Active Thinking: Merger Arbitrage – Probability and risk

The end of the near-zero interest rate era and record-high stock markets in 2024 have raised the expectations bar for equity arbitrage. GAM Investments’ Global Head of Investments & Products Albert Saporta outlines the main strategies and tools at investors’ disposal, both in equity and merger arbitrage, to capitalise on the global opportunity set.

20 May 2024

Since the 2007-08 Global Financial Crisis, with interest rates locked at close to zero across the developed world, the demands many investors placed on risk arbitrage managers were modest in today’s terms. Hence, ‘done-deal’, low expected return and – typically – low risk arbitrage situations dominated many strategies.

But the end of rock-bottom interest rates over the last couple of years has changed the whole investment landscape, raising the performance bar in terms of the returns investors should require to make these strategies attractive. With risk-free rates now at around 5%, compared to zero just two or three years ago, the bar is now set higher in terms of beating risk-free rates of return if we are limiting our investment horizon to purely the safest, lowest risk areas of risk arbitrage. So, to beat the returns available on cash we have to be prepared to take on some risk; that is something that, in my opinion, too many people in this business have forgotten how to do. Hence, there has been a shift from a primarily risk arbitrage approach to multi-strategy equity arbitrage.

Even with the best analysis, merger arbitrage is a probability game

In merger transactions, it is essential to evaluate the probability of a deal being done, then compare the likely profit upside if the deal goes through with the potential downside, and money lost, if the deal does not go ahead. By assessing the probabilities and taking positions accordingly of various sizes across different deal situations of varying risk, we can target a higher level of expected return. Of course, while the quality of our fundamental analysis can help us to judge the probabilities more accurately, it cannot remove the element of probability entirely; there can never be a guarantee of success on any one deal. However, on average, over a greater number of transactions, investors can have greater confidence.

There are several other types of arbitrage situations that I believe are set to take a more prominent role as investors take on more risk in pursuit of higher returns.

The first is what I call corporate structure arbitrage. Here, we look at investment holding companies – their net assets mainly consist of listed shares, which they hold. These can be priced by the market at discounts or premiums. Over time, these tend to be volatile, presenting opportunities for arbitrage. Typically investors might take a long position in the holding company and short positions in the underlying share holdings if the discount to NAV is large enough (and vice-versa in the case of a premium). If we open our positions when the holding company is trading at a significant discount to NAV – perhaps 30-50%, and sometimes even higher, then that is clearly attractive (the proverbial buying a $ for 50 cents). Occasionally, the situation is reversed when a holding company trades at a premium to its holdings, creating the opportunity to short the holding stock and buy the underlying assets, although this is more unusual. With the right valuation and statistical models, arbitrageurs can take advantage of all kinds of mispricing situations.

Overview of the other main arbitrage strategies – stub, share class and special situations

Stub arbitrage looks to take advantage of price discrepancies between companies holding stakes in others. Imagine a situation where company A owns shares in company B, a stake that makes up a significant share of holding company A’s market cap. The ‘stub’ is the implicit value that the market places on company A’s underlying business. As arbitrage investors, we can then compare the value of the stub with that of other companies in the same industry.

Another strategy with the potential to drive returns is share class arbitrage. This approach looks to take advantage of mispricing between different share classes. For example, in many markets, such as Germany, Italy, Sweden and Brazil, investors can trade in voting and non-voting shares. The relationship between these share classes can be highly volatile and can present arbitrage opportunities using statistical models. Typically we go long the stock that is trading at a discount, offset against a short in the more expensive share class, potentially making the volatility work to our advantage to establish the arbitrage at the most attractive level.

Finally, we can invest in so-called special situations, a generic term for distressed valuations, corporate events and market dislocations. Think of a company that has just announced bad quarterly numbers; imagine the market overreacts and the stock is down 30%, for example, creating a valuation dislocation with its competitors. Sometimes we might adopt a basic pair trade, taking a long in the sold-down stock against a short in a competitor, or alternatively against shorts in a basket of several competitors, in expectation that mean reversion will occur in the valuations. This kind of situation occurred recently when French bank BNP announced poor results. After the stock suffered a knee-jerk fall, the opportunity arose to take long exposure which could then be offset against a short position elsewhere in the banking sector. Within a matter of a few weeks, as mean reversion set in, arbitrage investors had the opportunity to close the trade having made gains.

In all the above strategies, potential catalysts may drive returns higher and faster.

Safety in numbers – the benefits of combining multiple arbitrage strategies

Again, I must emphasise that successful stock arbitrage is a probability game – while no single trade is guaranteed to deliver profits, and accepting that some individual losses will occur, by adopting multiple arbitrage strategies across many diversified market exposures, even modest gains over short time periods rapidly add up over a longer timeframe. When annualised, the returns from a combination of these multiple arbitrage strategies can be particularly attractive, especially when diversified arbitrage strategies also help to keep the volatility of returns relatively low.

Given capital flows into equities and other markets, volatility, mispricings and market dislocations are constantly creating significant opportunities for investors targeting returns across multiple arbitrage strategies.