Despite historically high market valuations, merger and acquisition activity remains subdued. Franklin Mutual Series CIO Christian Correa explains why corporate mergers have slowed, and why he thinks merger arbitrage strategies are worth paying attention to as activity in this area picks up.

Merger arbitrage opportunities tend to increase as equity valuations rise. As stock prices increase, corporate managers’ confidence rises along with their willingness to do deals. Despite the significant rally in equity markets over the past year, merger and acquisition (M&A) activity has remained depressed when compared to deal volume during other periods of historically high stock prices. There are signs this anomaly is ending, however, creating a fresh opportunity for those seeking a way to diversify sources of risk, invest in uncorrelated asset classes and increase risk-adjusted returns.

A Beginning

Merger arbitrage is a lesser-known investment strategy among the general investing public. The strategy seeks to profit from announced corporate takeovers or mergers. Historically, merger arbitrage returns have been relatively uncorrelated with equity market returns and can potentially reduce the return volatility of an equity portfolio.

When a company tries to acquire another company, the acquiring company’s bid will represent a premium for the target company’s stock when compared with the share price prior to bid speculation. Acquirers pay this higher price, called a control premium, to encourage acceptance of the deal by the target company’s shareholders. However, there is often a long period between the announcement of the proposed acquisition and its closing, and during this time the target’s share price trades at a discount to the acquirer’s bid price. The difference between where the target company’s stock is trading once the deal has been announced and the value of the acquirer’s bid price is called the spread.

There are several things that can affect the spread, including the likelihood the deal will get past regulatory and legal hurdles and the amount of time until the anticipated closure date of the merger or acquisition. As the closure date approaches and the deal makes it past various hurdles, the target company’s stock price normally converges on the acquirer’s bid price. The investor benefits from the increase in stock price plus any dividends that are paid by the target company prior to the closure of the acquisition.