Value-at-risk for merger arbs

New York-based consultancy Capital Markets Risk Advisors (CMRA) is developing a database it says will allow investors to apply value-at-risk to portfolios with investments in merger arbitrage hedge funds.

Merger arbitrage plays take the form of bets on the likelihood of the convergence of one or both stocks of companies involved in a merger. Speculators win in a merger stock deal, for example, by shorting the acquiring company’s shares and by going long the acquired company’s shares.

As with “market-neutral” strategies, investors like merger arbitrage investing because the risks are largely deal-specific – arising from the legal and regulatory challenges to a merger going through – and, hence, have low correlation to capital markets. Richard Horwitz, a principal at CMRA involved in the project, says that, especially with the recent decline in US equity markets, institutional investors want to expand their capacity to assess and manage the risks of hedge fund investing. CMRA has been working since July on the database in conjunction with a large client that manages a fund of hedge funds. Horwitz wouldn’t say when it would be finished.

Some major risks to merger arbitrage are that a deal will take longer to close than anticipated, which reduces overall returns, or that the announced acquisition price will be changed. But the chief risk is that the deal will collapse and the two companies’ stocks will diverge, returning to their historic ranges.
Horwitz says the CMRA database will allow more accurate analysis of the stock price behaviour of two merging companies after a merger announcement and, separately, if a deal falls through. The database will also help portfolio managers diversify away any market risk in the deals through better knowledge of the correlations that merger events have across debt and equity markets and their sub-sectors.

But applying VAR to merger arbitrage poses a special technical challenge, as the weaker of the two speculative assets concerned effectively detaches from its price history once a merger has been announced. This price “step” precludes the use of standard techniques to estimate the risks involved with the new stock price going forward to merger completion, because VAR typically requires data histories of a continuous nature.

And sceptics think VAR has little application to merger arbitrage given the deal-specific nature of the risk and the scarcity of merger bets possible. Ben Golub, co-head of risk management at BlackRock, the New York-based money manager and risk advisory firm, says that, conceivably, a risk manager could come up with statistics about the number of merger deals that fail, assume that the failures are uncorrelated, and then claim to have a VAR by applying the data to a particular portfolio of risk arbitrage bets. “But I don’t think I would believe it with my own money,” says Golub.

Even if it is technically feasible, others say presently available risk management techniques for funds of funds are adequate. Norman Chait, head of the hedge funds group at AIG Global Investment Corporation and portfolio manager of AIG Diversified Strategies Group in New York, says most good hedge fund managers would not give out the position-level data in the manner required for third-party VAR evaluators. Besides, a good fund-of-funds manager doesn’t need VAR, Chait argues. He just needs to be able to phone his managers. The basic information needed – gross, net, long and sector exposures, assets under management, and so on – are all obtainable from individual managers in time for effective risk management.

Many agree that recent attempts to “institutionalise” hedge funds are wrong-headed. Hedge funds, they say, are a talent pool not an asset class. With merger arbitrage funds, in particular, Chait makes an assumption that limits the appeal of the usefulness of fund of funds VAR. He says that, in his experience, all hedge fund managers doing merger arbitrage are in on the same deals. That means the marginal diversification gained by investing beyond a few “core” merger arbitrage managers is small, and a focus on manager talent and managers’ risk tolerances should be the major investment criteria.

Whatever the debate on the merits of VAR for merger arbitrage, Horwitz says several third parties are interested in the firm’s work, including a risk management technology vendor and a prime broker, which he declines to name.

Meanwhile, Measurisk, the New York-based risk management application service provider, plans to release FundScape, a new service that will perform VAR analysis for funds of funds, next month. To build FundScape, Measurisk worked with its long-standing client, the World Bank, and the 25 hedge funds it invests with, and with a newly announced client, Blackstone Alternative Asset Management, a fund of funds with $2 billion under management. Neil Paragiri, director of Measurisk, says access to a sufficient level of hedge fund position data is essential to VAR for fund of funds. Because Measurisk is an independent risk management provider, says Paragiri, Fundscape can guarantee the protection of the proprietary value of position data for merger arbitrage managers.