Merger Arbitrage Analysis And Spread Performance - March 17, 2019

by: Malcolm Spink, CFA

Pacific Biosciences of California reverses last weeks losses to be this week's best performer.

Versum Materials climbs to a 2.56% premium to the offer price from Merck KGaA.

Cash based merger arbitrage spreads tighten following last weeks expansion as broader moves higher.

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

Readers that have been following our analysis of Pacific Biosciences of California (PACB) will by now be fully aware of our strategy with regards to trading this spread. This deal still offers a simple spread (non-annualised) of 8.70% and so still has plenty of room to move. The volatility continued this week and this stock regained the losses encountered during the previous week. We stated at that point we had topped up our position and have now already exited part of that investment. We will 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 finished up 0.96% at $7.36. 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.

Mellanox (MLNX) was the bright spark in an otherwise subdued week for merger arbitrage. This new deal announcement has NVIDIA (NVDA) offering $125 per share in a deal expected to close by the end of the year. Generally speaking, the two words that check even the most optimistic of arbitrageurs, "China" & "Semiconductors" are enough to induce a noticeably widening of a given spread. However, this does not appear to be the case with Mellanox. The simple spread currently stands at 5.96%. As one reader on the Merger Arbitrage Website noted this deal still has a number of regulatory hurdles to clear such as SAMR (China). We don't think this spread looks particularly attractive and is too tight to invest in right now. Traders MUST be careful in chasing returns when opportunities are sparse and not bidding up a spread simply because there is now superior alternative. We are not convinced the risk/return profile is being accurately applied to this scenario.

Versum Materials (VSM) continued to defy gravity as the stock finished the week at $49.76. This is against the all cash offer of $48 per share from Merck KGaA (OTCPK:MKGAY) (not to be confused with the U.S. Merck). An offer that trumped the previous all stock offer from Entegris (ENTG). The adoption of a limited time poison pill by Versum has fueled speculation amongst arbs that a higher offer is required from Merck to gain the board's approval. The expiration of the HSR waiting period for the original deal occurred during the week and at the same time Merck continued its marketing campaign to convince Versum shareholders as to the superior benefits of their deal. We have already bought back our entire short position that we entered previously. This is a difficult situation analyse. Theoretically Merck should not need to raise their offer but this is clearly what the market expects. For now we shall remain on the sidelines and continue to monitor this position whilst expecting additional developments very soon.

Merger Arbitrage & Market Data

The rise in the broader market observed during the week relates primarily to renewed optimism on the outcome of trade negotiations between the U.S. and China and speculation on the Fed's interest rate decision coming this week. The S&P 500 ETF, SPY, delivered a hugely positive performance to finish up 2.51% for the week.

The MNA ETF however suffered another negative week to finish down by 0.19% for the week. This is a rare disparity considering the rules of constitution for MNA. (You can read more about that at the Merger Arbitrage Limited Website). The top 20 largest merger arbitrage spreads as defined by rose by 0.12% and the standard deviation of returns was a subdued 0.31%.

Table of Returns March 15, 2019 The one deal that closed during the week that we had previously been following was Esterline Technologies Corporation (ESL) .

Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw more winners than losers this week and the positive performance is welcome relief following two weeks of losses. The performance of the portfolio was bolstered largely because of Pacific Biosciences of California (PACB).

Cash spreads continue to remain tight on a historical basis but had begun to widen slightly in the last couple of weeks. New deals do appear to be forthcoming, such as Mellanox (MLNX) and despite our reservations (see above) this has helped increase the top 18 discount spreads which now offer an average of 1.62%. The T20 portfolio now has 2 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 2 portions of cash to fill the vacant arbitrage spots in the top 20 list. This action reduces the overall average spread to 1.46%. This figure falls to just 1.08% when PACB is omitted whose spread, currently at 8.70% is the largest available. Fortunately however, the impact of this spread is slowly subsiding as new deals are announced.

Merger Arbitrage Strategy

We had stated previously that positive portfolio performance going forward was relying on a small number of spreads with the capacity to move profitably. With the introduction of Mellanox (MLNX) this is starting to change. We continue to watch very closely the previously announced deal extension by Integrated Device Technology (IDTI). This spread still only offers 3.94% and as time moves on we may be willing to raise our preferred entry point of somewhere around the $48 level.

The rise in the broader market came continued again this week and merger arbitrage continued to squeeze what is left out of an already tight market. Should the broader market decline spreads could suffer noticeably. New deals have been announced but with limited opportunities available these already have minimal or in some cases negative premiums. There are not a huge amount of deals that are returning more than the level of return available for simply holding cash, let's say 2.55% pa. Therefore some spreads, on an annualized basis, do not justify inclusion in a portfolio. Arbitrageurs need to pay extra special attention to deal closing schedules and potential dividend payments to maximize annualized returns.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.