October 22, 2022
Because I specialize in a unique combination of value equities with an event-driven focus, I never liked the merger arbitrage space. It had always seemed to me an area with a too narrow focus and the truth is it is not an equity strategy but a cash alternative or fixed-income alternative.
Warren Buffett explains in his annual letters that he participates in only a few deals every year. The reason he focuses on a few large deals is not only because of his size limitations but because he prefers to spend the bulk of his time on more promising fundamental research. This is the way he looks at it and I think it is a correct attitude.
BarclayHedge Merger Arbitrage hedge funds index provided an average annual return of about 6.73% for the last 26 years since 1997.
Without going into many details of these returns, merger arbitrage strategy probably deserves a certain place under the sun.
However, I personally think that the idea of managing a dedicated merger arbitrage strategy or fund or portfolio and allocating to this significant resources is not a very attractive proposition. Similar to Warren Buffett, I think that these resources can be allocated to much more promising fundamental research.
Recently announced merger between Albertsons and Kroger illustrates this well.
According to Etalon Capital estimates, current merger arbitrage spread on the deal is approximately 41% percent. There are many uncertainties such as cash/equity proportion of the payment, the value of the spin-off and of course regulatory risk, rising interest rates and inflation, plus a long period required for deal completion.
So given all the risks and circumstances, at the end of the day this spread does not look too unreasonable and is probably justified, more or less.
This is from the perspective of merger arbitrage investors.
However, if you just expand your focus a little bit and think about this more broadly, from the perspective of a fundamental value investor, the picture here is totally different.
If you are buying Albertsons shares now, you essentially invest in the new merged company at a large discount..
But there is more to it.
First, you are investing in the new merged company at an EV/EBITDA (FY 21) valuation multiple of only x4.2 compared to current multiples of x4.7 and x6 for Albertsons and Kroger, respectively.
Second, just the free cash flow of the combined company can be ~$5 bil annually or more, so in the next three years, for example, you can get $15 bil in free cash flow or more than 50% of new merged company’s market capitalization (based on the “discounted” price mentioned above).
Third, there are many upside optionalities such as synergies, growth in revenue and EBITDA due to inflation, and also Albertsons real estate for which the company considered sale-leaseback transactions that are still possible.
So from the perspective of a fundamental value investor, the picture here is completely different from the picture of merger arbitrage investors.
The profit potential for merger arbitrage investors is limited and given many risks and uncertainties even highly limited. But for fundamental, value-oriented investors it is an open, developing story with significant upside potential.
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