Deck the Halls with Spreads Aplenty
There is currently over one trillion US dollars of announced and contractually binding merger activity in North America and Western Europe (measured by target market capitalization). We are now in an environment that we haven’t seen since the late 90s (a good period for arbitrage); there are simply too many merger situations for the amount of merger arbitrage capital looking for a home. The result is that spreads are widening (we are being paid more for providing liquidity) and there are a large number of situations from which we can construct an arbitrage portfolio. The chart below (source: UBS) shows the general widening of spreads in merger arbitrage since 2013.
Clearly, this is a more attractive environment in which to invest in merger arbitrage, with two caveats. The first is that not all mergers are created equal and we are seeing many large transactions with serious regulatory issues. The largest current deal, Pfizer inverting into Allergan ($200B+), trades at a 20%+ rate of return with fairly limited downside. However, it appears to us that the US Treasury (and Congress, potentially) is actively doing everything in its power to block the merger (or negate its economic attractiveness). Frankly, these are uncharted waters and we are steering clear for the moment. Updating a table from our last quarterly letter, again highlights how challenging some of these large situations are. As always, the decision to invest requires the careful analysis of the risks versus the reward.
Despite these more difficult deals, there are plenty of more straightforward situations ($5B to $15B market cap) which constitute the bulk of the Vertex Arbitrage Fund portfolio. This leads to the second caveat, which is that even straightforward deals are seeing considerable spread volatility as a result of the large number of attractive situations. Spreads that we liked at 7%, we love at 9%, but have to wear short-term negative P&L as a result of the widening. Fortunately with an average “maturity” of these deals under four months, we won’t have to wait long for the spreads to tighten.
To sum up, right now there are a great deal of attractive merger arbitrage situations to choose from and we expect the next six months to be very fruitful for the Vertex Arbitrage Fund. With forthcoming changes to interest rates, we favour the strategy for its low duration and ability to generate higher returns in higher rate environments. Our objective is to provide a return of 4% to 6% above short-term rates, with low volatility. Although 2015 was short of that range, the strategy did achieve its ultimate goal of providing investors with a positive return through volatile markets. 2016 is shaping up to be more in line with our expectations.
Until next time. . .
Short-Term Rates The interest rate on a loan or other obligation with a maturity of less than a year.
Current Rates (both annualized):
1 Month LIBOR = 0.24% (USD) 1 Month Treasury = 0.11%
Arbitrage Arbitrage is the practice of profiting from price differentials. Merger situations typically trade at discounts to their closing terms. As investors, we aim to profit from that discrepancy.
Deal The publicly announced merger or takeover between two companies for disclosed terms.
Spread A spread is the difference between the market price and the value in a deal. It is the primary source of return in merger arbitrage investing.
Widening & Tightening Widening occurs when the size of a spread increases. For existing positions it results in negative returns; for new positions it results in a larger return. Tightening is the opposite effect and typically occurs as the time to completion nears.
Deal Closure & Deal Failure (or break) Deal closure is a synonym for completion. It occurs when all parties agree to the terms and the transaction is effective.
A deal failure (or break) occurs when the terms of a deal are not met and the parties disengage. Deals are usually offered at a premium to a target company’s market value, so the result is a drop in share price and the evaporation of a spread.
Target & Acquirer In a deal the “target” represents the party receiving an offer and the “acquirer” represents the buyer.
Maturity The anticipated time from announcement to the closure of a deal.
P&L The profit or loss associated with holding an investment.
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