The Shrinking Merger Arbitrage Spread: Reasons and Implications

Abstract

The merger arbitrage spread has declined by more than 400 bps since 2002. This decline, which is both economically and statistically significant, corresponds to the decline in aggregate returns of merger arbitrage hedge funds, as well as increased inflows into merger arbitrage hedge funds. Part of the decline in the arbitrage spread may be explained by increased trading in the targets’ stocks following the merger announcement, reduced transaction costs, and changes in risk related to merger arbitrage. These findings suggest that some of the decline is likely to be permanent; therefore, investors seeking to invest in merger arbitrage hedge funds should focus on returns since 2002.

This article examines the evolution of the merger arbitrage spread between 1990 and 2007. The authors first analyzed arbitrage spreads and returns of merger arbitrage hedge funds and found that both have experienced statistically and economically significant declines in recent years.

In particular, the median first-day arbitrage spread ranged from 4.10 percent to 7.94 percent for deals announced before 2001, whereas for the period after 2001, the median first-day arbitrage spread ranged from 1.74 percent to 2.63 percent. The conclusion that arbitrage spreads have declined significantly did not change when similar comparisons were made for periods extending to 90 trading days following the merger announcement.

Similarly, an analysis of monthly returns of merger arbitrage hedge funds indicated that although the distributions of returns were similar for 1990–1995 and 1996–2001, the returns declined in the latter period. A regression analysis shows that for 2002–2007, relative to the earlier periods, the aggregate alpha of the merger arbitrage hedge funds declined by about 41 bps, equivalent to an annual decline of 4.81 percentage points.

Three possible reasons for the decline were explored: a reduction in transaction costs related to risk arbitrage, capacity constraints over time (i.e., more money chasing a limited number of deals), and a reduction in risks associated with merger arbitrage.

To test whether the transaction costs related to mergers experienced a similar decline, the authors compared the completion-date arbitrage spreads of successful deals and found evidence of a transaction cost decline.

To determine whether increased investment in merger arbitrage contributed to the decline in the spread, the authors analyzed the relative trading volume (RV)—the trading volume the day after the merger announcement divided by the average trading volume from 50 to 25 days before the announcement—in the target stock. The results show that first-day RV has experienced a significant increase since 2001.

To ascertain whether completion risk associated with merger arbitrage has changed, the authors first compared the success rates of mergers since 1990 and found that the overall success rate has remained relatively stable. Thus, that observed declines in the arbitrage spread are attributable to reduced completion risk is unlikely. Further, to measure any change in the loss an arbitrageur suffers upon deal failure, the authors computed the loss associated with failed mergers announced between 1990 and 2007 and found that the loss resulting from deal failure has declined.

The authors then used a regression model to analyze the factors that could explain, at least in part, the observed decline in the arbitrage spread. The regression results confirmed that part of the decline in the arbitrage spread and, thus, in the aggregate alpha of merger arbitrage hedge funds is the result of increased trading in the target’s stock following the merger announcement. This finding shows that one of the consequences of the increase in capital devoted to merger arbitrage is reduced aggregate profitability of merger arbitrage hedge funds. As a result, the increase in volume seems to be permanent. Therefore, to the extent that reviewing historical returns associated with an investment strategy is useful, investors seeking to invest in merger arbitrage hedge funds should focus on returns since 2002 rather than returns over a longer period.

Note: The views expressed in this article do not necessarily represent those of the Analysis Group.