Many strategic as well as financial investors are familiar with the numerous advantages of cross-border M&A. For example, expanding into potentially lucrative new markets, establishing a presence near existing or new clients, building and smoothing out revenue streams and diversifying international business risk. Investors, however, may be less familiar with another potential advantage of cross-border M&A. That is the possibility of creating financial and operational value through an investment strategy known as risk arbitrage.
Overview
Many people associate “risk arbitrage” with highly speculative M&A strategies. However, it is actually a simple concept that occurs in markets and affects businesses every day. In financial markets, arbitrage refers to a situation where an asset can be purchased for a price in one market and sold at a higher price in another market. Risk arbitrage, on the other hand, refers to taking advantage of a mispricing of risk and the impact of that mispricing on credit or asset prices to either build firm value or prevent firm value from being lost.
Examples of risk arbitrage in the credit context:
A fair interest rate for a loan based on the risk of a company or an activity is 8%. If, assuming the same level of risk, a bank is willing to lend money at a price of 6%, this represents a clear risk arbitrage opportunity for borrowers. Similarly, if borrowers are willing to pay a 10% interest rate, this represents a clear risk arbitrage opportunity for lenders. Borrowers are overpaying for the actual level of risk in connection with a loan that a creditor will take.
These opportunities also frequently arise with regard to asset purchases. To take another example, assume the capitalization rate for multifamily properties in a market is 6%. This means the asset price is calculated by dividing its net operating income by 6%. If the real risk of a property warrants a 4% capitalization rate, buyers have a risk arbitrage opportunity. In practical terms, this reduces the price paid for the asset. Conversely, if the risks warrant an 8% capitalization rate, selling at 6% creates a risk arbitrage opportunity for sellers. Here, the buyer is effectively discounting the asset’s risk by 2%.
It may well be asked how these types of opportunities can exist. One would assume that if a risk arbitrage opportunity existed, buyers and sellers would immediately take advantage of these opportunities. Therefore, the resulting market pressures would quickly cause the arbitrage spread to disappear.
However, often the arbitrage spread does not disappear, principally because of three key reasons:
1) Information necessary to accurately price assets is often not available, particularly with respect to companies that are not publicly traded.
2) Assets and the market context that defines asset values are in a constant state of change. This causes risk levels to fluctuate faster than they can be converted into accurate pricing terms.
3) Misperceptions of risk exist even in the face of clear information.
Risk arbitrage and cross-border M&A
Risk arbitrage opportunities often exist in cross-border M&A, particularly in emerging markets. This is because information regarding market fundamentals or assets may be more difficult to obtain. Moreover, key market drivers, such as inflation rates or currency values, may be more volatile than in more developed markets.
It commonly occurs in emerging markets. For example, investors may assume that because a country is considered to be “risky”, companies or assets in that country by definition must be equally risky. In fact, many companies that operate in riskier jurisdictions adopt measures that protect themselves from risk. For example, they have operations or assets abroad or hedging against currency risk. This means that if a company is acquired using a 15% discount rate to account for country risk, but its actual risk profile only warrants 12%, the investor gains a 3% risk arbitrage advantage.
Risk arbitrage opportunities can also occur in highly stable markets. In these risk pricing in the market does not reflect real levels of company, sector or market risk. In this type of situation, assets can be sold at a price in excess of the price which reflects real market risk. Hence, creating a risk arbitrage gain.
As well as risk arbitrage gains at the time of asset purchase, it is also possible to realize arbitrage gains throughout a company’s operation. For example, for a real estate development company, developing projects in a country where credit is mispriced can increase profitability and reduce market risk.
Risk arbitrage and investment exit issues
Many risk arbitrage strategies are employed with assets that have deep and liquid trading markets, such as publicly traded securities. Thus, once arbitrage opportunities are captured they can be quickly monetized. In the private M&A context, however, investors may hold an investment for many years. It can occur that the market context can significantly change over time. Therefore, assets that are bought at a discount in year 1 may need to be sold at an even larger discount in year 5. This is due to a worsening of market risk perceptions.
For investors taking a long-term view of strategy and company value, risk arbitrage should not be the sole criterion for investment. Instead, it should be part of a broader strategic decision. This decision should consider the investor’s overall strategy and the value created by acquiring an asset or entering a country, regardless of potential arbitrage gains.
This article was written by Darin Bifani. If you would like to discuss the potential for using risk arbitrage principles as part of a cross-border M&A strategy, please contact us.