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Merger Arbitrage Analysis And Spread Performance - February 17, 2019

by: Malcolm Spink, CFA

RedHat arbitrage spread continues to narrow following announcement of Berkshire stake.

Pacific Biosciences of California continues its volatile ride.

Multiple deal closures further reduce the available investment pool of cash based merger arbitrage opportunities.

This article explains the reasons behind the movement in a selection of the largest U.S. cash merger arbitrage spreads from the past week as calculated by Merger Arbitrage Limited. 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

Redhat (RHT) had another strong week and finished up 0.90%. Despite there being little direct news on the advancement on the deal with IBM it was reported that Berkshire had taken a stake. The simple spread now stands at 4.98%. In our opinion, a position initiated at this time by Berkshire would be based on a strong belief that this deal will close successfully. We have postulated for some time that we have been looking to take some money off the table here at the right price primarily because of the closing time frame. However in light of the limited alternative merger arbitrage opportunities available and this endorsement from Berkshire we are cautiously maintaining our position for the time being.

Tribune Media Company (TRCO) was up 0.72%. During the week, acquirer Nexstar Media Group was reported by Bloomberg to be close to finalising a deal with Apollo Global Management for the sale of a group of local television stations. This would be conditional of the successful purchase of TRCO and as such acts as another vote of confidence for its successful completion. The spread is now only offering 0.69% and is not expected to close until 3Q.

USG Corporation (USG) reported earnings during the week and came in below analysts' estimates. The proposed takeover by Gebr. Knauf KG (Knauf) is for $44.00 per share of which a special $0.50 dividend has already been paid. As reported in the earnings statement the deal is still expected to close in early 2019. The spread is now at 0.74%. We maintain our long (reduced) position in anticipation of imminent closure.

Pacific Biosciences of California (PACB) reported 4Q and annual results on Monday. Despite a muted effect initially the stock declined $0.06 for the week or 0.83%. As stated last week, the only official news during the week was a number of SC 13G/A filings which detailed the acquisition of beneficial ownership by individuals. The offer of $8.00 a share from Illumina leaves a spread of 12.20% and gives it plenty of room to move. We continue to actively trade the volatility of this spread and have increased our position during the week. In the absence of any deal developments we will take profits as and when they arise.

Merger Arbitrage & Market Data

The S&P 500 ETF, SPY, delivered a stunning performance to finish up 2.55% for the week.

The MNA ETF regained its winning streak and finished up 0.12% and the performance for the top 20 largest merger arbitrage spreads as defined by was positive 0.11%.

There were four deals to close during the week which now leaves vacant spots in our top 20 portfolio due to a lack of appropriate candidates. Aspen Insurance Holdings Limited (AHL), Mindbody (MB), Loxo Oncology (LOXO) and Athenahealth (ATHN).

Merger Arbitrage Portfolio Analysis

The rise in the broader market is despite the failure to resolve the ongoing trade war between the U.S. and China. Talks are expected to continue next week. This latent risk is not reflected in the performance of the merger arbitrage cash spreads.

U.S. based cash merger arbitrage positions saw more winners than losers this week for the eighth week running and the positive performance of the portfolio was due in large part to the performances of RHT and TRCO. Although this observation is consistent with a rising market, cash spreads are extremely tight.

As opportunities become increasingly scarce, the top 17 discount spreads now offer an average of only 1.66% which although at first appearing to be higher than last week simply reflects the fact that four deals, all with lower spreads closed during the week. This figure falls to 1.01% if PACB is omitted from the calculation and to 0.74% if RHT is removed. To maintain a consistent weighting across the portfolio we could allocate 3 portions of cash to fill the vacant arbitrage spots in the top 20 list. This action reduces the overall spread to 1.42% and to 0.85% and 0.62% when PACB and RHT are omitted.

Merger Arbitrage Strategy

Positive portfolio performance going forward will be relying on a small number of spreads with the capacity to move upwards. It is spreads such as PACB and RHT which will be the primary drivers of portfolio volatility. Spotting individual deals providing attractive returns is increasingly difficult. Even the announced deal extension by Integrated Device Technology (IDTI) has failed to significantly affect the spread and has now almost recovered to its preannouncement level.

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. Ongoing trade discussions between the U.S. and China demonstrate how another shock is more than possible before the issue is resolved. With interest rates hovering around the 2.50% mark investors need to pay extra special attention to deal closing schedules to maximize annualized returns.

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" content such as "how-to" & introductory guides, a reading list and much more including a list of the largest cash merger arbitrage spreads currently available can be found at the Merger Arbitrage Limited website associated with the author of this article.

Disclosure: I am/we are long rht, PACB, USG. 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.