Time Is Money: Costly Deal Delays Put M&A Arbitrage Returns In The Spotlight Summary

Summary

Annualized Returns are significantly adversely effected by the extension of closing dates for mergers and acquisitions (extension risk).

Acquirers tend to overstate expected completion times so as to reduce the likelihood (and embarrassment) of issuing extension updates.

This brief overview reviews the completion times (both expected and observed) of cash financed, U.S. targets since the start of 2016.

This article is intended to form part of a series of articles gradually taking the reader deeper into the mathematics of merger arbitrage deal analysis.

Introduction

How to calculate the return on M&A deals and pair that return with its associated risk has long been known. In this case, the “risk” is the downside potential should the deal fall through. This article assumes the reader is familiar with the basics of this alternative event driven strategy as identifying and calculating downside risk will not be covered. For additional information the reader is directed to the many excellent texts that have been previously written. Merger Arbitrage by Thomas Kirchner and a variety of informative and resourceful websites such as InsideArbitrage.com spring to mind.

One lesser known facet of the Risk Arbitrage strategy, at least as far as amateur investors are concerned is the time consideration. Along with risk analysis, being able to compare one deal to another requires the investor to consider the length of time over which the capital will be employed and then annualize the return to arrive at a usable comparative figure. This annualization calculation can be done as follows

Where,

AR = Annualized Return %

OP = Offer Price made by acquiring company

SP = Stock Price or Initial Purchase Price

t = expected days to completion

For example, deal A takes 12 months to complete and has a return of 6%. Deal B has a spread of 5% and is expected to close in 6 months. The comparison can now be made between 6% pa for deal A versus 10.25% pa for deal B. Deal B, which may have previously been ignored is now preferred to deal A.

Analysis

So here in lies the problem. What timescale should be used when making the annualized calculation? One source would be the Schedule 13D filing which gives an expected closing date as forecasted by the acquiring company and its advisors. But how accurate is this date? It is of course in the best interests of the acquirer to give a date which is not too long so that the market questions the effectiveness of management but simultaneously give a date that allows some leeway should an unexpected delay materialize.

It can be shown by our analysis and also confirmed in the Asif Suria article “Impact of Deal Delays on Merger Arbitrage Returns” that these dates given by the acquirer all too often overstate the time required to complete the deal. The largest overstatement from our data sample was the takeover of ZELTIQ Aesthetics (ZLTQ) by Allergan Plc (AGN). This deal was completed in less than one quarter of its expected time and was reduced to the bare bones timescale of customary closing conditions such as regulatory filings, shareholder votes etc.

The data set which we analyzed had an average expected completion time of 124 days but an observed completion time of 84 days. Almost a one third reduction. By choosing deals with a spread of 2%, this 40 day time reduction increases the annual return by 2.01%.

On the other hand, the longer each deal takes to complete, the fewer times that same capital can be reinvested in new opportunities. This naturally has a large negative effect on annualized returns and can be extremely destructive to the return of a portfolio. Occasionally, deals have been known to drag on indefinitely only to have their deal terms revised such as Cabela's (CAB), or worse, abandoned such as Rite Aid (RAD). For a recent example of extension risk see the takeover of Alere (ALR) by Abbott Laboratories (ABT). Announced on 2^nd Feb 2016, the deal was originally expected to close at the end of June in the same the year (150 days). The deal finally closed on 3^rd October 2017 (610 days), a 307% extension.

Action

So how can an investor better gauge the expected closing time for a deal and use this to their advantage? Are there clues such as regulatory issues at the sector level within certain “protected” industries (eg finance, utilities) that need to be considered? Are foreign takeovers a cause for concern once government level bureaucracy becomes involved?

A 2015 paper entitled “Antecedents of Time to Completion in Mergers and Acquisitions” by Luypaert & Maeseneire, studies the effects of merger delays from the perspective of the merging entities. From this paper one can determine three of the most important factors all prospective arbitrageurs should be aware of:

• Deal complexity
• Deal hostility
• Shareholder support

Using the expected closing date (as given by the acquirer) as a starting point one can begin to formulate an opinion of when the deal may close. The trick is to gauge how these factors have already been incorporated into the initial acquirer expected closing date. Prediction methods available depend on the resources at hand, the level of knowledge and time constraints (especially for the amateur investor). A multiple regression equation can identify a more accurate prediction of closure dates. This is my preferred route and in doing so we have been able to more than halve the prediction error when compared to the base case using the acquirer expected date. This heavily robust equation performs well during walk-forward analysis and is proving to be an indispensable tool in M&A valuation.

Alternatively a simple rule of thumb calculation can be employed. Investors would be aware of the tendency for deals to close early and adjust their calculation accordingly, i.e. shorten the expected deal time length, plug the figurers into the equation above and select a basket of deals based on the output. This reduction varies across industries but can be adjusted using the criteria and variables discussed above. Deals which heavily feature those elements highlighted in the paper by Luypaert & Maeseneire should be viewed with a healthy degree of suspicion for extension risk. Especially deal complexity which may involve industry regulators or CFIUS.

Conclusion

Time consideration plays and important role in M&A deal selection. Some of the most important factors have been identified and suggestions made as to how they can be utilized to enhance portfolio performance. It has been demonstrated how time consideration effects can improve portfolio performance by recycling investment capital into new opportunities.