I recently noticed that it seemed strange the big deals announced lately didn’t seem to be pricing like they would close. So found this interesting from Levine’s newsletter two days ago. Figured I’d post here and see if anyone has looked into this or has thought about it.
Limits to merger arbitrage.
If the proposed merger between AT&T Inc. and Time Warner Inc. closes as planned, Time Warner shareholders will get cash and AT&T stock worth $107.50. Yesterday Time Warner closed at $87.16. That’s … less. There is some reasonably straightforward arithmetic that you can do to translate that $20ish price gap into a market-implied probability that the deal will close:
Wall Street is giving the deal just a 28% chance of closing at the stated terms as of Tuesday’s market close, according to Macro Risk Advisors.
So if you think there’s a 35 percent chance of the deal closing at its stated terms, I guess you should buy Time Warner stock. But the people who are in that business are capacity constrained:
The average U.S. deal size hit an all-time high of $476 million last year, and there were a record 33 deals over $10 billion, according to Dealogic.
Over the same period, the total assets controlled by hedge funds dedicated to merger arbitrage have stayed roughly constant at around $23 billion, according to HFR, meaning their firepower hasn’t kept pace with the mergers- and-acquisitions boom.
And “the average $1 billion-plus deal that has been agreed upon but not yet closed has been pending 144 days, the most since 2002,” so more money is stuck in pending mergers.
One fun puzzle here is: Does that 28 percent implied probability of the deal closing mean that “the market” thinks that there is a 28 percent probability of the deal closing? Or has the market’s mechanism for expressing that probability broken down a bit, as merger arbitrageurs just don’t have enough money to express their views about the probability of giant mergers closing? If deal activity has grown much faster than merger arbitrage funds, and if those funds are locked into deals for longer, then the “arbitrage” part of merger arbitrage breaks down: If you think there’s a 35 percent chance of AT&T/Time Warner closing, but you think some other deal is even more mispriced, you might focus your firepower there. On the other hand, if there was really too little money invested in merger arbitrage, and if arbitrage opportunities were going begging, the strategy would be performing better (“Merger-arbitrage-focused hedge funds are up 2% this year, half the gain for hedge funds overall”), and more money would be coming into it. Maybe the reason there’s so little arbitrage money is because the expected probabilities really are so low.