As mentioned in a previous article, John Paulson (Trades, Portfolio) specializes in “risk arbitrage,” a strategy that buys stock in the target company and shorts stock in the parent company.
Due to the numerous risks involved in a merger, arbitrageurs should research past mergers and look for warning signs. To help investors exploit potential merger risks, Paulson invented the Merger Arb Checklist, which breaks down the risks based on seven criteria.
The following merger and acquisition study analyzes 600 mergers that occurred since 2015. For each merger, the study rates the seven criteria based on the following rubric. To compute the overall score of the merger, the checklist takes the simple average of the seven ratings.
The study observed an intriguing pattern among mergers occurring in the United Kingdom. Most of these mergers use the term “recommended offer,” which suggests a weak merger agreement. Thus, the rubric gives the “definitive agreement” criterion a rating of 1. However, this rating may be inaccurate if “recommended offer” is the U.K. term for “definitive agreement.”
Based on the study, the following criteria best predict whether a merger will succeed: definitive agreement, limited regulatory risk and no financing / due diligence conditions. The results are expected according to Paulson; the event arbitrage specialist highlights these risk factors in Chapter 8 of his book, “Managing Hedge Fund Risk.”
Mergers that do not have limited regulatory risk are most likely to fail, regardless if the merger has definitive agreements or strategic rationale. A previous article highlights two mergers that failed due to legal issues. The study highlights failed mergers in two ways: a “0” in the success column, and “12/31/1969” in the effective date column since the merger did not successfully close.
Mergers come in various styles
Depending on shareholder consideration, there are three types of mergers: cash mergers, stock mergers and mixed mergers. While the majority of mergers fall into one of the above categories, some mergers are unclassified, most likely because the shareholders can choose from multiple stock-consideration options.
Paulson warns that the more complex the shareholder consideration, the riskier the merger is to investors. Additionally, the study observes that mergers with complex consideration structures are less likely to succeed than all-cash or all-stock mergers.
While the Paulson Checklist only focuses on the micro risks, mergers also face a few macro risks: rising interest rates, declining commodity prices and other economic factors. Likely due to declining oil prices, the energy sector had the lowest success rate. Seven of the 23 mergers that failed came from energy companies.
On the other hand, industrials / materials had the highest success rate among all sectors, outperforming the financial services sector by about 2%. As the industrial production index increased to its three-year high of 107, the majority of manufacturing and mining companies had high performance and profitability. These likely resulted in successful and sustainable mergers.
Conclusions and see also
The success of mergers can give insights about investing. If a merger is expected to succeed, investors can exploit the “risk arbitrage” mentioned earlier. However, failed mergers can still provide good investing insights, especially if the merger failed due to macro risks. Even though it had a high merger failure rate, the energy sector still presents good investing opportunities based on its low Shiller price-earnings (P/E) ratio. As of Aug. 22, the oil and gas – drilling and oil and gas – integrated industries have the two lowest median Shiller P/E based on industry overview data. Additionally, the energy sector currently has the lowest Shiller P/E among all sectors.
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