November 30, 2021 — Recently, things have been eerily quiet in mergers and acquisitions.
In November, there were no deals that terminated. Mergers have been closing as expected.
In the world of M&A, quiet is good. Deals that are closing, drama free, are ideal for an arbitrageur, especially when arbitrage yields are high.
A great dichotomy is implied by current high merger arbitrage yields, indicating that the market remains poised for volatility. The market continues to price in that only 83% of announced mergers will close, not based on this year’s precedents, however, due to the perception of increased risk due to the political environment. Biden’s administration signalled that it would take a tough stance on anti-trust regulation, and the market listened. However, thus far, we have not seen the fallout of broken deals that the market expected.
A merger spread, or the price difference between the consideration offered for a deal stock and its market price, represents a risk premium. Specifically, a merger spread represents the market-implied probability that a deal will close on the terms. Merger arbitrageurs act as liquidity providers, buying deal stocks and allowing long-term investors to exit at a premium (but below the deal price). These arbitrageurs get compensated, through the spread, for accepting deal risk.
Given the fear of political and regulatory action in the market, merger arbitrage risk premia are wide and arbitrage yields are high.
Pre-Covid, arbitrage yields averaged 5.4% and the risk-free rate was 1.5%. Therefore the merger risk premium was 4.0%. In layman’s terms, pre-Covid, merger arbitrageurs were getting paid 4% to accept deal risk.
Currently, arbitrage yields an average of 8.2%, while the risk-free rate is 0.06%. Consequently, arbitrageurs are receiving more than 8% to accept deal risk.
Over the past two years, the risk premium offered to merger arbitrageurs has doubled from 4% to 8%.
Have deal risks gone up, or is merger arbitrage just far more attractive an asset class than it used to be?
Over the past ten years, Accelerate has analyzed nearly 1,300 US M&A transactions. Pre-Covid, the market was pricing in a 91% average probability of deal closing. Of the approximately 1,300 transactions over the past decade, 94% closed successfully.
Historically, the merger market has priced deal risk cautiously, chronically pricing in a higher frequency of deal breaks than what has occurred.
In 2021, 96% of deals have closed successfully, a rate 200 bps higher than the 10-year average. Lately, deal breaks have been happening less frequently than they used to occur. Oddly, the market is currently pricing in just 83% of deals closing successfully.
Not only is the widespread fear of significantly more deal breaks unfounded, but it has been just wrong. Moreover, this mispricing creates an opportunity for investors.
Pre-Covid, merger arbitrageurs received a 4% risk premium and 94% of deals closed successfully, higher than the market expectation of 91%.
Currently, merger arbitrageurs receive an 8% risk premium while 96% of deals closed on the terms this year, significantly higher than the 83% presently implied by merger spreads.
What does this all mean?
If we boil it down, merger arbitrageurs can earn higher than historical returns with lower than historical risk. That sounds like a great combination.
The risk / reward dynamics in merger arbitrage have improved dramatically over the past two years. The Accelerate Arbitrage Fund (TSX: ARB) has been selectively adding low-risk merger arbitrage investments that provide expected high-single-digit returns.
The below AlphaRank Merger Monitor represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized return of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.
Each individual merger is assigned a risk rating:
- AA — a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
- A — a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
- BBB — a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
- BB — a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
- B — a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
- CCC — a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
- NR — a merger rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.
The AlphaRank merger analytics database is utilized in running the Accelerate Arbitrage Fund (TSX: ARB), which may have positions in some of the securities mentioned.
* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit AccelerateShares.com for more information. Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Accelerate may have positions in securities mentioned. Past performance is not indicative of future results.