Merger Arbitrage Analysis And Spread Performance - March 10, 2019

by: Malcolm Spink, CFA

RedHat receives a second request from the Department of Justice.

Ultimate Software climbs to a 0.58% premium to the offer price from Hellman & Friedman.

Cash based merger arbitrage spreads drift outwards as broader market declines.

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 intend to take based upon the analysis given.

Deal Specifics

Redhat (RHT) has had a great run recently and was given an additional boost when it was announced that Warren Buffet had made an investment. During this time we stated we were looking to reduce our holding but were happy to stay long following the aforementioned investment. However, during the week the company received a second request from the DoJ and the stock declined. This offer has a very long completion timetable so a request such as this was probably anticipated by the company. However, this additional speed bump will extend the closing process beyond some of the more optimistic projections. This caused RHT to be the week’s worst performer down 1.03% at $180.71. This leaves the spread at 5.14% to the $190 offer price from IBM. We had just sold a small portion before this announcement as the annualised spread had declined to around 4%. Following this recent decline we are already keen to top back up should the stock decline any further.

This week’s surprise best performer was Ultimate Software (ULTI). The stock climbed 0.60% for the week or $1.99. What makes this situation all the more interesting is the spread now stands at a 0.58% PREMIUM to the $331.50 offer price from Hellman & Friedman. The only official news announced during the week was the award of two Excellence in Technology 2018 awards from Brandon Hall Group which is not connected to the deal. One can assume from this price movement that traders are expecting a revision to the initial deal terms here although there has not been any no public speculation on the details.

Spark Therapeutics (ONCE) also had a good week as Roche formally announced the beginning of its tender offer for the stock. This sent the stock up 0.45% for the week and the simple spread now stands at 0.62%. Tender offers tend to complete quicker so the annuailsed spread on this deal is attractive. The company announced the merger on February 22nd. With hindsight we should have initiated a good position in this stock but missed our opportunity. We will look for an attractive entry point in the coming week.

We have commented many times how have been trading Pacific Biosciences of California (PACB). We continue to practice this active arbitrage strategy of frequently entering and exiting this stock to exploit the volatility of the spread. During the past week PACB was the second worst performer and finished down 0.82% at $7.29. Having previously sold the majority of our position we were able to buy some back during the recent dip. There was no new deal related news concerning the $8.00 a share offer from Illumina (ILMN) during the week but the volatile nature of this stock continues to offer up ample opportunities for investment.

Merger Arbitrage & Market Data

The decline in the broader market observed during the week relates primarily to the outcome of trade negotiations between the U.S. and China and weak U.S. economic data. The S&P 500 ETF, SPY, delivered a negative performance to finish down 2.12% for the week.

The MNA ETF suffered one of its worst declines in recent times to finish down by 0.71% for the week. The top 20 largest merger arbitrage spreads as defined by declined fractionally by 0.03% and the standard deviation of returns was 0.53%.

Table of Returns March 8, 2019 The one deal that closed during the week that we had previously been following was Civitas Solutions (CIVI).

Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw more winners than losers this week and the negative performance continues a losing streak which begun a week ago. The performance of the portfolio was bolstered largely because of Ultimate Software (ULTI) whose stock now trades at a 0.58% premium to the offer price of $331.50 from Hellman & Friedman.

Cash spreads continue to remain tight on a historical basis but have begun to widen in the last couple of week. Opportunities have appeared in the market but are quickly exploited. New deals do appear to be forthcoming although for the time being the top 16 discount spreads now offer an average of 1.47%. The T20 portfolio now has 4 vacant spots in our top 20 portfolio due to a number of spreads trading at a premium (ie above the current offer price) rendering them ineligible for inclusion. To maintain a consistent weighting across the portfolio and through time we are allocating 4 portions of cash to fill the vacant arbitrage spots in the top 20 list. This action reduces the overall average spread to 1.17%. This figure falls to just 0.72% when PACB is omitted whose spread, currently at 9.74% is the largest available.

Merger Arbitrage Strategy

As stated in previously, positive portfolio performance going forward continues to rely on a small number of spreads with the capacity to move profitably, specifically PACB and RHT despite the fact that in general spreads have widened. Although during this last week it was ULTI that provided the largest return as arbs look for an improved offer. We are watching very closely the previously announced deal extension by Integrated Device Technology (IDTI). Unfortunately the spread tightened marginally during the week whereas we are looking for an entry point somewhere around the $48 level.

The rise in the broader market came to an abrupt halt this week and merger arbitrage had to make do without this support. Beyond this, should the broader market decline further spreads will start to suffer noticeably. New deals have been announced but with limited opportunities available these already have minimal or negative premiums. Deducting the level of return available for simply holding cash, let's say 2.55% pa, some spreads, when annualized basis, do not justify inclusion in a portfolio when the downside is considered Arbitrageurs need to pay extra special attention to deal closing schedules to maximize annualized returns.

We continue to retain some long positions, and some we have increased, namely RHT, but are level of committed capital is still quite low. As with previous guidance we now hold only a handful of the smallest positions but expect to increase these positions in the coming weeks.

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 sitemap 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.