On Wednesday August 6, 2014 the first broad-based merger spread widening occurred since the Fall of 2011. The simultaneous break up of three announced deals that day widened spreads and provided a unique entry point to capture value through the anticipated convergence of these spreads.
Early that day the news broke that “Walgreens is staying in the US.”1 The firm had chosen to keep its US tax domicile after buying Alliance Boots thereby forfeiting the highly-controversial “inversion benefit.”2Later that same day, Bloomberg reported both that Sprint and T-Mobile decided not to merge, and that Rupert Murdoch “gave up” on his bid to acquire Time Warner.3 The equities for firms involved in these deals were off considerably on the news, selling off more than 10%. Finally, Secretary of Treasury Jacob J. Lew urged Congress to act immediately to limit corporate inversion by making it a less economical option for US companies. By market close, contagion had ensued in merger arbitrage, causing a broad-based spread widening that persisted for days. Many deal spreads were in the high-teens by the end of the week after trading significantly tighter for several months, sometimes without regard for the nature of the deal — local or cross-border, simple or complex, short-term or long-term, with or without regulatory risks.
The Causes of Contagion:
The widening of merger spreads was caused by a number of factors. In the weeks leading up to August 6th, there was an abundance of merger deal flow focused in the healthcare sector and on corporate inversions. Some investors were speculating on which companies might announce inversion deals, buying them and propping up their prices as a result (see Alper Ince’s July 2014 PAAMCO Viewpoint).4 In some cases, with losses caused by widening merger spreads, risk management mechanisms may have recommended scaling back positions on existing deals, creating uneconomic sellers in otherwise attractive situations. Similarly, traditional long-only buyers who were long-term owners of shares of companies targeted for inversion benefits also started selling to minimize their overall exposure to US regulatory risk.
Looking deeper into the cause of the contagion, leverage levels — a common driver of merger spread movement — do not explain investor behavior in this particular case. Leverage did remain below peak levels. However, overall deal quality was lower and deal complexity had increased.5
In fact, leading up to August 6th, these two factors, when observed together, were far above the normal expected tradeoff band (see graph below), and contributed to the wider de-risking.
Current market conditions present an opportunity for investors to capture value by positioning for the convergence of merger spreads back to normal levels. A healthy credit market and the notion that market contagion irrationally widened spreads on many deals unrelated to corporate inversions, both support an opportunistic increase in the risk allocation to the merger arbitrage strategy.
Such an opportunistic increase needs to be nimble and dynamic, in nature and in structure, in order to capture the potential convergence before merger spreads normalize. Dynamically positioning for convergence can be effectively implemented through the use of variable leverage in managed accounts or by gaining exposure to hedge fund replicators/alternative beta via swaps. The managed account approach will effectively increase (and later reduce) exposure without the need to wait for the monthly subscription cycle. The replicators should also be able to reduce the need for a cash transaction if the appropriate counterparty set-up is in place. Once the market normalizes, allocators should aim to bring back their exposures in line with their longer-term targets.
1 “Walgreen Will Stay on U.S. Soil, Bows to Political Pressure“, Forbes.com, 8/6/2014, by Bruce Japsen.
2 “The financial advatage gained as a result of a change in a compay’s tax jurisdiction. Usually, a firm becomes a subsidiary of a new parent company in a jurisdiction with beneficial tax laws.
3 “Sprint and SoftBank End Their Pursuit of a T-Mobile Merger,” The New York Times, 8/5/14, by Michael J. De La Merced; “Murdoch’s Fox Withdraws Time Warner Takeover Offer,” Bloomberg, 8/6/14, by Jeffrey McCracken and Anousha Sakoui.
4 “Opportunity Set From Increased Corporate Deal Activity“, July 2014, by Alper Ince.
5 Friendly, logical, strategic deals are considered better quality than, for example, a cross border hostile takeover subject to regulatory approval.
Mayer Cherem, CFA, CQF is a Managing Director and Head of the Portfolio Solutions Group. He is also the Sector Specialist responsible for the evaluation and management of opportunistic investments and offensive risk management initiatives. Mayer focuses on identifying new, uncorrelated sources of alpha through fundamental analysis and their optimal integration into client portfolios. He chairs the firm’s Strategy Allocation Committee where he focuses on assessing the impact of asset allocation on overall portfolio risk and performance. As a member of the Risk Management Committee, Mayer is involved in the ongoing development of the firm’s risk criteria and quantitative aspects of portfolio construction. Mayer is also a member of the firm’s Investment Oversight Committee. Mayer earned his MBA from Columbia Business School after graduating from the Universidad Simon Bolivar of Venezuela with a BS in Production Engineering.
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