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Merger Arbitrage Analysis And Spread Performance - February 3, 2019

by: Mal Spink, CFA
Mal Spink, CFA
Event-driven, arbitrage, long/short equity, hedge fund manager

Essendant Inc tender offer closes, catching the market unaware.

Pacific Biosciences of California (PACB) continues its decline.

U.S. merger arbitrage cash spreads tighten even further.

This article explains the reasons behind the movement in a selection of the largest U.S. cash merger arbitrage spreads from the past week. We analyze the attractiveness and profitability of each spread going forward and indicate the trading position or action we have taken or will take (if any).

Deal Specifics

The big news this week is the closure of the Essendant Inc (ESND) deal on Thursday. The stock started the week with a $0.32 spread compared to the $12.80 offer price and thus became the strongest performing cash merger arbitrage spread for the week. It appears the market was caught unaware that closure was imminent. Traders who purchased this stock at the beginning of the week could have made a 2.6% gain. With the required shareholder tender threshold already met, all that was needed was the fulfilment of the HSR clearance condition. Staples and Essendant had already claimed they "expect the merger to close in early 2019". It is important to realize despite the tightening spreads opportunities such as this where early closing is a distinct possibility still exist and can continue to produce attractive returns.

A filing from NxStage Medical (NXTM) on the 29th of January pointed to the progression of the deal with regards to the expected closure date "to extend the end date from February 5, 2019 to the earlier of (1) August 6, 2019 and (2) the first business day that is at least 60 calendar days after the Federal Trade Commission ("FTC") has been appropriated funding to be fully operational for at least 60 consecutive days during fiscal 2019." The company and acquirer, Fresenius Medical Care AG & Co, continue to await approval from the FTC for the consent decree divesting the bloodlines business. The spread still offers 2.92% despite gaining 2.50% during the week. We maintain a small position but with increasing confidence in this deal we will be keen to increase our position on a pullback in the stock price.

On Tuesday a filing was made by Pacific Biosciences of California (PACB) which detailed the financial payments to be made to the putative class action complaints. However this was not unexpected although the stock continued to decline by a whopping 4.60%, $0.33 for the week. The significance of this is the following on from last week's decline and the only negative performance of the cash spreads we are monitoring. The stock now offers a simple return of 16.96%. The delay caused by a second request for information from the FTC and speculation as to the severity of that request continues to weigh on the stock. If some clarity emerges regarding the takeover by Illumina, Inc. and FC Ops Corp we will be ready to take a position but the decline does suggest there is more to this situation then we currently know. For that reason we remain extremely disciplined as to not enter a position here without additional clarification.

Arris International (ARRS) released preliminary results at the beginning of the week which were in line with expectations. However, Friday's 8-K filing announced the results of the shareholder vote. Unsurprisingly, shareholders voted overwhelmingly to agree to the takeover. The deal remains subject to various closing conditions. The spread has now narrowed to just 0.89% as the stock gained 1.19% for the week. We maintain our long position but will be ready to take some profits is the stock moves nearer the offer price of $31.75 from CommScope (COMM) rather than risk a delay.

Redhat (RHT) filed a "Form SC 13G/A - Statement of acquisition of beneficial ownership by individuals" on Friday although the stock had been climbing all week up 1.07%. We believe this is in part to speculation of the deal closing early and the positive effects of the broader market. The spread is now down to 6.51%. As noted last week, if this rise continues we'll be looking to take some money off the table.

The Broader Market

US based cash merger arbitrage positions saw more winners than losers this week for the sixth week running. This is consistent with a rising/flat market. The performance for the top 20 largest spreads was positive 0.39% despite the negative effect of PACB. This is in line with the MNA ETF which returned a positive result for the sixth straight week running up 0.31%. The S&P 500 ETF, SPY, also produced a very healthy return to finish up 1.61%. This continued recovery in the broader continues to have a positive effect on cash merger arbitrage spreads. This reflection of the performance of the broader market continues to make it difficult to justify the level of return for the level of risk/volatility currently available from market arbitrage spreads at the portfolio level.

The top 20 spreads now offer an average of only 1.94% which is extremely low in recent times. Indeed this figure is reduced to only 1.15% if PACB is omitted from the calculation. Some individual deals do continue to offer attractive returns, for instance NXTM, whose closure has been delayed but has seen renewed confidence in the deal gaining FTC clearance. Ongoing trade discussions between the U.S. and China could still provide another shock before the issue is resolved and send stocks into a downward spiral and causing a widening of merger arbitrage spreads. We remain long but have reduced positions in accordance with the shrinking opportunities available.

Merger arbitrage trading is not without risks as the Avista Corp (AVA) deal mentioned previously demonstrates. This strategy, although accessible to individuals as well as professionals should be thoroughly understood BEFORE investment capital is put at risk. To assist the reader, supplemental literature such as "how-to" guides, introductory guides, a reading list and much more original content can be found at the website associated with the author of this article.

Disclosure: I am/we are long ARRS, RHT, NXTM. 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.