Merger Arbitrage Analysis And Spread Performance - April 14, 2019

by: Malcolm Spink, CFA

Versum Materials and Merck KGaA officially sign merger deal.

Spark Therapeutics continues it decline.

Merger arbitrage spreads for cash deals stabilize.

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 Spotlight

The biggest story of the week (but not perhaps the most surprising) was the official announcement on Monday of an agreed deal between Versum Materials (NYSE:VSM) and Merck KGaA (OTCPK:MKGAF). We had always been hesitant to speculate on what a higher offer might look like. It seems Merck are prepared to pay top dollar for the prize despite Entegris not choosing to increase their offer.

The offer is at $53.00 per VSM share. With the current stock price at $52.00, the spread is 2.23% if two dividend payments of $0.08 are included. [Author's update, April 16, 2019, 9:30 a.m.: This return calculation has been corrected to include two dividend payments.] The deal is expected to close in the second half of the year. It is unlikely that any problems encountered further down the road would deter Merck from claiming their prize. Especially as they have clearly shown their fondness to pry VSM from the jaws of Entergis. In which case, the spread remains relatively loose due to the closing time frame suggested by the companies. We think this is a touch generous and see this spread offering a return clearly in excess of others available at this time. At around this level we will be looking to initiate a small position in the coming week.

Deal Specifics

This week’s worst performer was Spark Therapeutics (ONCE). The stock declined 1.29% or $1.45. The spread now stands at 3.04% for a tender offer that was originally expected to close April 2nd. However, with only 29.4% of the stock tendered, Roche has extended the offer until May 2nd. This low take up of the tender offer continues to weigh on the stock. A prior comment from Roche, "All terms and conditions of the offer shall remain unchanged during the extended period" has clearly not inspired traders to speculate on a higher bid forthcoming. In addition to this, Roche has also withdrawn and refiled the Premerger Notification and Report Form under the HSR act effective as of April 2nd. They were expected to refile on or about April 10th. As this is a tender offer, the waiting period will expire on the 15 days later.

As we stated last week "We will monitor this spread and look for an entry point if the spread widens sufficiently". It appears we might have been a bit too hasty in initiating a position in this stock. We assumed there would be a positive bump following a refiling and a more concerted effort from Roche to convince investors why they should tender their shares. Fortunately we do not have a particularly large position but we will monitor closely any developments.

Pacific Biosciences of California (PACB) was the biggest gainer this week. The stock climbed 1.52% or $0.11 to $7.37. Despite once again there not being any deal news the stock continued it volatile ride. We mention the rise here so as to highlight our previously stated strategy. During the week we were able to exit a little more of our position on the up move and we will be looking to buy back the stock on any weakness.

Merger Arbitrage & Market Data

The broader market saw respectable gains for the week focused on renewed optimism of a resolution to the U.S. - China trade deal and hopes for strong earnings season. The S&P 500 ETF (NYSEARCA:SPY) finished up 0.54% for the week.

Surprisingly, the MNA ETF produced a calamitous return to finish the week down by 0.69%. It is unusual that this product has such a disparity to the performance of the SPY when no significant negative deal news was announced during the week. This once again shows the shortcoming of investing in this particular product as the short leg of that stock for stock deal is not accurately represented. (You can read more about the MNA ETF in the "Strategy" section at the Merger Arbitrage Limited Website).

Merger Arbitrage Returns April 14, 2019 Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw more winners than losers this week for the third week in a row. The positive performance means the portfolio is in the process of putting together a nice stable positive run. The top 20 largest cash merger arbitrage spreads as defined by rose by 0.09% and the standard deviation of returns was a lower than in recent times at 0.53%. The performance of the portfolio was largely attributed to the rebounding of PACB and the higher standard deviation because of the decline in Spark Therapeutics (ONCE).

Cash spreads stabilized during the week holding firm due to the rebound of PACB but also the continuing slide of ONCE. There were no new deals that made our list. The top 20 discount spreads now offer an average of 1.90%. The T20 portfolio now has a full complement of deals and no vacant spots. This return figure now remains at a respectable level even when PACB and BXG are omitted. The figure now only falls to just 1.43% when their spreads, currently at 8.55% and 5.07% are removed.

Merger Arbitrage Strategy

The T20 list is now back to full strength (no cash positions). We continue to relax our point of view that positive portfolio performance going forward would be reliant on a small number of spreads with the capacity to move profitably as we noted in last week's article.

However, deals are not appearing as fast as we would like. Political situations should not be underestimated by the merger arbitrageur despite the recent optimism as spreads could suffer noticeably. The rise in the broader market this week has broadly helped existing spreads move towards their offer prices. New deals that have been recently announced have very quickly moved towards their respective offer prices despite the lengthy closing times (In a previous article we discussed deal closing schedules and how understanding this facet of merger arbitrage can help to maximize profitability).

Almost half of the spreads on our top 20 list (available from the Merger Arbitrage Limited website) are not above the level of return available for simply holding cash, circa 2.40% pa. Some spreads on an annualized basis, do not justify inclusion in an investment portfolio when using the official timeline guidance. We retain our positive outlook for the profitability of merger arbitrage but with the market going from strength to strength the key will be the quantity and quality of new deals that become available.

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 ONCE, 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.