A new paper in the Journal of Economics and Business presents data on merger arb, and which factors, especially sector size and individual fund size, do or do not have an impact on the alpha available in the pursuit of this strategy.
For a given time period, the total dollar amount of all the announced deals serves as a proxy for the demand for arb capital.
The authors maintain that alpha is related not just to the supply of arb capital (the companies in transformation) but to the demand for it, and that this requires analysis to refer to sector and fund size. They find that a larger sector size depresses the arb spread, and in that way lowers alpha. They also fail to find any such “dis-economy of scale” arising from a larger fund size.
Start with the Basics
Arb spread, after all, is compensation for the assumption of deal risk. If a fund buys a lot of the target company stock with the expectation that the deal will proceed, then the fund is taking the risk the deal will fall through, for any of number of reasons. As sector size increases on the demand side, all else being equal, there will be more money chasing any particular risk. This is a competition for the prerogative of assuming a given bite of risk. It will likely have the effect competition has—it will reduce the price of the service all the competitors offer to provide. In this situation, that means a reduction in the arb spread.
Analysts more often discuss the size of arb spread from the supply side: the characteristics of the acquirer, of the target, and of the deal they have made. But the authors of this paper: Zaur Rzakhanov, of the University of Massachusetts, Boston; and Gaurav Jetley, of Analysis Group Inc., look at it from the demand side. They refer to the key phenomenon under study, the competitive effect on the arb spread, as “Merger Arbitrage Capital Abundance,” or MACA.
In testing the role of competitive pressures, Rzakhanov and Jetley look to net-of-fees alpha as their key metric, because they “want to examine the ability of hedge fund managers to deliver value to hedge fund investors, and not simply their ability to outperform a benchmark.” They find that an increase in MACA does reduce net-of-fees alpha. They contend moreover that this finding is robust and can explain fully half of the total variation in merger arb spread.
Rzakhanov and Jetley used the HFR database to determine the relationship between sector seize and alpha. But, to test robustness, they then combined their HFR data with data from the TASS and CISDM databases. The augmentation “did not materially change the results derived from our panel analysis.”
They also recognized that the focus on alpha net of fees (rather than gross returns) might give rise to criticism. After all, fees and contract provisions can have non-linear impact. So, as another robustness test, they compared the annual gross returns to the net of fees returns and found that they exhibit a similar pattern. Both exhibit the same inverse relationship with MACA.
The robust result, then, is that “greater sector size is associated with significant diseconomies of scale.”
Skill is Good: Experience … meh
On a distinct but related issue, Rzakhanov and Jetley tested whether managerial skill increases alpha in the merger arb field. They did find evidence of skill as a factor: there is a component of net-of-fees alpha within this strategic space that cannot be explained by MACA, or any of the usual explanatory factors (fund size, prevailing economic conditions…), and that this can plausibly be attributed to skill.
One final take-away from this study. Skill in this case does not mean experience. It isn’t something one picks up by staying at the job. That, at least, is the inference Rzakhanov and Jetley draw from the fact that fund age has no effect on alpha. If experience produced talent, then presumably age would show up as an explanatory factor.