Hedge funds in the business of breaking up deals see big payoff, study finds

  • Carl Icahn recently tried to destroy Cigna's $54 billion purchase of Express Scripts by buying shares of Cigna and pushing it to get out of the deal.
  • Usually shares of an acquiring company fall and those of a target rise, allowing traditional merger arbitrage traders the chance to profit on their price movements as the deal nears completion.
  • But Icahn's strategy, also employed by others, runs counter to this traditional merger arbitrage and is one researchers have dubbed "activist arbitrage."
Carl Icahn speaking at Delivering Alpha in New York on Sept. 13, 2016.
David A. Grogan | CNBC
Carl Icahn speaking at Delivering Alpha in New York on Sept. 13, 2016.

Turns out, killing deals, or even attempting to do so, can be a profitable business.

That's the thinking behind an increasingly popular tactic for hedge-fund activists — and it seems to be paying off.

Carl Icahn recently used it to try to destroy Cigna's $54 billion purchase of Express Scripts. When reports of Icahn's plan surfaced on Aug. 1, Cigna's shares gained about 2 percent, while Express Scripts shares slumped 6.3 percent.

That upends the usual dynamic, in which the stock of the acquiring company falls after a merger announcement while that of the target company rises. Traditionally on Wall Street, traders betting on the success of a merger would buy shares of a target company and pair that trade with a short position in shares of the acquirer, reaping profit as the deal nears completion.

But Icahn's strategy, also employed by others, runs counter to this traditional merger arbitrage and is one researchers have dubbed "activist arbitrage."

As he explained in an open letter to shareholders on Aug. 7, Icahn bought stock of acquirer Cigna and shorted Express Scripts. Because most mergers tend to benefit shares of the target, blocking the transaction or lowering the deal price would pay off for shareholders in the acquirer.

On average, so-called activist arbitrageurs create an extra, risk-adjusted, 5.7 percent bounce in the shares of acquirers in the 20 days following the activists' disclosures, according to a new study by researchers at Columbia University and the University of Florida. On an annualized basis, the average gain in the period after the deal announcement to a resolution of an activist fight is about 5.5 percentage points higher than what shareholders in an acquirer would see without activist intervention, according to the researchers, led by Wei Jiang, Chazen Senior Scholar at Columbia.

"Our evidence indicates that activist M&A arbitrage serves as a governance remedy for acquiring firms' shareholders, as well as a profitable investment strategy for the activists themselves," the authors wrote.

That was the case when a $20 billion chemicals deal was killed last October after a group of activist investors argued the transaction would destroy shareholder value.

Jana Partners

White Tale, the investment vehicle of Keith Meister and the New York fund 40 North, acquired as much as 20 percent of Swiss chemicals giant Clariant and got a few other shareholders to protest its acquisition of Huntsman. Clariant gained 11 percent between the day White Tale disclosed its plans in early July and the merger's collapse on Oct. 26. Clariant has gained about 5 percent since then.

In 36 percent of targeted deals, activist arbitrageurs were able to successfully block the deals, the research found. (Comparatively, deals signed without activist intervention closed about 91 percent of the time). In about 17 percent of the cases, activists were able to get better terms for the acquirers in the deal. Those that lowered their offer premiums did so by 4 percentage points on average, the research showed.

Of the 70 unique investors that the researchers studied, Jana Partners tended to be the most frequent user of this strategy. The firm last year opposed a $6.7 billion cash-and-stock tie up between EQT Corp. and Rice Energy. Ultimately, shareholders voted overwhelmingly to approve the deal, though.

The study found that activist arbitrageurs tend to target deals that are not well-perceived by investors — those that have steeper declines once the transaction is announced. The targeted deals are likely to be those that use stock as currency and those with acquirers that have a track record of poor returns on their invested capital.

Just the mere disclosure of Icahn's Cigna plan was likely a boon for him even though he did not successfully break up the deal. By the time he abandoned his quest less than two weeks later, Cigna had gained 3.7 percent. But activists on the other side, notably Glenview Capital, supported the deal and helped boost shares of Express Scripts.

Sometimes, the strategy becomes Plan B when an activist is caught by surprise after an inopportune deal is announced.

"What happens is an activist is already in the buyer and building a stake and then they get flat-footed when their target announces a deal," said Kai Liekefett, who leads Sidley Austin's shareholder activism practice. "The company the activist is targeting is now buying another company and their stock price goes down."

Activist arbitrage is an offshoot of another popular strategy known colloquially as "Bumpitrage." This happens after a deal is announced that requires a shareholder vote. An activist will come out and threaten a proxy contest to urge shareholders not to vote for the deal unless the buyer agrees to a bump up the price.

"Once a buyer has invested the time and money into buying a company, they're not going to chicken out of the last couple dollars," Liekefett said. "The buyers always want to salvage the deal."