Merger Arbitrage

We believe successfully navigating today’s markets is a colossal task.

Over the last several decades, we’ve witnessed the painful dynamic that increased market volatility wreaks havoc on most asset classes. Whether it’s the Dot-Com Bubble of 2000 or the Great Financial Crisis of 2008 or the Covid-19 Pandemic of 2020, nearly all investment strategies suffered significantly during those turbulent times.

The 60/40 “Balanced” portfolio, consisting of both stocks and bonds, has long been revered as a trusted guidepost for the moderate investor. Nevertheless, in 2022, this established methodology had one of its worst years on record as both sides of the portfolio came under pressure.

So what is an investor to do? During a market maelstrom, the few asset allocations that perform relatively well are the ones that exhibit low correlation to the overall markets.

At SAM, we assign considerable thought to how we have formulated our strategic bedrocks of asset allocation. Each one of them possesses a comprehensive array of investment principles that we believe should collectively shepherd our portfolios during a typical market cycle, particularly during bouts of heightened instability.

The asset allocation bedrock we would like to highlight is Merger Arbitrage, an idiosyncratic investment blueprint that large multi-strategy hedge funds have successfully implemented for their institutional clients. Investment returns related to this unique strategy are driven by the outcome of the specific transaction, rather than the direction of equity or bond markets.

Since our inception, we’ve managed to implement this low-correlation strategy for SAM clients with considerable achievement.

Merger Arbitrage: What is it?

Merger Arbitrage: Textbook Example

In late October 2018, IBM announced the acquisition of software provider Red Hat for $190 cash per share, which represented a 63% premium over Red Hat’s prior closing price of $116.68.

When the deal was announced, Red Hat quickly rose from $116.68 to $170 per share, still well below the $190/share deal price, which reflected a 12% discount (or spread) to the actual takeover price.

Thus, the $20 spread between the $170 price per share and $190 deal price created a merger arbitrage buying opportunity.

Ultimately, the deal closed on time and without any incident in early July 2019. Investors who bought Red Hat stock when the deal was announced would have earned 12% over the subsequent 8 months, or an annualized ~17% return. [see graphic below]

In our opinion, the Red Hat acquisition is a textbook example of how an investment manager can exploit a positively asymmetric Merger Arbitrage trade for their clients.

Red Hat Acquisition Timeline

Source: Bloomberg

Merger Arbitrage: Low Correlation to Equities

Earlier, we described Merger Arbitrage as possessing powerful idiosyncratic investment characteristics. But just how favorable are they? They are perhaps best exemplified during periods of extreme equity market volatility.

As you can see in the graphic below, there are days when the S&P 500 has dropped at least 1% over the last 5 years, which is denoted by the blue bars.

Days When the S&P 500 Index Dropped at Least 1% Over Last 5 Years

Source: Bloomberg

The important thing to note is that the drawdown of the Merger Arbitrage ETF, as seen by the orange bar, was only a fraction of the overall market drawdown.

In fact, there were several instances where Merger Arbitrage managed to generate positive returns despite a down market! How is this even possible?

Well, remember that absent any litigation, mergers and acquisitions are contractually obligated to close at the agreed-upon price. So, despite a significant drop in equities, Merger Arbitrage investments held their ground and even managed to squeeze out a small gain. Thus, well-managed exposure to this specific asset allocation provides an optimal hedge during periods of distress, while also providing potential for meaningful upside as well.

All of which is simply a testament to the notion that this particular strategy can generate meaningful out performance in a myriad of market conditions.

Merger Arbitrage: Low Correlation to Fixed Income

Another material benefit is that Merger Arbitrage can provide positive returns in a rising rate environment—a scenario on possibly every income investor’s mind.

Over the past decade, there have been five years in which 10-year Treasury yields have risen and the Global-Aggregate bond index has lost money.

As interest rates rose in 2013, 2015, 2018 and 2021, bonds lost money. Meanwhile, Merger Arbitrage provided positive performance. [see graphic below]

We now know that 2022’s Treasury sell-off was unprecedented. Yields rose substantially and as a result, all fixed income got crushed, down more than -16%. Yet, despite the interest rate headwinds, Merger Arbitrage generated a 2.8% positive return across the entire index.

Years When 10-yr Treasury Yields Rose Over the Past Decade

Source: Bloomberg

Conclusion

Unfortunately, textbook Merger Arbitrage examples are few and far between. Many of these investments possess specific nuances that separately influence the deal spread, which therefore requires a manager with a deep and broad investment acumen.

At SAM, through decades of experience, we’ve amassed the skill-set necessary to successfully navigate this strategy. Time and again, we’ve demonstrated that SAM can profit from capitalizing on this deal spread by painstakingly analyzing the specific dynamics of each corporate acquisition.

At the end of the day, Merger Arbitrage lays the foundation for substantial uncorrelated returns, which is an extremely compelling proposition— especially in a market environment where overall volatility is spiking and so many assets move in tandem with one another.

SAM Merger Arbitrage Analysis Framework

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¹ Source: Merger Arbitrage: A Strategy for Consistent Profits in the Market — AccelerateShares, Aug 2019