Merger Arbitrage: Arbitraged Away?

Another Questionable Diversification Strategy

May 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • As AUM in merger arbitrage has increased, alpha decreased
  • Investors can access merger arbitrage via hedge funds, bank indices, and ETFs
  • The strategy is not as uncorrelated from equities as likely perceived by allocators

INTRODUCTION

Working in the restructuring team of a corporate finance boutique is like being a trader focused on short-selling. Most money is made when companies falter, and stocks turn bearish. A restructurer’s cyclical counterpart is the ever-optimistic merger & acquisition (M&A) banker that thrives when the economy is booming and companies trade at their all-time highs, which in turn allows them to use their overvalued stock as cheap acquisition currency.

The coronavirus crisis has not only put M&A activity on hold, but also has led many mergers and acquisitions to fail. Xerox abandoned its $34 billion hostile bid for HP, Softbank canceled its $3 billion offer for WeWork shares, and private equity company Sycamore Partners is trying to get out of its $1 billion acquisition of lingerie and beauty product maker Victoria’s Secret.

Betting on M&A activity by buying the shares of the company to be acquired and shorting the acquirer’s stock is a classic strategy employed by hedge funds, commonly called risk or merger arbitrage. The long leg of this trade, acquiring the target, pays because investors tend to underestimate the probability of a deal closing. Shorting the acquirer, on the other leg of this trade, pays because the acquirer is using overvalued equity that will go down in value, in part because of the signal the very same merger sends to the market. These two trades, put together, provide a unique source of seemingly riskless profits. When this strategy is deployed over a large number of deals, the market-neutral profile of simultaneously being long and short stocks lowers drastically its correlation with equity markets and makes it an attractive vehicle for diversifying a traditional equity-bond portfolio.

However, as seen during the current coronavirus crisis as well as during the great financial crisis from 2008 to 2009, many deals fail when stock markets crash, which might make the strategy less uncorrelated than allocators expect, and in the worse possible moment.

In this short research note, we wil