24 June 2020
GAM Investments’ Roberto Bottoli assesses the current deal making landscape and comments on additional event-driven arbitrage opportunities.
It has been a tough second quarter for mergers and acquisitions (M&A). Global M&A has essentially been non-existent throughout the quarter and remains at historic lows, largely because of the practical impossibility to travel and arrange meetings (pre-requisites for arranging a transaction). More strategically, deal making is on hold due to uncertainty on the prospects of a global economic recovery in the wake of Covid-19 lockdowns, see Chart 1. While we expect M&A levels to stay subdued in the coming months, we believe the majority of transactions between industry peers with strong long-term logic should not be disrupted in the medium term by the impact of coronavirus. Moreover, fiscal and monetary stimulus from governments and central banks around the globe is in place to provide support to economic activity and M&A going forward.
Chart 1: M&A activity faded in March due to the Covid-19 pandemic. Global M&A deals – target companies with a minimum market cap of USD 200 million
Merger arbitrage spreads
So what is the potential opportunity from M&A activity? When a takeover is announced, the share price of the target company starts converging towards the takeover price. Shares of the target company no longer behave like stocks, but like a zero-coupon bond. The price pattern is determined by the likelihood of the deal being completed or not. Merger arbitrage spreads – the difference between the price of the target companies and the price offered by acquirers – exist due to the uncertainty that the transaction will close on the same economic terms. In March 2020, median arbitrage spreads hit a peak level last seen during the global financial crisis (GFC) in 2008. March spread levels, in our view, overstated the chance of terminations / price cuts to M&A deals. Spreads retraced towards the end of March, mirroring the volatility pattern of equity and credit markets, and have now stabilised around a level that is roughly 4% higher than pre-Covid-19, see Chart 2.
Chart 2: Spreads hit an historical peak in March and then re-traced
US Merger Arbitrage Annualised Spread (0%-30%)
Not all deals reach completion. Common causes of deal failure include adverse antitrust rulings, decisions by foreign investment authorities, problems with deal financing and adverse events affecting the business of the companies involved in deals. Clearly, doubts remain about the financial and economic sense of certain transactions due to Covid-19. A number of M&A deals were abandoned during Q2, including an acquisition of Front Yard Residential by Amherst Holdings in the residential real estate sector and the merger between Texas Capital Bancshares and Independent Bank Group in the banking sector. In both cases, the parties mutually agreed to terminate the transactions because of the impossibility to realise projected synergies in the current economic environment. The need to concentrate efforts on stand-alone businesses without the complication of managing the integration of two companies was also mentioned. In both examples it is important to note that lack of funding was not given as a reason for termination.
Another example of a terminated deal includes the buyout of software firm Forescout Technologies by private equity company Advent. In this case, the private equity buyer called off the transaction claiming that pandemic had an “incremental disproportionate impact” on Forescout. The company sued Advent and the trial is scheduled for July; formally the deal has not yet been cancelled. Leaving this example aside, transactions are more securely structured than 2008 and while decisions by private equity companies were major factors in terminations during the GFC, today the market is not facing a credit crunch and many private equity firms appear willing to close deals. In general, we also observe that M&A risks to the downside appear more evident in cash only deals as opposed to stock deals.
Deals that have benefited from Covid-19
LogMeIn, a provider of remote access software, is being acquired by a private equity consortium (Elliott and Francisco Partners). The deal was agreed in mid-December at a relatively modest premium. Later on, connectivity solutions became crucial during the pandemic and the buyers appear to be strongly committed. In the meantime, share prices of the acquiring companies performed in line or better than LogMeIn (including the takeover premium) putting a floor or even implying some upside to the shares in case of no deal. Almost all regulatory authorisations and shareholder votes have been received.
Meanwhile Qiagen, a global provider of diagnostic equipment for the healthcare sector is the process of being acquired by its US peer Thermo Fisher Scientific. The deal was agreed in early March at a price to earnings multiple at the low end of the sector range after a negotiation. The pandemic raised the demand for testing tools, especially Covid-19-focused ones such as those produced by Qiagen. Thermo Fisher Scientific shares performed in line or better than Qiagen (including takeover premium), putting a floor or even implying some upside to the shares in case of no deal. Antitrust authorisations remain outstanding.
Deals harmed by Covid-19, but still have a rationale
Grandvision, a retail distributor of optical products in Europe and Asia, is being acquired by EssilorLuxottica, the optical products manufacturer. In our view, this vertical integration makes sense for the buyer, which would then control the entire value chain in the consumer optical business. Nonetheless, deterioration in Grandvision’s business due to Covid-19 shutdowns has raised doubts about the buyer’s commitment to the transaction. The EU antitrust review is adding further uncertainty because if concessions are going to be too demanding, EssilorLuxottica could ask for a price cut or even walk away from the transaction. Nevertheless, this deal is strategic for the buyer and Grandvision’s controlling shareholder is committed to inject cash into the company, if needed, to respect financial covenants.
Tiffany, the American jewellery manufacturer and retailer, agreed a deal to be acquired by LVMH, the French luxury company, at end of November at a considerable premium. It has strong strategic sense for LVMH because of its brand and scale. The pandemic and shutdowns, specifically in the US, hurt the earnings of the company. Shares of Tiffany are currently reflecting the possibility that LVMH could ask for a price cut or even walk away from the deal.
Arbitrage opportunities outside M&A
In volatile markets, many types of dislocations can take place, resulting in arbitrage opportunities in other areas. In the case of spin-offs, holders of the parent company, specifically benchmark funds and ETFs, tend to sell shares of the spun-off entity as it is not part of their benchmark. After an initial period of underperformance, the spun-off company typically draws interest because of its cheap valuation. Another area of arbitrage opportunity occurs when indexed market players adjust their portfolios at the inclusion / exclusion date, causing a predictable out / underperformance of the added / deleted stocks versus the index. Official inclusion / exclusion is made public by the index providers days or weeks in advance. Dual listings can also provide arbitrage opportunities. As an example, in April, the ratio between Unilever’s two listings diverged substantially from the historical average. Unilever already attempted to consolidate two legal entities into a single Dutch corporation back in 2018. Finally, at the start of June, the company announced a consolidation into a single UK-based legal entity. Discrepancies between the price of a holding company and the sum of underlying businesses could also originate an arbitrage opportunity for a market neutral trade, as could possibly be the case at present when looking at Deutsche Telekom and T-Mobile US, for example.
In 2008, after a short-term pronounced contraction (6-12 months), deal-making activity recovered thanks to the monetary stimulus. This time around, on top of monetary easing, additional fiscal stimulus will be in place to provide a further boost to economic activity and M&A. In the meantime, event-driven opportunities continue to emerge in volatile markets. Ultimately, we believe that a diversified and conservative risk arbitrage strategy has the potential to deliver attractive risk-adjusted returns independent of market direction.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The companies listed were selected from the universe of companies covered by the portfolio managers to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.