The recent market swings and declines impact mergers in many ways. Let's consider two. First, we have the parties involved in making a deal. These are numerous, but for convenience let's just focus on the firm to be acquired (target) and firm doing the acquiring (bidder).
If cash is the form of payment and a fixed price is set, target shareholders are in a fairly secure position. I say fairly, because extreme swings can threaten any deal (e.g. Dow Chemical's Acquisition of Rolm and Hass right after the 2008 market crash). The bidder may nevertheless squirm as market shakeups impact the value of the target and the related projection of future cash flows.
In stock deals, things get more interesting. Suppose, for example, a deal is set with a one to one stock swap. If the price of the target changes relative to the price of the bidder, the value received and paid can be quite different than originally envisioned.
One way to mitigate this risk is the use of collars - essentially boundaries framing a range of values in which a deal will take place, depending on the price of the shares at closing. This can offer upside protection to a bidder (a maximum payment or ceiling) and downside protection to a target (a minimum payment or floor). For more detail on this, see our previous post Acquisition Risk, Collars, and the Time Warner Deal.
Another group active in mergers and affected by market swings are merger arbs, essentially trying to buy at one price, sell at another and minimize the risks. For example, the Beta of The Merger Fund (MERFX) is 0.08 - taking close to zero market risk. Again, see our related post Speculation Spreads and the Market Pricing of Proposed Acquisitions.
However, volatility and market dips can widen spreads and make arbitrage opportunities more attractive. This works particularly well if, as mentioned, the arbs can appropriately hedge market (and where possible, deal) risk. An interesting example of this comes from The Deal's post Stock Market Volatility Creates Opportunities for Merger Arbs.
All the best,
Ralph
Showing posts with label MERFX. Show all posts
Showing posts with label MERFX. Show all posts
Thursday, September 3, 2015
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,
Ralph
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,
Ralph
Subscribe to:
Posts (Atom)