ETF Cashes in on M&A Revival

M&A activity jolted back to life in the middle of last year after lying in a near-comatose state for years.

Deal flow has increased, and — very important — more deals have been completed.

"Finally, CEOs are putting their capital to use," said Adam Patti, chief executive of IndexIQ, an alternative investment manager. "They feel more comfortable with the economy, and perhaps more comfortable with the regulatory uncertainty that has been occurring. Perhaps, they just want to get to work."

According to IndexIQ's analysis of data from global developed markets, 856 deals were announced in 2012, 511 were completed and 98 were canceled. In 2013, 814 deals were announced, 612 closed and 98 were canceled.

Year to date, 35 deals have been announced, 26 have been completed and five canceled.

Patti is seeing the increased activity in his firm's IQ Merger Arbitrage ETF (MNA), which debuted in November 2009, based on the firm's two-year-old IQ Merger Arbitrage Index.

At times over the past few years, there were only 20 or 25 companies in the portfolio, he said. Now there are about 50.

"When deal flow increases," Patti said in a recent telephone interview, "merger arbitrage strategies tend to perform better because they get to capture that spread."

He said MNA's performance, which was "pretty dismal for three years," picked up last year. The fund was up 7.7% "with low volatility that is typical of merger-type strategies."

Patti said the firm would increase its focus this year on the small fund, which ended 2013 with some $23 million in assets, "because we feel the trend is finally coming to fruition. We think it's going to be a good year for M&A."

The Fund

Patti said IndexIQ's research showed that merger-arbitrage strategies lend themselves well to mechanical construction. Analysts examine data to identify attributes that merger arb portfolio managers consistently look for.

He and his colleagues studied 10,000 merger arb transactions over 10 years, looking for what made a successful deal versus an unsuccessful one. Dozens of criteria emerged.

Patti listed three core criteria for including a deal in the IQ Merger Arbitrage Index. A deal must be for the majority of the company. "We found that deals that aren't for at least 51% of the company generate poor returns."

They also found that deals receiving "low-ball" offers, even if they were bid up, generally got "busted"; they did not close. IndexIQ excludes busted deals from its analysis.

The analysts also look at the probability of a deal closing, and that probability influences holding periods. "We find deals close on an average of 120 days," Patti said.

"We hold some deals a lot longer than that, typically those with a high probability of closing by their stock price movements, but also based on industry; for example, utility deals because of a lot of regulation could take longer to close."

If a deal closes within the holding period prescribed by the probability of its closing, the fund reaps the rewards. Deals that fail to close within the holding period are removed from the index.

Patti and his colleagues rebalance the index every month. They consider only announced deals, he said. They do not speculate that a company might be acquired.

The deals are weighted based on trading volume. The more liquid a deal is, the higher its weight will be in the index.

IndexIQ invests in a deal at a critical juncture in the transaction, Patti said. "We find that once a deal is announced, there's an immediate spike in the price, but then that spike levels out, and that's where we're buying. Because we rebalance monthly, we're buying a deal on average with a two-week gestation on the announcement."

Most deals are cash deals. But for the portion of the index that comprises stock-for-stock deals, IndexIQ shorts the market exposure. Say 20% of the index is in stock-for-stock deals, the firm will short out 20% exposure split between domestic U.S. exposure and international exposure.

"Doing that gets rid of that market exposure," Patti said. "It doesn't take out individual company risk, but it gives you a bit of a higher return profile than would a typical merger-arb strategy and still provides lower volatility and overall better performance."

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Check out Tiburon's projections for advisor M&A this year on ThinkAdvisor.

ETF Cashes in on M&A Revival

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ETF Cashes in on M&A Revival

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