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Merger arbitrage investors have been struggling this year. Their luck could start to turn soon. In July, the Federal Trade Commission lost an appeals court bid to block Microsoft’s acquisition of video game maker Activision Blizzard. The FTC also agreed to withdraw from a trial against Microsoft slated for August. This could open the door for merger arb to make a comeback. At its core, merger arbitrage involves buying stock in a company targeted in a takeover or merger then selling those shares as the deal closes. It is sometimes paired with a short bet against shares of the acquirer. Essentially, investors in this space are betting on the likelihood of a deal closing. That said, there are risks to this strategy, making it difficult for regular investors to implement it. This strategy has yielded steady returns going back to 2013. In 2021, it returned more than 10%, according to according to data from Hedge Fund Research. However, hedge funds employing it have lost 2.78% year to date, while the S & P 500 is up more than 16%. The tide, though, could be turning for merger-arb. “My opinion is that the opportunity of merger arbitrage will probably be very good over the next several years,” said Andrew Beer, Managing Partner at Dynamic Beta Investments. “I think the courts will limit the [FTC’s] ability because the likely legal conclusion is that it has been exerting or trying to block deals beyond the scope of its legal authority to do so.” Tough 2023 Merger arbitragers have been challenged this year as the pipeline for M & A transactions hit a drought — thanks in part to higher rates and falling stock prices. Global M & A activity dropped 40% in the first half of 2023 compared with the same period a year ago, according to Dealogic. Dealmaking also became more unpredictable as competition watchdogs have been more aggressive in going after corporate takeovers. “Investors were too fearful that even solid deals that we did not think faced significant antitrust scrutiny were trading at very wide levels in terms of spreads and return opportunities,” said John Orrico, chief investment officer of Water Island Capital, which runs the $1 billion arbitrage fund. The antitrust risk was evident in widening the gap between the stock and deal prices. In May, the Federal Trade Commission sued to block Amgen’ s $27.8 billion acquisition of Horizon Therapeutics , the first pharmaceutical deal the agency tried to block since 2009. Horizon’s stock plunged 14% on May 16 following the FTC announcement. It has since rebounded around 8%, but the spread between Horizon’s the agreed deal price and where shares are trading now has widened to about $12 per share. HZNP 6M mountain Stock plunged on May 16 “It’s been very challenging this year, because of the headwinds, fewer deals, heightened antitrust regulation has made it a more difficult market,” said Salvatore Bruno, chief investment officer at IndexIQ. Tide turning? In the past few weeks, merger investors have been more confident in their bets on deals that have drawn regulatory scrutiny after the revival of the Microsoft-Activision deal. “For the first half of the year, we were basically flat but then we’re up close to 2% in July. Part of that is due to the sentiment improving,” said Orrico of Water Island Capital. “For instance, Microsoft and Activision winning in court, helps bring in spreads out of the deals because people realize the law is on their side.” The agency’s loss has since narrowed the spread on some pending deals. marking a stark reversal in merger-arb portfolios. Shares of Activision Blizzard jumped 10% the day after the ruling, bringing the spread closer to the offer price of $95. Meanwhile, VMware’s planned $61 billion combination with Broadcom was cleared by both the European and British competition regulators, sending VMware shares jumping by around 3% from a month ago. ATVI VMW 3M mountain Stock performance of ATVI and VMW That said, merger arbitragers should not expect totally smooth sailing from here. Regulators are not backing down from their aggressive approach — though recent court rulings bolster confidence that these deals will be completed. On Monday, the FTC agreed to dismiss a federal court case against Intercontinental Exchange ‘s $11.7 billion proposed acquisition of mortgage provider Black Knight . The agency sought to block the deal in March, noting it would lead to higher costs for lenders and home buyers. “It just takes time to bear out in court. For those companies willing to fight or spend the time and money and see their mergers delayed, it’s gonna pay off, and it has paid off for many of them already,” said Orrico. An FTC spokesperson told Tech Zone Daily that “the FTC only brings cases when the facts show that a proposed merger would stifle competition. The FTC’s actions are firmly grounded in the law and decades of precedent, and we will continue to act to protect consumers from unlawful businesses practices and monopoly power that can lead to higher prices, lower wages, and reduced innovation.” Play the gap Merger arbitrage can be a tricky strategy for regular investors to incorporate. However, there are some ways to do it. Investors can buy into the following funds for exposure to merger arbitrage: The Arbitrage Fund (ARBNX) The Merger Fund (MERIX) The NexPoint Merger Arbitrage fund (HMEAX) The First Trust Merger Arbitrage ETF (MARB) The IQ Merger Arbitrage ETF (MNA) To be sure, many of these funds charge a hefty fee. The ARBNX, MERIX, HMEAX and MARB funds all have an expense ratio north of 1%. The MNA fund charged 0.76%, still well above what 0.09% charged by the SPDR S & P 500 Trust ETF (SPY). Investors can also directly purchase the target company’s stock in takeover situations. Kroger and Albertsons , the two largest biggest grocers by revenue, just notched a regulatory win after a judge dismissed a consumer lawsuit challenging the $25 billion merger. With Albertson’s trading for about $21.7 a share and Kroger’s offer at $34.10 a share, it presents a spread of more than 50% on the deal closing. The transaction is expected to close in early 2024. Intel tabled a $5.4 billion bid that values Israel-based Tower Semiconductor at $53 a share. Tower Semiconductor is trading for around $34 a share such that the arbitrage spread stands at more than 50%. However, the deal was expected close by June 2023 but has been delayed because of pending regulatory approvals.
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