary on deals.  See, in particular, The Quarterly Review.

All the best,


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