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Merger Arbitration Strategies and Protection

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After a long period of relative quiet, market volatility has again become an issue, with investor concerns focusing on a host of matters including global trade, interest rates, and the aging of the economic cycle. Alternative investments, specifically merger arbitration strategies, are designed to provide some protection in times like these while allowing investors to maintain exposure to the market.

Merger arb strategies, a subset of event-driven alternative investments, seek to take advantage of the pricing inefficiencies in an environment isolated from current market influences that often results after an acquisition deal is announced to when it closes.

For example, ABC company announces its intent to acquire XYZ company for $100 a share. Prior to the news, XYZ is trading at $90 and subject to typical market activity; post-news, its shares jump to $99, still a dollar short of the offer price. The reason for this spread, or difference in share prices, is the risk of deal failure, or the chance that the deal won’t go through for one reason or another. Once the deal is announced, the acquisition target is usually less subject to the movements of the market, potentially creating a smoother source of returns. When the deal does close at $100 a share, the arbitrage, or potential gain, is $1 a share.

The construction of the deal may make it even less subject to the ups and downs of the stock market. A deal typically consists of a combination of stock and cash. In an all-stock deal, the stock of company XYZ is exchanged for stock of company ABC. This can result in a decrease in stock price of the acquirer due to risks surrounding the deal. Because the majority of deals are now financed with cash, the correlation, or association to the equities market, should further be reduced. In fact, the number of all-stock deals has been declining for some time and represented just one in ten of all U.S. transactions in 2017, down from around one in four the year before1.

To further help mitigate the risk of deal failures and to increase the opportunities to potentially benefit from price inefficiencies, merger arb strategies typically establish positions in multiple transactions, each in different phases of completion. Additionally, taking a short position in U.S. and non-U.S. markets is another strategy that seeks to mitigate downside participation.

Related: The Market’s Wild Ride

The benefits of M&A strategies have been available to high net worth investors and institutions for decades in a traditional hedge fund structure. However, hedge funds are known for their high investment minimums and fees, limited access into their holdings and investment process, and lengthy lock-up periods. Innovations in the ETF market have created access for retail investors to very similar strategies at a fraction of the cost and with better transparency, liquidity and tax efficiency.

M&A activity remains strong by historical standards, with $2.5 trillion in deals announced globally in the first half of 2018, according to data from Thomson Reuters. Deal count has declined only modestly, to about 10,800 in 1H 2018 from 11,700 in the same period last year2.  Still, by the end of 3Q, 8,683 deals had closed in North America alone so there’s no shortage of transactions for potential inclusion in a merger arb strategy3.

A thoughtfully constructed merger arb strategy has the potential to create a source a smooth and consistent returns isolated from broad market influences. You don’t have to guess the next big takeover target; you just have to be patient as the merger and acquisition process plays out across a broad range of publicly announced transactions. It’s an idea worth considering as we head into what promises to be another interesting New Year.

1. “Companies shunned all-stock mergers in 2017,” The Financial Times, December 6, 2017.
2. “10 charts illustrating M&A activity in 2018,” pitchbook.com, August 28, 2018.
3. “9 charts explaining M&A activity in 3Q 2018,” pitchbook.com, November 21, 2018.
About risk:
All investments are subject to market risk and will fluctuate in value.  Alternative investments are speculative, not suitable for all clients, and intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, located at 51 Madison Avenue, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.
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