Merger Arbitrage - The Light Is Red

| About: Cabela's Incorporated (CAB)

Summary

Merger arbitrage can produce equity-like returns with low volatility and correlation to the stock market.

Cash deals are the easiest ones to focus on, since only one trade is required.

Avoid abnormal yielders, and deals with substantial regulatory risk.

One of my favorite event trading strategies is merger arbitrage. When done right, and with some luck, merger arbitrage can produce equity-like returns with much lower volatility and correlation to the stock market. Rather than use one of the two ETF's available (MNA/IQ Merger Arbitrage ETF and MRGR/Merger ETF), I prefer to pick a few candidates out of the pool, since I believe I can generate a better return by picking a few winners. It has been a good year, with a few notable wins in Cvent, Hutchinson and Apollo, and one key loss (Alere).

Several public sources which provide merger arbitrage information are available. My favorite is provided by Suria Investment Newsletter (SINLetter), which was available at http://www.sinletter.com/merger-arbitrage/ and has now transitioned to a new site http://www.insidearbitrage.com/merger-arbitrage/.

The website provides a wealth of information. I often sort the columns by Closing Date, then by Profit. By sorting by Closing Date, I can find mergers expected to close sooner, with the sweet spot typically in the next 3-6 months. After looking for near term mergers, I look at the spread and annualized profit. Obviously the yield (i.e., profit) should be higher than the 10 year Treasury rate, otherwise why take the risk? The level of yield it takes to entice you into a transaction is entirely related to (1) your risk tolerance, and (2) your perspective on the likelihood of the deal closing. I typically look only for cash mergers, so I screen out cash and stock deals. Cash and stock deals are not bad, but require an additional step to capture the yield (not only buying the seller's stock, but shorting an equal amount of the buyer's stock). Finally, look at the nature of the buyer and seller to determine the regulatory risk. Out of many mergers, only a handful will satisfy the criteria we have laid out. Consider purchasing several of those. These positions do not need to be monitored daily by any means, but it is recommended to check in on the positions once every week or two to see if any news may potentially impact the transaction.

Cash M&A Sorted by Profit, Greater than 2.5% Profit

What criteria can be used to screen out deals? I consider these general categories of situations to avoid:

  • Low Yield. If the merger provides a realizable or annualized profit which approximates the yield of Treasuries, then we are not being compensated enough for taking the risk. Seek mergers that will produce higher profits.

  • Negative Yield. If the seller's price exceeds the buyer's offer price, which is a rare situation, keep looking. The yield or spread is technically negative. Why does this happen? In this situation, investors expect another bidder to emerge, raising the price even more than the bidder's offer. Since the notion of an unknown bidder raises a fair amount of risk, avoid these merger situations.

  • Abnormally High Yield. When the yield is extraordinarily high, then investors expect the merger to fail. There is no reason to reach for that yield by stepping into that merger situation. Stick to the sweet spot. We have no more knowledge than other investors about this particular situation, and most likely, a lot less. So there is no need to try and be a hero. Take a pass. How will we know if the yield is extraordinarily high? If the yield is disproportionately higher than other spreads (in today's rate environment, low teens would be extraordinarily high).

  • High Regulatory Risk. What kind of deals have high regulatory risk? Any deal which requires regulators to opine due to a true public interest or above average competition issue. For example, be wary of acquisitions which involve larger utilities acquiring smaller utilities. Often times, each state affected in this kind of merger will have to weigh in on whether the merger is likely to benefit the customer of the seller, and this can take a long time. The longer the time to close a merger, the worse the annualized profit, and the lower likelihood it will close. Another example involves Chinese companies acquiring US technology companies. This is not an automatic showstopper, but in today's world these deals generate quite a number of headlines and it should be expected that these deals will be scrutinized heavily to ensure that the transaction does not allow critical US technology to fall into the hands of the Chinese. Note I'm not making a political statement here, just pointing out the facts. And with President-elect Trump's seemingly adverse to China, I would avoid merger arbitrage involving Chinese companies or investors. Yet another example are deals where the FTC has already indicated that the merger won't pass cleanly. You have to be very comfortable buying into that kind of risk.

  • Expected close beyond 9 months. The longer the time to deal close, the greater the chance that something bad will happen to the merger. Focus on nearer-term opportunities, nine months or less. Of course, keep an eye out for these longer-term mergers, since after a few months, these will enter a more attractive time window.

So where does this leave us, looking for cash-secured merger arbitrage?

Looking at the table above, you cross out a number of deals that have challenges. Taking the criteria above, which removes China risk, FTC competition risk and long-time-to-close deals, I would seriously consider only two deals - Valspar/Sherwin Williams, and Cabela's/Bass Pro Shops. These each have regulatory risk, but in the broader world there are plenty of places to buy paint and fishing gear, so the world won't end if these deals get approved. But even so, the profit potential is "average" considering the risk. Many of the potentially greater profitable deals have the risks highlighted above, with China risk or FTC competition risk. Despite the lack of available opportunities, it is always worth checking back into the list of opportunities. Merger arbitrage is yet another tool of opportunity.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VAL, CAB over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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