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Merger Arbitrage a Good ‘Alternative?”

Investors and financial media seem enamored these days about ‘alternative investing.” Alternative investing includes such things as private equity, hedge funds, managed timberland and futures strategies. The reasoning is simple – when one’s traditional mutual fund portfolio has returned close to nil over the course of the last 10 years, one starts to look elsewhere for investments.

One of the people most responsible for motivating individual investors to consider more ‘alternatives’ in their portfolio is Yale endowment manager David Swenson who diversified the school’s funds into real estate, timberland, and private equity many years ago. After it was revealed that Yale’s portfolio enjoyed strong positive returns in the 2000’s – while the average investor rode a roller coaster to small or even negative returns – individual investors began clamoring for a piece of the action. AND, the financial industry was only too happy to comply. Soon, we saw for example, an explosion of hedge “fund of funds” available to investors for as little as a $100,000 minimum investment (compared to the 5-20 million dollar minimums that institutions have, this IS low:).

Of course when an investing idea goes mainstream, it’s usually the end of the road. And some of the late comers got the reality check in 2008 when, with an larger amount of their assets in illiquid investments, such as real estate, hedge funds, in addition to their stocks, their asset statements were ‘punished’ with enormous losses.  People were hoping to avoid another 2000-2002 but instead got worse.

An Alternative?

One boring “alternative” idea that has been around for a long time, but may provide the lowered volatility that many people seek, is merger arbitrage (or “merge-arb”). Merger arbitrage is a strategy based on announced takeovers of public companies. In its simplest form it works like this – company A offers to buy company B for $100 per share in cash. After the announcement, company B’s stock rises from 72 to 98.25 per share. Why doesn’t it rise to $100? No one wants to own dead money, so if it hits 100, many would sell – and do even if it’s merely close to 100. So the stock price drops to – in this hypothetical example – 98.25/share. If it’s currently August 1, and this deal is expected to close on Nov 1, that is 3 months. in 3 months, I can invest 98.25, and based on how sure I am this deal will go through, my investment would grow to $100/share on the buyout date – a return of $1.75 in 3 months, which is roughly a 1.78% return. Annualized over 12 months (3 months x4) we have 1.78% x4 or 7.12%. not bad in this interest rate environment especially!

Among these deals, the smallest spread between the market price and buyout/takeover price would likely occur in all cash offers, on friendly terms, and with the buyer being likely to consummate.

All cash offers – if company A offers their stock to buy out company B, then the actual buyout value will fluctuate along with the price of A’s stock – makes it hard to estimate a return, and the return could shrink or go negative for merger arbitrage.

Friendly terms – this can be a good or bad thing. if it’s on friendly terms, it will likely close on time, meaning your estimated return is more likely to be correct. If it’s on unfriendly terms, such as with Yahoo and Microsoft a couple of years back, the company B, in that case Yahoo, can ruin it and cause a loss (and they did reject the offer and the stock is now much lower than Microsoft’s offer price). However, if it’s on unfriendly terms, and company B goes and seeks another offer at a higher amount, then the profit could be much higher.

The buyer being likely to consummate – in executing this strategy, it is important that the buyer has the cash, cash access, or strong stock currency to pull off the deal. It helps if the buyer is respected which could smooth the whole process. Warren Buffet’s buyout of Burlington Northern happened smoothly because Buffet offered all cash, it was on friendly terms (a significant premium was offered), and Buffet had the means to pull it off.

How does a regular investor get involved? There are funds that focus on this strategy – some are private and there are even a couple of mutual funds that focus on this. Interestingly, in a time when corporate balance sheets are flush with cash, we may see a pick up in mergers and acquisitions (M&A) and therefore merg-arb might be one investment refuge from the volatility/lack of progress of this market.

For more color on this, see this recent Financial Times article.

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