Merger Arbitrage Analysis And Spread Performance - June 9, 2019

by: Malcolm Spink, CFA

CIRCOR International rises on hopes of a higher offer.

Advanced Disposal Services is the only decliner of note during a strong week for merger arbitrage.

Average Merger arbitrage cash spreads remain wide following announcement of new deals.

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

CIRCOR International (CIR) was the biggest winner this week. Following last week's decline, the stock was up an impressive 6.74%. This deal remains an unsolicited approach from Crane (CR). During the week, Crane reiterated their commitment to buy Circor and this sent the stock price soaring. Crane expressed their desire to “enter into meaningful discussions regarding a transaction that would provide a significant premium for CIRCOR shareholders“. However, Crane also stated the $45 initial offer price was a fair one based on publically available information. Investors cheered the prospect of a higher offer based upon the possibility that “CIRCOR management engages with us and provides sufficient justification.” We have sold our position in CIR despite expecting both sets of managements to engage in dialogue in the near future. Speculating on higher offers in these instances can be fraught with danger and may tie up capital for lengthy periods if talks fail to make progress. Following the release of more concrete details, we will be ready to re-enter a position as necessary.

This is a similar situation to Wageworks (WAGE), another unsolicited bid approach. HealthEquity (HQY) have so far offered $50.50 per share in cash. The stock was the second best performer this week up 3.06%. Last week we stated, “We try to take advantage of the spread volatility before an agreement is reached“. In this situation, we were half-right. The spread volatility exists, but the spread moved in one direction only. Up. That has not worked well for our short call position. As the stock is now $1.00 above the offer, the market is also expecting the announcement of a higher offer. We will be keen to exit this position on any pull back and are prepared to take a loss if necessary.

Pacific Biosciences of California (PACB) again found itself amongst the biggest movers for the week. The $8.00 a share offer from Illumina (ILMN) offers an arbitrage spread of 16.11%. This week the stock finished 2.84% higher at $6.89. Once again, there were no regulatory filings and no new deal news or commentary. However, during the week an initial rise gave us the opportunity to exit part of our position around the $7.00 level. This is consistent with our long time strategy of actively trading this spread. We are still long for the time being. For further details, one can simply search the performance archives on the mergerarbitragelimited website for a complete listing of our commentary on this spread.

For the sake of completeness, Advanced Disposal Services (ADSW) was the worst performer this week declining 0.28% or $0.09. With no news announced, the stock appears to have succumbed to a bout of profit taking. This deal has a large closure window and may be deterring investors who seek faster profits elsewhere. The spread is 3.43% but we caution investors that should the spread widen there is still a long time to forecast completion.

Merger Arbitrage & Market Data

The broader market performed strongly during the week. The aversion of a trade war with Mexico re-established confidence that trade deals are achievable. Thoughts now turn to China as negotiators seek a solution to the ongoing dispute. Domestically, weaker than expected manufacturing job growth has reduced the threat of interest rate rises. This sent the market into a frenzy and the S&P 500 ETF (NYSEARCA:SPY) finished up 4.47% for the week.

Surprisingly, the MNA ETF remained relatively unchanged. By Friday, the MNA ETF was down 0.03%. (You can read more about the MNA ETF in the "Strategy" section at the Merger Arbitrage Limited website).

Merger Arbitrage Returns June 9, 2019

Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw 14 winners and 5 losers this week with zero non movers. The top 20 largest cash merger arbitrage spreads as defined by appreciated by 0.87% and the standard deviation of returns was 1.68%. This is significantly above the 3 month and long term averages. The performance of the portfolio was attributed to the large rebound in CIR & WAGE. Both deals where the market is anticipating higher offers before both either deal becomes "friendly".

The portfolio of cash spreads remained steady during the week. The top 20 discount spreads now offer an average of 4.13%. The T20 portfolio has 20 deals and 0 vacant spots filled by cash. The return figure is more broadly based than ever as spreads have declined across the board.

Merger Arbitrage Strategy

Investors have a number of options to choose from for a healthy return as deal spreads have widened across the board over the last few weeks. The average merger arbitrage spread has remained wide this week despite an improvement in many deal spreads. This is due to the introduction of new deals such as Cypress Semiconductor (CY) and El Paso Electric (EE). The portfolio is no longer as reliant on a small number of spreads as noted previously, although PACB remains significantly large at 16.11%.

We previously warned of the failure to resolve the US-China trade talks. However, despite macro-economic factors effecting the performance of merger arbitrage spreads, it was economic data closer to home which provided the impetus for this weeks rise. Interest rates can have a huge effect of the performance of merger arbitrage. We suggested some weeks ago that returns from the spreads on our top 20 list (available from the Merger Arbitrage Limited website) were becoming so tight they were barely above the level of return available for holding cash. Since that time, the interest rate has declined to circa 2.03% and the level of return on cash merger arbitrage has increased.

The market has presented opportunities for which we were waiting. Early closing could even help increase the attractiveness of those opportunities. We discuss deal closing schedules in a previous article. We have increased our long exposure yet again during the week to take advantage of this weakness. As always, difficulties still remain with individual spreads but we maintain our positive outlook for the profitability of merger arbitrage.

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 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.