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Part I
The Arbitrage Process
The first part of this book describes the environment in which arbitrageurs work, as well as the major principles of merger arbitrage. Although they are often analyzed within the context of corporate financing, M&A are essentially tied to the financial markets and to changes therein, as the first chapter will show. In Chapter 2, we will study the financial mechanisms at work in the arbitrage process, as well as their different characteristics depending on the payment method of the transaction. The third chapter looks at the risk and return factors of merger arbitrage.The final chapter in Part I examines the historical performance of merger arbitrage and the different approaches adopted by specialist managers.
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1
The Role of the Market in Mergers and Acquisitions
In spite of the many laws governing mergers and acquisitions (M&A), it is always the market that has the final say. Takeover bids may have to comply with various national and international laws, but by accepting or rejecting the terms of these bids the market is the ultimate judge of whether they are successful. Whether they like it or not, the market can sometimes usurp even the decision-making bodies of the target company in this role as the ultimate judge. As you might expect, the market's role of arbitrator is governed strictly by securities regulations, whether during bull periods, such as the beginning of the 1990s, or during more difficult times for financial markets, such as we have seen since 2008.
The concept of “the market” has evolved considerably. It now comprises as many different operators as strategies, and recent changes have served only to make it more fragmented and diverse in terms of the operators it groups together. These market operators include investment funds (arbitrage funds, private-equity funds, etc.), family offices, wealth managers, asset management units of major financial institutions, and individual shareholders. Each operator follows its own investment process in order to achieve its own goals, whether it is managing its own money or someone else's. All this means that the market, now more than ever, is a complex sum of individual interests. The partial or total liquidation of many so-called alternative investment funds, in the wake of early redemption requests from investors following the recent financial crisis, is a prime example. Moreover, the increase in trading volumes on global stock exchanges means a much greater turnover of shareholders in the share capital of companies. Combined with the different behaviors of market operators and the wide range of financial instruments available, this makes takeover bids – and the factors that determine whether they will be successful – more complex.
Such diversity on the financial markets means there can be no broad-brush analysis of takeover bids. As well as the individual characteristics of each operation, the reactions of the many parties involved and their respective dynamics need to be taken into consideration. The success, or otherwise, of takeover bids therefore depends fundamentally on the market. Over the last few decades, the market has undergone many changes that have affected M&A practice.
1.1 STRUCTURAL CHANGES TO THE FINANCIAL MARKETS
Over the last few decades, the global financial markets have experienced several major structural changes as they have risen on the back of the growth and globalization of listed companies. The total stock-market capitalization of all US and international companies listed on the New York Stock Exchange rose from $2,700 billion in 1990 to more than $13,300 billion in 2010. Over the same period, the S&P 500 climbed from 350 points to more than 1,350 – an increase of over 285%.
The first thing to point out is that market liquidity has increased considerably. Average annual trading volumes on the New York Stock Exchange rose from around $1,325 billion in 1990 to more than $11,600 billion in 2010. This significant increase in trading volumes, and therefore market liquidity, enables market operators to position themselves more easily, and above all more quickly, in the share capital of companies. Those wishing to launch a takeover bid can therefore quickly build up significant stakes in the share capital of target companies, whether before or after the bid is actually submitted.
There are many ways of building up blocks of shares, such as purchasing shares on the market, buying blocks of shares off market, and using derivatives. Whatever method is used, it is made easier by a more liquid market. Having said that, all these techniques are subject to strict regulatory control. There are two major determining factors: first, the notion of privileged information held by the potential instigator of the transaction (moreover, different jurisdictions interpret this issue in different ways – does a market operator preparing a takeover bid for a target company have privileged information?); and second, ownership threshold disclosure requirements. These issues are topical and often trigger debate, as shown by the recent creeping takeover of Porsche by its German competitor Volkswagen.
A second significant change to the markets is their integration with international capital flows. Nowadays, foreign capital always represents a large part of the volumes traded on all global financial markets. This change has significant consequences and goes hand in hand with the first change we discussed earlier. It encourages ownership fragmentation and the circulation of capital – both of which are conducive to takeover bids. The greater openness of the markets also means that individual investment choices depend increasingly on economic and financial criteria. In the context of takeover bids, these criteria are particularly crucial in determining whether or not an investor tenders their shares.
There are many reasons for this change. First, EU regulation encourages the free circulation of capital. Second, advances in communication technology have brought about the development of new types of electronic trading platforms, which facilitate market access and allow for faster execution. Lastly, the harmonization of international accounting standards and better access to financial information have also contributed to better global integration of capital markets.
Countries have responded to the opening up of the international capital markets, but it remains to be seen what effect this response will have on M&A. Several countries have created investment structures aimed at protecting “sensitive” assets. There is, of course, nothing new about sovereign wealth funds (SWFs); the first, the Kuwait Investment Board, was set up in 1953. These funds now manage more than $3,000 billion, and their primary aim is to diversify their investments. Until now, they have been most active in taking minority stakes in large US or European groups that have built up a dominant position in their markets. There have been several recent examples of conflict between SWFs and the authorities in the country of the target company, such as the attempted takeover in 2006 of US oil company Unocal by state-controlled Chinese group CNOOC. It remains to be seen what effect will arise from these funds being in the share capital of M&A target companies. As they are largely a recent phenomenon, it will be interesting to see the stance adopted by these funds, especially if their presence in the share capital has come about through a concerted effort with the management team of the target company.
The third major change in the markets is the growing importance of hedge funds. The main aim of these funds is to deliver “absolute” returns, i.e. to generate positive performance whatever the conditions on the financial markets, as opposed to benchmark management where performance is compared to that of a reference index. Other specific characteristics of hedge funds include widespread and sometimes mass usage of leverage, short selling, derivatives, and fee systems that include performance fees. The hedge fund industry currently has $2,000 billion of assets under management, which is fairly small compared with the asset pool of traditional, long-only mutual funds. Redemption requests from investors and many fund liquidations caused hedge fund assets under management to fall sharply during the recent financial crisis. Fundraising has been positive since 2010, however, with investors once again very keen on returns that are uncorrelated to the markets. Furthermore, we need to take into account the leverage used and the actual exposure of hedge funds, which in general is much greater than for other asset management players and therefore increases the amount of assets.
Hedge funds are something of a broad church in that they comprise many different investment strategies, asset classes (equities, bank debt, high-yield bonds, etc.), and financial instruments. And yet the names given to the different styles have become familiar: long/short, event driven, macro, convertible arbitrage, etc. With regard to takeover bids, “activist” funds specialize in acquiring significant stakes with a view to acting as a catalyst, or sometimes with the explicit aim of encouraging a bid, whether under their own steam or on behalf of a third party. The strategies employed by these funds are very similar to the conduct of individual activist investors such as Carl Icahn or T. Boone Pickens. Among other things, Mr Icahn was particularly active in the split of Motorola into Motorola Mobility (housing all the mobile phone activities) and Motorola Solutions (specializing in corporate telecoms services). This separation enabled the acquisition of Motorola Mobility by Google, which was on the lookout for patent buys to help its Android system compete better with Apple's iPhone. A large number of takeover bids are the result of moves by these activist investors or funds.
The final change to the financial markets is that the different markets are becoming increasingly integrated. The connections between the equity and derivative markets and the markets for other products have become much stronger in recent years, partly because hedge funds use all of these financial instruments at the same time.
LVMH's acquisition of a 21.4% stake in Hermès once again provides a good example of how derivative products (in this case, equity swaps) can be used to build blocks of control. It also shows the role that regulation needs to play in market transparency. In most cases, the use of derivatives is not regulated. Since 2009, however, regulation has gradually evolved in its attempts to encourage more transparency by making more information available to market operators, particularly on the existence of such derivative products. Furthermore, intermediaries have developed new ways of financing call and put options. These strategies involve less exposure and greater leverage. Their development has therefore enabled certain highly specialized operators – such as arbitrage, activist, and sovereign funds – to play a greater role in the markets. We can see that all of these financial innovations, brought about by greater market integration, require changes to regulation and have undeniably transformed the markets themselves.
1.2 CHANGES TO M&A PRACTICE
The transformations we have just discussed, which have altered the environment of the financial markets and how they operate, have also affected how takeover bids are conducted. The first thing to note is that the increase in the size of mergers and acquisitions is closely linked to the increase on the financial markets. Since the mid-1990s, M&A volumes have been around 10% of stock-market capitalization on average in a given market. In recent years, as well as the increase in the size of M&A, there have been significant changes to takeover bids and the way they are conducted.
The first change involves the greater role of cash in M&A transactions. Before the dotcom bubble burst in 2000, cash-only deals represented around 35% of all M&A. Since 2005, this figure has climbed steeply to between 60% and 70%. There are several reasons for the rise of cash deals at the expense of all-share and mixed offers:
- Since 2000, large international groups have shaken up their cost structures to generate more cash and therefore improve their liquidity. Since 2005, the trend has been to use this cash, and one of the main uses has been the acquisition of target companies with a view to improving growth prospects.
- The increased role of cash goes h...
