Satellite radio company SiriusXM (SIRI) made news recently when it announced its intention to buy streaming music service Pandora (P) for $3.5 billion in stock. The deal, which has the potential to reshape the audio entertainment industry, is expected to close in early 2019.
If you have been investing in individual stocks long enough, you may have owned a stock of a company that has bought another company, or has been bought itself. Last year alone, 22,861 mergers and acquisitions (M&A) were completed globally for both public and private firms, worth $1.7 trillion (see Number and value of M&A deals chart). That was down substantially from the prior year's deal value, which matched an 11-year record high.
As the chart above also demonstrates, the level of M&A activity can be cyclical, tending to be somewhat correlated to the economic environment—factors like GDP growth, corporate earnings growth, interest rates, tax policy, and the regulatory environment. Note the relative dip in deals during the financial crisis that began nearly a decade ago, and gradual rebound in the recovery years thereafter. As the economy and stock market improved in subsequent years, so too did the relative number and value of deals.
In terms of deal value, M&A is on pace to slow again in 2018—less than $0.8 trillion in deals have been closed, as of late September. One possible reason why is uncertainty as it relates to the sustainability of the bull market, global trade, the potential unwinding of central bank balance sheets, and other factors. Yet there have been several notable mergers. The 10 largest deals1 year to date are:
- Hochtief AG (HOCFF) and a consortium of other investors' purchase of Abertis Infraestructuras for $33 billion
- Keurig Green Mountain's purchase of Dr Pepper Snapple Group for $27 billion
- AXA's (AXAHY) purchase of XL Group for $15 billion
- GlaxoSmithKline's (GSK) purchase of GSK Consumer Healthcare for $13 billion
- Two Harbors Investment's (TWO) purchase of CYS Investments for $12 billion
- Sanofi's (SNY) purchase of Bioverativ for $11 billion
- ATP Arbejdsmarkedets and a consortium of investors' purchase of TDC A/S for $11 billion
- The Williams Cos' (WMB) purchase of Williams Partners for $10 billion
- Microchip Technology's (MCHP) purchase of Microsemi for $10 billion
- General Dynamics' (GD) purchase of CSRA for $10 billion
Despite the slower pace thus far this year, several of the factors that helped M&A activity rebound in the wake of the financial crisis are still in play. Among them:
- Relatively low interest rates. For example, the fed funds rate remains low—even taking into account the recent rate hikes—compared to historical norms, helping companies borrow money cheaply to finance deals.
- Record amounts of corporate cash. US corporations have over $2.1 trillion in cash and short-term investments,2 as of September 2018).
- Some companies seeking to augment their financial performance. For example, to boost lagging or smooth volatile short-term earnings amid a mostly positive yet relatively slow global growth environment.
So, how might M&A affect the stocks of companies involved, and what can you do if a stock you own is involved in this type of deal?
While past performance is not a guarantee of future results, several historical studies have shown that owning stocks of takeover targets has generally been lucrative, on average.3 That has not typically been the case for shareholders of acquiring firms. One meta analysis3 of M&A trends found that these deals have tended to benefit the target company's shareholders significantly in the short run. For the company being acquired, the final acquisition price has historically been a 30% premium above the stock's pre-announcement price, on average. On the other hand, the acquirer's stock price has historically declined 1% to 3%, on average, 3 years after the deal's announcement.
Another study found that acquiring companies experienced a 4.3% price decline, on average, in the 3 years after an acquisition, with 61% of these companies underperforming industry competitors.4 These studies have suggested that many underperforming acquiring firms have been unable to capture synergies that were expected prior to the deal's announcement.
Cash vs. stock
As it relates to the form of M&A financing, another meta study found that, on average, both the acquirer and the target have historically experienced better stock performance for all-cash deals versus all-share deals over the short run (e.g., under 3 years).5
Of course, each M&A transaction is unique, subsequent stock performance of the acquirer and target could differ (perhaps significantly) from the historical averages of similar M&A deals, and each deal should be evaluated on its own merit. With that said, investors who own shares of either the acquiring or target company should still be prepared for their stock prices to become potentially volatile after a deal is announced.
One reason for a potential increase in volatility is the additional risks created by the deal—including event risk (uncertainty about where the stock price will end up if the deal closes), regulatory risk (uncertainty about whether regulators will block the deal—more on this later), or the risk that the target company's shareholders will reject the proposal.
Acquirer's stock: What to look for
If you own the stock of a company that has offered to buy another company, you may want to do some research to determine if the combined company still supports your reasons for owning the stock. Data from various studies suggest that there are 4 primary characteristics of M&A deals that tend to create value for shareholders (i.e., earnings growth that translates into stock price appreciation) of the acquiring company over the long run3:
- Acquirer's earnings and share price growth rate are above their industry average for the 3 years preceding an acquisition. You can find this information on Fidelity.com on a company's snapshot page.
- The premium paid by the acquirer is relatively low versus comparable deals. You may be able to find the premium paid for comparable deals via a financial data provider, Fidelity's news tab search function, or an internet search.
- The number of bidding companies is "low." Being the lone bidder is optimal for the acquirer's shareholders, with one obvious reason being avoiding a bidding war that might drive up the acquisition price.
- The market's initial reaction is positive. Some studies suggest this can be measured by the acquirer's stock price not closing lower in the 10 trading days after the deal is announced.3
Additionally, when a proposal is announced, there are several questions you might consider to help evaluate it. These include:
- Will the deal create synergies (i.e., will the company be worth more after the combination, perhaps due to cost reductions or revenue enhancements)?
- Will the deal help the company achieve growth?
- Will the deal help the company gain market share and/or pricing power?
- Will the deal help the company access unique capabilities and resources?
- Did the acquirer pay fair value for the target business?
It can be difficult for many investors to evaluate some or all of these factors. If you are interested in managing your potential exposure to M&A, and you want help navigating the M&A waters, you may want to consider professionally managed investment products or services. Professional managers have the research capability necessary to evaluate the complexity of these types of deals, and the potential impact on the stocks of the acquirer and/or the target.
If you are looking to do this research on your own, there are tools and resources—including company filings, research reports, and analyst opinions—that can help you evaluate an M&A deal. Much of this research can be found in the Stock Research Center on Fidelity.com.
Target stockholders: What to look for
Acquiring firm voting rights
While target company shareholders can vote on a proposed M&A deal, this same right does not always exist for the shareholders of acquiring firms. The SEC and major stock exchanges do not require shareholder approval by the acquiring firm, except when, to help finance the deal, new shares are issued in the amount of 20% or more of the common shares outstanding before issuance. In that case, the acquirer must call for a special meeting and obtain shareholder approval. Information for the deal is obtained in the proxy statement.
If you are a shareholder of a publicly traded company that is being targeted for an acquisition in the US, for example, it's important to know that state laws and stock exchange regulations mandate the right to vote on a takeover offer.
In addition to voting on the proposed deal, shareholders of the target company can either continue to hold the stock or decide to sell at some post-announcement price. Recall that, based on historical data, the target company's stock price is likely to have increased from the pre-announcement price. This can occur via an auction, tender process, or through open market operations. Any decision you make should be based on careful analysis, and should align with your specific investment objectives, risk tolerance, and tax situation.
If the deal is completed, the stock price will typically move toward the agreed upon purchase price by the closing date. However, if the deal falls through, the stock could decline—potentially by a large amount, and perhaps even below the pre-announcement price level (more on this later).
Merger fund activities and risks
Short positions pose a risk because they lose value as a security's price increases; therefore, the loss on a short sale is theoretically unlimited. The fund can invest in securities that may have a leveraging effect (such as derivatives and forward-settling securities) that may increase market exposure, magnify investment risks, and cause losses to be realized more quickly. Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, economic, or other developments. These risks may be magnified in foreign markets.
In addition to evaluating individual stocks, there are professionally managed funds, known as merger arbitrage funds, which specifically target M&A deals after they are announced (see sidebar for merger fund risks). The IQ Merger Arbitrage ETF (MNA) and Merger ETF (MRGR) are the largest ETFs of this kind by net asset value, and the Merger Fund® Investor Class (MERFX), Arbitrage Fund (ARBFX), and Touchstone Merger Arbitrage Class A (TMGAX) are the largest merger arbitrage mutual funds by net asset value.6
Merger arbitrage funds depend heavily on the number of deals available to invest in at a given point in time; many of these funds have relatively high expense ratios, and their performance can be volatile. Among the primary risks of these types of funds is the potential for an announced deal not closing that the fund has invested in.
One high profile example of a failed M&A deal occurred when AT&T's (T) $39 billion March 2011 bid for T-Mobile USA was rejected by the US Department of Justice. Both stocks declined in the months after the deal was blocked in the summer of 2011, with T-Mobile suffering the deeper decline (at one point, it actually fell below the pre-deal announcement price level).
This example also highlights how companies can eventually rebound after a deal falls through, even if it does take some time. In fact, both stock prices climbed above their pre-deal announcement prices by mid-2013.
Despite these risks, merger arbitrage funds have generally grown in size in recent years, based on assets under management. Is merger arbitrage a strategy that you should consider for your portfolio? Russel Kinnel, director of manager research at Morningstar, has noted that a merger arbitrage fund could be "a nice diversifier" for some investors who can withstand volatility, primarily due to the performance of these funds not being entirely dependent upon the stock market's performance. Kinnel also notes that, since these funds deal in shorter-term trades, investors should be mindful of taxes to be paid on any capital gains.
Yet you need to carefully consider the risks of these funds, and if they align with your strategy. Additionally, the recent track record of some merger arbitrage funds isn't great. MERFX, the largest of all the merger arbitrage funds, is up 5.4% year to date, vastly trailing the S&P 500's 9% price return.1 Over the past 10 years, MERFX has generated a 3.2% average annual return, compared with 13% for the S&P 500.1
Moreover, FINRA recommends exercising caution in regards to M&A and investing. As noted on FINRA's website, most M&A deals provided little value, according to research. For all the excitement and headlines surrounding M&A announcements, more often than not M&A deals don't serve acquiring companies as well as executives and shareholders would hope.
This is by no means a comprehensive discussion regarding the potential impact of M&A. However, if your strategy involves seeking out high-quality companies trading at attractive valuations, you may end up owning the types of investments that M&A deals tend to involve. The more information you have, the more likely you may be able to manage the potential effect of an M&A deal on your portfolio.
You should have a plan in place to reassess your holdings periodically, or if circumstances change. An M&A announcement is one example of an event that should require you to reevaluate your investments.
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