By Salvatore J. Bruno, Chief Investment Officer, and Mark Lacuesta, Director of Index Strategies, IndexIQ.

Merger arbitrage ETFs: what happens when M&A activity slows down?

Given that merger arbitrage deals are the core component of a merger arbitrage strategy, what happens when merger & acquisition deal volume declines?

For several years, we’ve been in the midst of an M&A boom. According to Dealogic, in 2018, US-targeted M&A volume reached a total of $1.74 trillion and 7,791 deals.

Q1 2019 was busy, too, as US-targeted M&A broke historical first quarter records, reaching a total volume of $537.6 billion and 2,158 deals. So, while it may seem a little early to worry about running out of transactions, M&A is highly cyclical and the day will come when volume declines.

Two of the key metrics that drive the performance of a merger arbitrage strategy are deal premiums and completion rates. We raised the question, are either, or both of these key performance drivers impacted by a decline in the number of deals?

Our research revealed two significant findings. First, there appears to be a positive relationship between S&P 500 Index returns and the subsequent change in the number of deals that are announced. The chart below shows an increase in deal flows following positive market returns.

Source: IndexIQ.

Second, there appears to be no statistical relationship between the changes in the S&P 500 Index and the merger premiums offered by acquiring companies.

Source: IndexIQ.

Examining merger deal premiums grouped by calendar year shows the annual average ranges from 20% to 47%, with the historical average at 31.2%. The data suggests that while the pipeline of transactions may correlate with the market (as proxied by the S&P 500 Index), acquirers are still offering a consistent premium for target companies. Therefore, the S&P return and number of announced deals (above a bare minimum needed to execute the strategy) should have little or no impact on the potential return of a merger arbitrage strategy, in our opinion.

Additionally, our research showed that in terms of completion rates, on average, 81% of deals successfully complete. These numbers are consistent across up and down markets, with regulatory and shareholder reaction having more of an impact than market direction. This consistent completion rate allows for enough turnover to occur within the strategy to introduce newer deals as they become announced.

Source: IndexIQ.

The IQ Merger Arbitrage Index has historically demonstrated a low correlation to the broader market. The data on premiums provides one explanation as to why merger arbitrage strategies work to add diversification to a portfolio. Because the deal premiums remain largely consistent regardless of whether the S&P 500 Index is moving up or down, the returns may also be relatively consistent, assuming the deals get done. While the volume of deals may vary from year-to-year, other factors like the strategic importance of an acquisition mean that there should still be a sufficient quantity of quality transactions to choose from to add to a strategy.

The IQ Merger Arbitrage Index employs a systematic, rules-based process to identify deals for inclusion in the index. The criteria include a listing in developed markets, a minimum percentage of the target company’s shares being sought, limiting the maximum deal age, and sufficient liquidity.

For now, there is no shortage of deals that meet these criteria, and the stock market, while it’s been more volatile lately, continues to be supportive of M&A. But when the cycle turns, our research suggests that there should be no major impact on a merger arbitrage strategy to continue to successfully execute on its strategy. Furthermore, a strategy with strong deal selection criteria could be especially effective in identifying more qualified opportunities in times of reduced deal flow.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)