Are We in a New Golden Age of Merger Arbitrage?

When antitrust regulators take a light-touch approach to mergers and acquisitions, the opportunities to profit from merger arbitrage tend to be slim. If the regulator only occasionally moves to block mergers, and only in the most egregious cases, the announcement of any reasonable merger agreement will be priced in almost immediately. This was, more or less, the way the Federal Trade Commission had for many years approached its antitrust mandate. That all changed when the Biden administration installed Lina Khan as FTC chair.

Under Khan, the FTC has been far more aggressive in pursuing antitrust action. While this has hampered some merger activity while increasing volatility among stocks involved in merger actions, it has also resulted in the FTC sometimes picking fights it cannot win. A result of this has been a resurgence of interest in merger arbitrage.

The FTC’s recent attempt to block the merger of Amgen Inc. (AMGN, Financial) and Horizon Therapeutics PLC (HZNP, Financial) offers an instructive example of the growing opportunities for merger arbitrage.

Case study: Horizon merger

The FTC challenged Amgen’s $27.8 billion bid in May, citing “concern that Amgen would leverage its big selling drugs to pressure insurance companies and pharmacy benefit managers to give favorable terms for Horizon's two key products.”

The commission’s action succeeded in spooking the market, initially at least, but the regulator struggled to make its case stick. As a result, the FTC paused its challenge last month. While the FTC’s quixotic attempt to block the Amgen-Horizon merger burned some investors, it also proved a boon to several investment firms that were willing to ride out the crisis, as the Wall Street Journal reported on Sept. 24:

“The efforts by Federal Trade Commission Chair Lina Khan to protect Main Street are inadvertently enriching some on Wall Street, generating outsize profits for Pentwater Capital Management and other large hedge funds that bet on merger deals. Florida-based Pentwater stands to be a large winner from the FTC’s recent failed bid to block the Amgen-Horizon deal. It built a stake of almost 7% in Horizon after the drugmaker began fielding takeover interest last year. Pentwater is estimated to have scored around $100 million on its Horizon trade on paper, according to an analysis of the hedge fund’s public filings…‘Because of the FTC’s lawsuit, we have had the ability to take something that would have made tens of millions of dollars and instead make many, many times that amount,’ said Matt Halbower, Pentwater’s chief executive.”

Pentwater was far from alone in profiting from the FTC-induced shakeout of Horizon’s stock price. The D.E. Shaw Group, for example, also built up its position in Horizon during the summer’s heightened uncertainty; its stake is now worth more than $500 million.

Expert insights: Roy Behren's perspective

Roy Behren has long had a taste for arbitrage. That taste has shaped the strategy of his investment firm, Westchester Capital Management, turning it into a leading merger specialist. Interestingly, Behren first became acquainted with merger arbitrage working for the Securities and Exchange Commission. The future guru spent seven years at the SEC’s New York office, serving in its securities law enforcement department. Armed with broad experience from both the private and public sector sides of mergers and acquisitions, Behren is a formidable arbitrageur.

Behren’s many years in the merger arbitrage space have furnished him with considerable insight, some of which he has been willing to share with other investors interested in following in his footsteps. One classic piece of advice in particular stands out to me in light of the shifting antitrust environment:

"We [don’t] play what we call 'Last Mile Trades,' which involve taking positions in deals that are almost certain to happen—ones with four or five days to closing that you can maybe make a nickel in. To us, the asymmetric optics of buying a position to make a nickel when – God forbid – something could go wrong and you'd lose $8…Inevitably there will be broken deals. There will be fraud at a company, there may be a natural disaster—anything can happen...We deal with that by limiting our position sizes and properly diversifying."

In light of the FTC’s newfound aggressiveness, investors thinking about playing the arbitrage game would do well to review Behren’s advice first. There may be more potential opportunities, but not all of them will pay off.

Conclusion: Betting against the FTC

From my viewpoint, it looks like there is a lot of money to be made betting against the FTC these days. However, one must be willing to weather the volatility and uncertainty, both political and legal, that comes with the territory. After all, there are precious few "sure things" in the market at the best of times. In the world of merger arbitrage, it is best to assume that nothing is certain.

Investors eager to bet against the FTC will likely find some big winners, but they should also be prepared to be on the losing side from time to time. Consequently, it might be wise to work out one’s strategy for position sizing and portfolio risk management before diving head-first into the merger arbitrage game.