Merger Arbitrage Analysis And Spread Performance - February 10, 2019

by: Malcolm Spink, CFA

Pacific Biosciences of California rebound provides cheer amongst the arbs.

CFIUS extended review of Renesas' purchase of Integrated Device Technology.

U.S. merger arbitrage cash spreads remain tight.

Deal Specifics

Aspen Insurance (AHL) reported results for the fourth quarter during the week and despite Chris O’Kane, Chief Executive Officer, commenting: “Aspen's fourth quarter 2018 results were impacted by the significant natural catastrophe activity that we witnessed across the industry during the period", the stock climbed 1.70% for the week. We suspect this is mainly due to what wasn't said during the report such as anything that may give grounds to invoke a MAC clause. The press release stated "the closing of the transaction is subject to closing well as the maintenance of certain financial strength ratings by Aspen's subsidiaries". This, we believe encouraged the arbs to bid the price of AHL stock up to within 5 cents of the offer price at one stage and now leaves the spread at only 0.45%. With such little meat left on this bone we have exited our position. We are already looking to reenter should the stock pull back a little further.

Integrated Device Technology (IDTI) announced that CFIUS has extended its national security review of Renesas' purchase and is now expected to finish no later than March 22 instead of by February 5. Despite this drop the spread has only widened to 1.30%. We were expecting to see a larger movement than this as a delay not only lowers the annualised return but also affects the probability of deal closure. We do not believe the current spread accurately reflects these changes in circumstances. The market appears to maintain a reasonably confident approach and appears convinced this deal remains high quality. As the spread remains relatively tight we have refrained from taking a new position but remain ready to do so if the stock pulls back a little more.

This week’s stand out best performer in the merger arbitrage cash deal portfolio was Pacific Biosciences of California (PACB). The stock appreciated an incredible 5.12% or $0.35. This rise is marginally more than last week's decline. The only official news during the week was an SC 13G/A filing which detailed the acquisition of beneficial ownership by individuals. With such little news flowing regarding the deal it would appear jittery investors are pushing the stock to more extreme levels than what would be expected in this type of market and the decline from the previous week appears somewhat overdone following this week's recovery. We are now actively trading the volatility of this spread and have entered and exited positions during the week. We maintain a small position but in the absence of any deal developments we are keen to take profits as and when they arise.

InfraREIT, Inc. (HIFR) announced during the week the results of the Company’s stockholders vote to adopt the Merger Agreement and approve the acquisition of the Company by affiliates of Oncoron. The overwhelming support for the merger was not unexpected. Should the deal close early shareholders might not be entitled to the dividend if it is not declared. This could be impacting the performance of the stock and no other news was immediately obvious. The stock was down 0.38% for the week but is still trading $0.14 above the $21.00 offer price from Oncor Electric Delivery Company LLC. The absence of a higher offer or a dividend payment would make this a losing proposition.

Redhat (RHT) had another strong week and finished up 0.55%. Despite there being company specific news there was little advancement on the deal. However the spread came in by $0.99 and now stands at 5.93%. Although we still maintain our long position, this continued rise leaves us very close to taking some money off the table in light of the expected timetable of completion. Should this be the case, we will be ready to jump back in should the opportunity arise especially if the market undergoes a broader pullback. We have been looking to exit this position if a significant rise in any short period of time take the spread above where we think it should be in this stage of the deal completion process. However, narrowing of the spread is evolving gradually and in light of the significant reduction in positions elsewhere we maintain our long position.

For the sake of completeness Civitas Solutions (CIVI) reported earnings on Monday and Esterline Technologies Corporation (ESL) on Wednesday. Neither of these stocks were significantly impacted by the results and we do not hold any positions here

The Broader Market

U.S. based cash merger arbitrage positions saw more winners than losers this week for the seventh week running and this is consistent with a rising/flat market. The performance for the top 20 largest spreads was positive 0.42% due in large part to the performance of PACB. The MNA ETF however finally broke its winning streak and finished down 0.40%. The S&P 500 ETF, SPY, barely scraped to a positive return and ended the week up 0.15%. This flat performance for the week disguises the initial positive start followed by a retracement of these gains on concerns about the in-going trade war between the U.S. and China. This volatility, and latent risk was not reflected in the performance of the merger arbitrage cash spreads. These spreads remain tight and the risk associated with 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 1.49% which continues to creep lower by the week. Indeed this figure dips below 1% to 0.98% if PACB is omitted from the calculation. The individual deals which have until recently provided attractive returns, for instance NXTM, continue to tighten making it more difficult to spot good opportunities in this market. AHL almost traded at parity during the week whilst ongoing trade discussions between the U.S. and China showed how another shock is more than possible before the issue is resolved. Although we remain long we have reduced positions in accordance with previous guidance of the shrinking opportunities available and now hold only a handful of the smallest positions.

Merger arbitrage trading is not without risks. 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, "evergreen" 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 RHT, PACB. 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.