Regulators Have Cracked Down on Big Deals. Why Investors Might Try Some Merger Arb.

By trying to stop large deals, the government may be trying to deter more mergers, a strategy that looks as if it’s working, with the number of U.S. merger-and-acquisition deals down 20% this year relative to the weak pace of 2022.

That has made life difficult for merger arbitrageurs, practitioners of a decades-old strategy that involves purchasing the shares of companies that are subject to takeover offers. Deals have crumbled, shares of takeover targets have tumbled, and funds dedicated to the strategy have suffered losses.

Investors, though, may want to get exposure to the sector, despite the regulatory crackdown, because returns are finally looking more appealing, and compensate for higher regulatory risks at home and abroad.

“The environment is as attractive as we’ve seen in two decades,” says John Orrico, chief investment officer at Water Island Capital, which runs the $1.1 billion
Arbitrage Fund
(ARBFX).

Merger arbitrage, or risk arbitrage, is fairly simple. Most arbitrageurs buy shares of a takeover target and short the stock of the acquirer, betting that the two will converge when the deal closes. As the risks of government challenges have risen, so have spreads between the current stock price of target companies and the takeover price.

Orrico says investors stand to earn double-digit returns based on current arbitrage spreads, up from mid-single digit levels a year ago. “A diversified portfolio can absorb setbacks from delayed or blocked deals and still deliver attractive returns,” he says.

Investors can play the sector through mutual funds like the Arbitrage Fund, the
Merger Fund
(MERFX), and
NexPoint Merger Arbitrage
(HMEZX), or exchange-traded funds such as
IQ Merger Arbitrage
(MNA). These funds are down 1% to 2% this year after a tough May, and most have posted lackluster three-year annualized returns of about 1%.

The recent losses reflect a widening in arbitrage spreads and busted deals like
Toronto-Dominion Bank
‘s (TD) attempted purchase of regional bank
First Horizon
(FHN). With arb spreads more attractive than in recent years, investors shouldn’t look backward, though that should be a given now that risk-free Treasury bills yield 5%, up from near zero.

Investors can take a do-it-yourself approach to investing in takeover situations by purchasing the target company’s stock. Many deals now are all or mostly in cash, so buying the target is a reasonable strategy. Berkshire Hathaway CEO Warren Buffett is a skilled arbitrageur and has periodically invested in merger situations over his 80-year investing career. Based on its most recent filing, Berkshire is a holder of Activision, the maker of the popular Call of Duty videogame. Its stock trades at just $80, despite Microsoft’s $95 takeover price. The reason: United Kingdom regulators have opposed the transaction, arguing that Microsoft’s strength in cloud computing could give it an unfair advantage as videogaming moves to the cloud. Wall Street figures the deal has a 33% chance of getting done, at best.

Activision stock could score even if the deal dies. Financial results have been good in recent quarters, and the company could be sitting on $17 a share in net cash by year-end 2023, including a $3 billion breakup fee if the deal isn’t completed, according to Citi analyst Jason Bazinet, who has a $90 price target on the stock. Activision currently trades around 20 times 2023 earnings estimates.

Other situations look attractive, as well. Software maker
VMware
(VMW) trades at about $136, roughly $37 below the current value of chip maker
Broadcom’s
(AVGO) cash and stock offer, due to concerns over possible antitrust objections from the FTC and overseas regulators.

Roy Behren, co-manager of the Merger Fund, views the risk/reward as favorable, in part because the run-up in technology valuations lessens the downside risk if the deal falls apart. The downside to VMware stock could be $105 a share if the deal doesn’t happen, offering a good risk/reward with an upside to about $173, up 27% from the recent price.

Horizon Therapeutics stock, at $100 and a discount to Amgen’s $116.50 cash offer, is down 10% since the FTC sued to block the deal under a novel theory that the transaction could potentially lessen competition in the future, a decision that also has depressed shares of
Seagen
(SGEN), which is being acquired by
Pfizer
(PFE).

“The FTC has brought a terrible case,” Behren says. He sees a good chance that the judge assigned to the case, an appointee of President Donald Trump, will rule against the FTC by the end of October. Investors stand to make about 15% on Horizon Therapeutics within six months if the deal closes.

Merger arbitrage has been likened to picking up nickels in front of a steamroller because investors often risk a lot to make relatively little. That has changed. The risks still exist, but investors are playing for $100 bills rather than for pocket change.

Write to Andrew Bary at [email protected]