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At RegentAtlantic, one of our core portfolio allocations is to a broad set of active managers
called “Hedging Strategies”. The term Hedging Strategies refers to actively managed funds that seek
to produce returns that are not correlated to the stock market. This paper will focus on one
particular hedging strategy, known as Merger Arbitrage. We will discuss its primary
characteristics, sources of return, and risk factors. We will also analyze its historical performance
and present a tool that may be used to value the asset class going forward.
One of the most important tools in portfolio construction is the concept of diversification. A
portfolio made up of many different, uncorrelated asset classes may have less risk than any one
asset class on its own. This is because the asset classes, as long as they remain uncorrelated,
generally will not move in the same direction at the same time. This tends to reduce the volatility of
the overall portfolio as the various asset classes plot their own course.
At RegentAtlantic Capital, we employ a number of different asset classes to diversify our clients'
portfolios. One of the asset classes that has a relatively low correlation to stocks is our allocation to
hedging strategies. We allocate to hedging strategies through a number of mutual funds, whose
managers pursue several different strategies with the goal of delivering returns that are not
correlated to stocks.
One of these alternative strategies is merger arbitrage. A fund that employs this strategy will
purchase shares of the stock of a company after a takeover of that company has been announced.
As long as the takeover price is higher than the price paid by the fund to purchase the company
shares, the fund stands to earn the difference if the merger is consummated.
Two of the most common types of mergers are cash mergers and stock mergers. A cash merger
is the simpler of the two. In a cash merger, one company will offer to pay a fixed amount of cash per
share for another company. In a stock merger, one company will offer to exchange its own shares
for shares of the company it wants to acquire. It is also possible to have a hybrid merger, in which
case the acquired company’s shareholders will receive some combination of cash and stock for their
Cash mergers are common, and are simpler to arbitrage, so we will use an example of an actual
cash merger that occurred in 2009 throughout this paper. On April 20, 2009 Oracle Corp.
announced a takeover offer for Sun Microsystems Inc. which would pay $9.50 in cash per share of
Sun Microsystems stock. The day before this announcement, Sun Microsystems closed at $6.69 per
share. The day after this announcement, Sun Microsystems closed at $9.15 per share. At the time
of the announcement, the merger was expected to close on January 27, 2010.
This takeover announcement created an opportunity for funds employing merger arbitrage.
For a period of time, the funds could purchase shares of Sun Microsystems in the market for less
than what they would be worth in the takeover. A fund could purchase shares of Sun for $9.15, hold
the shares until January 27, 2010, and receive $9.50 per share if the merger was successfully
completed. That would result in a profit of $0.35 per share for the fund (ignoring taxes).
Why didn’t shares of Sun Microsystems trade at $9.50 per share immediately after the takeover
announcement? There are two primary reasons for this:
• Time Value – Time value refers to the concept that investors would rather have $1 today
than $1 at some point in the future. In our example, why would an investor want to pay
$9.50 for a share of Sun Microsystems today when the best possible outcome is that he will
simply receive $9.50 back in 8 months, when the merger closes? Instead, the investor can
take the $9.50, deposit it with a bank and receive $9.50 plus interest back over the same
period. Therefore, the shares of Sun Microsystems should trade at a discount to the
takeover price. This entices investors to purchase them instead depositing their money
with a bank.
• Risk Premium – Risk premium refers to the concept that investors expect to be
compensated for the risks that they take. In our example, an investor buying shares of Sun
Microsystems runs the risk that the takeover will not occur. If that is the case, then it is
possible that Sun Microsystem’s shares will trade for significantly less than $9.50 per share
once the fact that the takeover has failed is announced, and the investor will suffer a loss.
For this reason, the investor should be able to buy the shares at an even bigger discount
than just the time value discount. Shares of Sun Microsystems should trade at a discount to
their $9.50 per share value in the takeover to compensate investors for the fact that they
could have deposited their money with a bank and also to compensate investors for taking
the extra risk that a merger may fail to close. Investors will not purchase shares of Sun
Microsystems if they are not enticed to take on the extra risk by buying the shares at a
Figure 1 Source Bloomberg
Merger arbitrage does have a number of risks associated with it. The biggest risk to any one
merger is the possibility that the merger will fail. There are a number of reasons why this may
happen, including but not limited to the three below:
• Regulators may not allow the merger to take place. In the US, the Department of Justice may
rule that a merger would be anticompetitive. In our example, the Department of Justice
approved the merger in August 2009. However, on November 9, 2009, regulators in the
European Union raised a number of objections against the takeover. In response to this,
shares of Sun Microsystems closed as low as $8.10 in November 2009. You may recall that
in our example the merger arbitrage fund purchased shares for $9.15, so the fund would
have had an unrealized loss of $1.05 per share at this point.
European regulators did ultimately approve this merger and the merger did successfully
close on January 27, 2010. Nonetheless, the European regulators’ opposition to this merger
illustrates one of the risks of merger arbitrage.
• The board of directors of the company to be acquired may decline the offer. Although
takeover offers are frequently higher than the market price of a company’s shares before
the takeover announcement, there are cases where management and the board of directors
believe that the takeover offer undervalues the company. The board of directors may vote
to decline the offer in that case.
• The shareholders of the company to be acquired may decline the offer. In some cases,
activist investors may try to block a merger if they believe that it would destroy shareholder
Apart from risks that may affect any one merger, there are also a number of risks that affect the
entire merger arbitrage market. For example, although merger arbitrage mutual funds use little, if
any, leverage because (like all mutual funds) federal regulations limit how much debt they can
incur, there are other participants in this market. Banks, hedge funds and other market
participants turn to merger arbitrage as a way to earn returns and feel comfortable using leverage
in an attempt to enhance their returns. This means that, when banks and hedge funds have
difficulty securing funding for their margin loans, it can have adverse impacts on merger arbitrage
strategies. This contributed to the volatility of the merger arbitrage strategy during the credit crisis
of 2007‐2009, as banks and hedge funds de‐leveraged and sold out of their merger arbitrage
Based on historical performance data, merger arbitrage has been an extraordinarily
successful strategy. The Center for International Securities and Derivatives Markets (CISDM)
maintains a database of a number of indices tracking the performance of hedge fund strategies. The
CISDM Merger arbitrage index has delivered an average annualized total return of 9.7% since its
inception on December 31, 1989 through December 31, 2009. Over the same time period, the
standard deviation of returns has been 4.1%. Standard deviation is a measure of risk, and captures
how volatile a stream of returns has been over a period. For comparison, the S&P 500 produced an
average annualized total return of 8.2% over the same 20 years, and had a standard deviation of
returns of 15%. On average, merger arbitrage investors had higher returns with lower risk over
this 20 year period than S&P 500 investors.
Although the returns of the merger arbitrage index have had a relatively low volatility, they
have not been consistent over time. In the ten years ended December 31, 1999, the index had an
average annualized total return of 13.5%. However, in the ten years ended December 31, 2009, the
index had a significantly lower average total return – just 6.1% annualized.
Figure 2 Source Bloomberg
What explains the difference? One possible explanation is a shrinking arbitrage premium.
In our example, an arbitrageur could have purchased shares of Sun Microsystems at $9.15 after the
takeover announcement and held the shares until the deal completed to receive $9.50. Therefore,
the premium on this deal is $9.50 minus $9.15, or 35 cents per share. As a percentage of the share
price, this is about 3.8%. This premium captures the two components of return that we addressed
earlier – time value, to compensate investors for tying up their capital and risk premium, to
compensate investors for the risk that a deal may fail.
The premium is an important driver of returns for merger arbitrage funds. Merger
arbitrage funds should earn higher returns when the premium is higher, and lower returns when
the premium is lower.
Arbitrage Spreads – a way to value merger arbitrage
The premium alone, however, is not a great way to value merger arbitrage as an investment
strategy. The number it captures is a best case scenario – how much will investors make if the deal
closes at the predetermined price. Recall that merger arbitrage funds should be compensated for
two things – time value and risk.
The premium alone is not adequate because we do not know how quickly the deal will close.
Investors want the deal to close sooner – this allows them to take the proceeds of the deal and
reinvest them into another deal more quickly, and potentially make higher returns. Therefore, to
better capture the time value, it would be appropriate to adjust the premium for how long a deal
takes to close. We can do this by annualizing it (assuming that we could reinvest the proceeds into
an identical deal over the course of a year).
An annualized premium gives us a better idea of how much we are being compensated than
the premium alone. One more adjustment is appropriate, however. We should find out what the
difference is between this annualized premium and the rate that we could earn on a low risk
deposit with a bank. We will use the London InterBank Offered Rate (LIBOR) to approximate what
we could earn on bank deposits. We subtract LIBOR from the annualized premium – this gives the
incremental amount that we can earn over bank deposits by investing in merger arbitrage. This
captures the risk premium that merger arbitrage investors can earn. If this number is low, the risks
of merger arbitrage may not be commensurate with the likely returns. Investors may be better off
depositing their cash at a bank. If this number is high, however, merger arbitrage may earn high
returns over and above a low risk deposit in the near term.
So to summarize, merger arbitrage investors are better off when:
• Deal premiums are high
• Deal durations (how many days a deal takes to close) are low
• The spread of the annualized premium to LIBOR is high
The table below summarizes the evolution of the risk premium for merger arbitrage from
1990 through 2007.
Year Average Median Annualized LIBOR Annualized
Merger Merger Premium Risk Premium
1990 164 7.94% 18.26% 8.30% 9.96%
1991 164 7.50% 17.20% 5.95% 11.25%
1992 183 7.76% 15.84% 3.93% 11.91%
1993 174 7.27% 15.63% 3.43% 12.20%
1994 148 7.58% 19.45% 5.20% 14.25%
1995 143 5.57% 14.62% 6.07% 8.55%
1996 125 5.07% 15.31% 5.60% 9.71%
1997 130 4.10% 11.77% 5.85% 5.92%
1998 134 6.32% 17.90% 5.51% 12.39%
1999 125 5.90% 17.95% 5.58% 12.37%
2000 105 4.59% 16.63% 6.67% 9.96%
2001 119 2.63% 8.17% 3.57% 4.60%
2002 116 1.74% 5.50% 1.86% 3.64%
2003 123 1.94% 5.78% 1.23% 4.55%
2004 139 1.84% 4.84% 1.86% 2.98%
2005 116 1.90% 6.02% 3.84% 2.18%
2006 121 2.26% 6.88% 5.30% 1.58%
2007 103 2.03% 7.28% 5.20% 2.08%
Table 1: Source Financial Analysts Journal
As you can see, the falling returns of merger arbitrage funds are explained by two factors:
(1) the overall level of interest rates as measured by LIBOR fell around 2000, and (2) the risk
premium over and above the interest rate has been substantially lower since 2000 than it was
before. Low interest rates and low risk premiums reduced the return potential of merger arbitrage
as an investment strategy.
What about the future? Will investors be compensated better going forward than they have
been over the previous ten years? To find out, we studied all outstanding merger deals as of June
30, 2010, and used the following data to calculate the risk premium: (1) the median premium; (2)
the average duration; (3) LIBOR.
Year Median Median Annualized LIBOR Annualized
Merger Merger Premium Risk Premium
2010 61 1.54% 9.61% 0.53% 9.08%
Table 2: Source Bloomberg
Based on the calculation above, the risk premium for merger arbitrage is 9.59% as of June
2010. This is almost as high as its average level over the course of the 1990s (10.77%) and
significantly higher than its average level in 2000‐2007 (3.95%)
This paper discussed the characteristics of Merger Arbitrage as a hedging strategy and
analyzed its historical performance. The strategy’s historical performance was particularly
impressive in the 1990s, although the returns were lower over the ten years ended 2009 than
during the previous ten years. We believe that the risk premium, as measured by annualizing the
merger premium and reducing it by LIBOR, may explain the lower returns. Furthermore, it may be
a useful tool for analyzing merger arbitrage going forward.
Important Disclosure Information
Please remember that different types of investments involve varying degrees of risk, including the loss of money
invested and that past performance may not be indicative of future results. Therefore, it should not be assumed
that future performance of any specific investment or investment strategy, including the investments or investment
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