Trump Victory Could Be a Boon to Deal Stocks
Trump’s administration will likely be more lenient on mergers. How to capture double-digit returns.
The Obama administration took a tough antitrust stance on corporate mergers and acquisitions, but investors expect a more relaxed attitude under President-elect Donald J. Trump. Yet even as deals seem more likely to succeed, M&A arbitrage—a bet that a transaction will go through—could remain a profitable investment strategy, yielding annualized double-digit percentage returns.
Here’s how it works: Shares of the target company in a pending acquisition typically sell at a discount to the final offer price until the deal closes. The spread between the market price and buyout price reflects investor uncertainty that the transaction will occur, for regulatory or other reasons. The wider the spread, the greater the perceived risk.
Investors who buy the seller’s shares have an opportunity to lock in a relatively quick and secure profit, as spreads tend to narrow with the approach of a deal’s closing date, and disappear when the transaction is done. Some practitioners of “merger arb,” especially professional investors, also short the buyer’s stock, which usually falls ahead of the closing date.
There are four main risks to M&A, and to M&A arbitrage: financing, contract issues, shareholder approval, and regulatory objections. The last weighed particularly heavily on M&A activity in the past year.
SINCE THE ELECTION, however, arbitrage spreads have tightened to 8% to 9% from 11%, reflecting the market’s belief that Trump-appointed regulators will have a lighter touch. “History suggests Republicans have been less regulatory in nature and more favorable to deals,” says Alex Vogel, a managing partner at VogelHood Group, a Washington-based policy, research, and consulting firm that evaluates regulatory risk.
With interest rates rising and bond prices falling, M&A arbitrage also looks less risky than other yield-oriented investment strategies, says Ilya Feygin, senior strategist at WallachBeth Capital.
The market currently offers several attractive merger-arbitrage opportunities, including some all-cash deals with a high likelihood of closing on schedule. WallachBeth likesHarman International Industries (ticker: HAR), which drew a $112-a-share cash bid fromSamsung Electronics (005930.Korea), the electronics giant, earlier this month. Harman, which makes automotive infotainment systems, recently fetched $109.50.
The linkup is unlikely to pose antitrust problems. Samsung and Harman don’t have materially overlapping businesses, and vertical deals tend not to be blocked, Feygin says. He expects the takeover to close next spring. Based on Harman’s price, investors could realize an annualized return of 5.6%.
Another merger-arb investor, Jean-François Comte, co-president of Lutetia Capital, likes privately held Bass Pro Shops’ $5.5 billion, or $65.50-a-share bid for rival Cabela’s(CAB), which would create an outdoor-sporting-goods empire. Cabela’s shares shot up 15% after the deal was announced Oct. 3, and traded last week at $62.18. Some skeptics see antitrust risk, but Comte is confident, given the plethora of small retailers competing in the market for outdoor sports equipment. Wal-Mart Stores (WMT) also is a player. He looks for the deal to close by spring, for an annualized return of 15.3%.
ONE ADVANTAGE OF merger arbitrage is that its returns don’t depend on the stock market, says Roy Behren, co-manager of the Merger fund. NXP Semiconductors(NXPI), which received a $110-a-share cash bid in October from Qualcomm (QCOM), is a fund holding. NXP recently traded for $99.33, 10.7% below the bid.
A Qualcomm-NXP pairing would be the largest deal in the semiconductor industry’s history. That alone suggests it will attract regulatory attention. But Qualcomm specializes in smartphones, while NXP makes automotive products, an area in which Qualcomm hopes to expand. Behren expects the transaction to close in nine months, pending regulatory approval in other nations, including China. He’s looking for an annualized return of 12.6%.
Another deal expected to yield a double-digit annualized return is Danone ’s (BN.France) proposed $12.5 billion purchase of WhiteWave Foods (WWAV). Shares of WhiteWave are trading at $55.12, versus a buyout offering price of $56.25. The Federal Trade Commission (FTC) reportedly is examining the deal. The Cornucopia Institute, which represents small organic farms, has complained it would concentrate organic dairy production. Danone, which owns Stonyfield Farm, an organic yogurt brand, would be acquiring WhiteWave’s organic milk and yogurt brands.
Lutetia’s Comte says the antitrust risk is “probably overblown.” The companies might need to divest some product lines, but the market is highly competitive, with relatively low barriers to entry. Earlier in November, Dean Foods (DF) and Cropp, an independent-farmer cooperative, announced a partnership under which Dean would process, refrigerate, and deliver organic milk. That is a positive for the WhiteWave acquisition, he says. Spreads tightened on the Dean news.
WallachBeth’s Feygin thinks Rockwell Collins ’ (COL) $62-a-share cash-and-stock bid for B/E Aerospace (BEAV) should be in any merger-arb portfolio. Since both make components for aircraft cockpits, there’s fear U.S. or foreign regulators will block the marriage. Also, one large Rockwell holder reportedly might try to disrupt the deal. While one or both might have to divest minor operations to satisfy regulators, Feygin expects the deal to close by mid-2017, offering investors an annualized return of 10%-15%.
Most merger-arbitrage investors recommend buying several deal stocks as insurance against the failure of any one transaction. That seems particularly advisable if betting on the largest pending deal: AT&T ’s (T) controversial $109 billion offer for Time Warner (TWX), announced last month. Candidate Trump said merging the media companies would put “too much concentration of power in the hands of too few.” But President Trump might feel differently.
AT&T’s bid equals $107.50 a share, 15.9% above Time Warner’s recent $92.78. As the spread suggests, investors fear the Federal Communications Commission and Justice Department will withhold approval. But says VogelHood’s Vogel: “Our analysis and data on past deals says this deal gets done.” If he’s right, it would be a home run for arbitrageurs, returning an annualized 15.6%.
Another huge deal, the $66 billion bid by Germany’s Bayer (BAYN.Germany) thatMonsanto (MON) has accepted, also is controversial. Monsanto is trading about 20% below the $128-a-share offer, with good reason. Even under Trump, the merger, which would create a agricultural-chemical and seed behemoth, faces tough antitrust hurdles, especially in Europe. This one might be more suited for speculators than investors.