Stacking Merger Arbitrage with Corey Hoffstein
Overview
In this special interview, Corey Hoffstein sits down with Advisor Analyst to discuss merger arbitrage and its role in portfolio diversification.
Key Topics
Return Stacking, Merger Arbitrage, Portable Alpha, Risk Premia
Introduction
In this special interview, Corey Hoffstein sits down with Advisor Analyst to discuss merger arbitrage and its role in portfolio diversification. Corey breaks down how investors can capture the residual spread in merger deals, comparing the strategy to traditional credit markets, and explaining how return stacking and portable alpha can enhance portfolio efficiency. Originally recorded for Advisor Analyst (advisoranalyst.com), this conversation offers valuable insights for investors exploring alternative risk premia and advanced portfolio construction techniques.
Topics Discussed
- Merger Arbitrage Fundamentals and Spread Mechanics: Understanding how the time value of money and deal‐break risk create the residual spread in announced deals
- Execution Strategies in Merger Arbitrage: Detailing the tactical process of buying target shares and hedging acquirer exposures
- Risk Premium Analysis in Merger Arbitrage: Examining how the risk premium from merger arbitrage compares with classic equity and credit risk premia
- Diversification Benefits with Alternative Risk Premia: Outlining the low correlations merger arbitrage offers relative to equities and bonds for portfolio stability
- Comparison with Traditional Credit Strategies: Assessing how merger arbitrage can serve as an alternative to conventional corporate bond investments amid compressed credit spreads
- Return Stacking and Portable Alpha Concept: Explaining the overlay strategy that layers merger arbitrage on core Treasury exposures to enhance overall returns
Summary
The global financial landscape is undergoing significant transformation as investors seek alternatives to traditional asset classes amid historically thin credit spreads and heightened market uncertainty. In this episode, Corey Hoffstein explores how merger arbitrage—where the target company’s stock price only partially closes the gap to the deal price due to time value and deal-break risks—can offer a distinct risk premium. He explains that once a merger is announced, markets price in the uncertainty of deal completion and the delay until closing, leaving a residual spread that investors can capture. This residual spread is not a classic true arbitrage but rather a reward for bearing risks similar to those seen in credit and fixed-income sectors. Corey further describes the tactical nuances of buying the target company’s stock and hedging appropriately, depending on whether a deal is structured as an all-cash or a cash-plus-stock transaction. The discussion situates merger arbitrage within a broader portfolio context, noting its moderate correlation with both equities and traditional credit instruments, thereby enhancing diversification. He contrasts the risk premium available from merger arbitrage with that of conventional corporate bonds while emphasizing its potential to generate a return profile similar to investment-grade assets when combined with core Treasury exposures. The conversation also highlights the concept of return stacking—borrowing from the portable alpha playbook—to overlay merger arbitrage on standard portfolios without disturbing existing allocations. Importantly, Corey acknowledges the behavioral challenges investors face when venturing into less familiar strategies, underscoring the importance of patience and clear communication regarding risk and return. Overall, the episode provides a comprehensive examination of how incorporating merger arbitrage can create a multi-risk-premia portfolio that is both diversified and resilient in varied market conditions.
Topic Summaries
1. Merger Arbitrage Fundamentals and Spread Mechanics
Corey Hoffstein begins by outlining the mechanics behind merger arbitrage, clarifying that when a company is acquired, the target’s stock price rises toward the announced deal price but typically leaves a spread below that level. This spread exists largely because of the time value of money, as deals usually take several months to close, and the inherent uncertainty regarding the deal’s eventual completion. He explains that two primary factors contribute to this residual spread: the time needed for the deal to close, and the risk that unforeseen issues (such as regulatory hurdles or capital constraints) may cause the deal to fall apart. This risk of deal break is factored into the market price as a risk premium, compensating investors for the additional uncertainty. The discussion emphasizes that rather than being a pure arbitrage opportunity, merger arbitrage should be seen as a strategic bet on earning a risk premium over time. By capturing this spread, investors receive compensation similar to that for bearing other well-known risks in the market. Additionally, Corey points out that the unique pricing dynamics in mergers make the residual spread a measurable indicator of market confidence in the deal’s eventual success. This detailed evaluation lays the foundation for understanding why merger arbitrage is not simply a bet on price convergence but a calculated play on risk and time. The session establishes that solid comprehension of these basics is essential for deploying this strategy effectively in a diversified portfolio.
2. Execution Strategies in Merger Arbitrage
Corey details the tactical execution of merger arbitrage strategies, describing how investors typically initiate a position by purchasing the target company’s shares as soon as a deal is announced. For deals involving both cash and stock, he notes that a hedge is often constructed—such as shorting the acquirer’s stock—to neutralize market-wide movements and isolate the merger-specific spread. The trade timing is critical, as the gap between the current market price and the deal price may fluctuate based on evolving market sentiment and deal-specific developments. Corey also emphasizes that understanding the structure of the deal (all-cash versus mixed consideration) is crucial in designing the proper execution strategy. He discusses how managing these positions requires diligence to monitor the progress of the deal, the financing environment, and possible regulatory developments. Moreover, precision in execution not only helps in managing the inherent risks but also in maximizing the capture of the embedded risk premium. The approach requires a blend of quantitative analysis and tactical market participation. Additionally, the execution strategy is tailored to suit a diversified portfolio framework that includes core Treasury or bond exposures, ensuring that the merger arbitrage overlay enhances overall risk-return characteristics. By explaining these operational details, Corey illustrates how disciplined execution in merger arbitrage can effectively harness an alternative source of returns.
3. Risk Premium Analysis in Merger Arbitrage
In his analysis of risk premia, Corey presents merger arbitrage as a distinctive risk premium that arises because investors absorb both time delay and potential deal-break risks. He stresses that the residual spread, which remains after the market reacts to the initial deal announcement, constitutes compensation for bearing these uncertainties. This risk premium is akin to those seen in equity and credit markets, where investors are rewarded for accepting additional risk. Corey points out that, historically, the merger arbitrage premium has at times been even more attractive than conventional credit spreads. He also lays out how this premium is less about benefiting from directional market moves and more about accruing a steady return by matching risk with reward. The risk premium in merger arbitrage is derived not solely from credit risk but from a unique set of event-driven factors less correlated with broad market cycles. By comparing these dynamics to the equity risk premium, he makes a strong case that the reward-to-risk balance in merger arbitrage is compelling over the long run. This detailed consideration is critical in understanding why investors should consider allocating to merger arbitrage as a standalone component in their portfolio strategy. Overall, the discussion highlights that the merger arbitrage premium offers not just potential returns but also diversification benefits in portfolios that are otherwise dominated by more traditional risk exposures.
4. Diversification Benefits with Alternative Risk Premia
Corey explains that merger arbitrage provides notable diversification benefits due to its relatively low correlation with broader equity and bond markets. He outlines that while merger arbitrage exhibits some correlation—around 0.5—with both stocks and credit risk, its behavior differs substantially from cyclically sensitive asset classes. This moderate correlation means that merger arbitrage can act as a counterbalance to market volatility, offering stability during periods when equities or credit instruments underperform. By incorporating this strategy, investors can spread their exposure across multiple risk premia, reducing the overall portfolio risk. The episode details how the independent drivers of merger arbitrage returns—primarily deal-specific outcomes—provide a valuable overlay against the broader fluctuations impacting traditional investments. Corey also suggests that pairing merger arbitrage with diversified Treasury holdings creates a synthetic profile resembling investment-grade corporate bonds, thereby enhancing portfolio resilience. This approach not only broadens the risk exposure but also leverages alternative sources of return that are less subject to the prevailing economic cycle. The diversification benefits are especially appealing in environments where traditional credit spreads are compressed, and conventional bonds offer limited compensation for the risks undertaken. Ultimately, this strategy reinforces the importance of exploring alternative risk premia to achieve a more balanced and robust asset allocation.
5. Comparison with Traditional Credit Strategies
Corey draws a comparison between merger arbitrage and traditional credit strategies, highlighting the advantages of the former in an environment of tight credit spreads. He notes that while investment grade and high yield bonds have long served as vehicles for earning credit risk premiums, the rewards may be diminishing as spreads have contracted to multi-decade lows. In contrast, merger arbitrage offers an alternative risk premium derived from the specific risks associated with merger deals. By integrating merger arbitrage into a portfolio, investors can potentially replicate the return profile of corporate bonds while diversifying away from credit-specific risks. Corey emphasizes that the distinct risk factors—such as deal break uncertainty and the timing of the merger close—make merger arbitrage less cyclically sensitive than traditional credit. This characteristic can prove beneficial during economic downturns when traditional credit instruments may experience elevated risk. Furthermore, he describes a structured approach where merger arbitrage is layered over a base of Treasury exposure, resulting in a composite profile akin to that of investment-grade corporate bonds. This method underlines the strategic advantage of swapping some conventional bond allocation for an alternative that may offer superior risk-adjusted returns. By comparing these two asset classes, Corey makes a compelling case for why merger arbitrage should be considered a vital tool in the broad diversification toolkit of modern investors.
6. Return Stacking and Portable Alpha Concept
A significant portion of the discussion centers on the concept of return stacking, also known as portable alpha, which Corey describes as layering alternative risk premiums onto core portfolio structures. He details how, rather than completely replacing traditional asset allocations, investors can supplement a standard 60/40 portfolio with an additional overlay—such as merger arbitrage—to potentially achieve higher overall returns. This strategy allows investors to retain the familiar return characteristics of stocks and bonds while capturing incremental premiums from alternative strategies. Corey explains that by isolating the merger arbitrage element—the risk premium derived from deal break risk and time delay—and combining it with diversified Treasury investments, the resulting portfolio mimics the risk and return of high-quality corporate bonds. The approach is founded on the idea that different sources of risk premium are complementary rather than competitive. Through return stacking, capital efficiency is enhanced because each component of the portfolio is optimized to contribute an independent source of return. This method has a long pedigree in institutional investing but, as Corey argues, is now becoming accessible to a broader base of investors. By illustrating the mechanics of portable alpha, he shows how merger arbitrage can be seamlessly integrated into a portfolio without significantly increasing overall risk or volatility. The discussion underscores that such advanced strategies enable investors to maximize returns while addressing behavioral constraints tied to traditional asset classes.
7. Investor Behavioral Considerations and Allocation Challenges
Corey addresses the practical challenges and behavioral considerations that have historically limited the adoption of merger arbitrage. He observes that many investors and financial advisors gravitate toward familiar asset classes like stocks and bonds, partly because these are easier to understand and monitor. Despite its attractive risk premium, merger arbitrage is often perceived as opaque, higher in cost, and more complex in terms of tax efficiency, which can make it unpalatable during periods of market stress. Corey highlights that even when merger arbitrage delivers solid returns, investors may be inclined to exit the position if it deviates momentarily from expectations, thereby undermining long-term performance. He also explains that the strategy’s performance cycle may include periods of underperformance—behavioral “dog years”—which can trigger hasty reallocation decisions. Such behavioral biases can lead to performance chasing, reducing the realized benefit of the strategy over time. By advocating for a return stacking approach, Corey suggests a solution that keeps the core asset allocations intact while layering alternative risk premia on top, making it easier for clients to stay committed. The narrative stresses that investor education and disciplined portfolio construction are key to overcoming mental anchors that favor traditional investments. Ultimately, this segment underscores the importance of integrating alternative strategies like merger arbitrage as a stable long-term component of a diversified portfolio, despite short-term challenges that may arise from investor sentiment.
Transcript
[00:00:00] Corey Hoffstein: When a company, when there’s an announcement that one company is going to buy another, if this is a public company that’s trading, the company that’s getting acquired, typically its share price is going to jump up towards the announced price, but it typically doesn’t go all the way. There’s usually a spread left, and that spread is going to represent two things.
One, it’s going to represent the time value of money. The deals typically aren’t closing imminently. They’re typically closing, say an expected deal, time might be 6 to 12 months, and so the market’s going to build in some sort of time value of money for that deal to close. The other thing the market is going to price in is the expected expectation of any deal break.
We have very strong laws about mergers and acquisitions in the U.S. but there’s still a probability that a deal might fall apart for capital reasons, or a deal might fall apart because of regulatory reasons. And so that represents deal break risk, and that’s going to be baked into the premium as well.
And so you can almost think of how far the deal jumps, how far the stock price jumps from where it was trading to announced deal prices, a pseudo probability of how much the market thinks the deal is likely to get done, with some time value money baked in there. And so what merger arbitrage does is it says, after the deal has been announced, we are going to buy into that, acquired company, if it’s an all-cash deal. If it’s a cash plus stock deal, we’re going to buy into that company and short the stock of the acquirer, if it’s a public company, and then we’re going to try to capture that remaining spread over time. It’s less an arbitrage in the sense of a true arbitrage. I like to think of it as a risk premium, right?
A lot of those investors who are along for the ride got that initial jump. There’s a little bit of juice left to squeeze in that spread, and so when you’re stepping at that price that you are taking on the risk, the deal could fall apart. You’re taking on the risk that the deal might take longer than the market’s expecting.
And so by taking on those risks, you should earn a risk premium. And so, a well diversified M&A portfolio in the public markets, once these deals are announced, should look very much like a mix between a duration, a low duration portfolio. You’re getting paid, compensated for that time value money premium, and a little bit of something that looks a little bit like credit risk. It’s not perfectly credit risk, but it’s credit risk adjacent, and it’s a different unique risk premium that you can earn.
There’s two ways I’d want to answer this. One is an Evergreen answer, right? When we’re building portfolios, I think it’s always prudent to be looking to diversify across as many unique risk premia as possible. When we look at the returns of a merger ARB strategy, it’s lowly correlated to bonds. It’s got about a correlation of 0.5 to equities, a correlation of about 0.5 to the credit risk premium.
And so as we’re looking to just further diversify our portfolios structurally, I think it’s a great Evergreen allocation at this point in time. We’re in an environment where credit spreads are very thin, and so for more conservative investors who have a lot of investment grade corporate bond exposure, or even high yield bond exposure.
The question you have to ask is, are we being fairly compensated for the risk we’re taking, particularly if there is a potential hard landing coming around the corner from an economic perspective. I’m not going to prognosticate on that. But when you have credit spreads this thin, the margin for error is quite low.
And so one of the things we’re talking a lot about is saying what if you took the merger risk premium and put it on top of Treasuries? What you end up with is something that over the long run looks a lot like a corporate bond return profile, but the excess return that you’re earning above the Treasuries isn’t coming from credit risk. It’s coming from deal break risk. And again, there’s some low correlation there. There is some similarities in certain markets, but it is its own unique risk premium. And so we think it makes a great diversifier to corporate bonds in an environment like we’re in today.
The expectation is typically there is a bit of cyclicality to merger arbitrage, right? People typically think, oh, there’s a big recession, right? That’s bad for M&A, and that is true to a certain extent, and that’s where you do tend to see a little bit of correlation between merger arbitrage and credit.
And equities, M&A deals might dry up. It might take longer for people to get the financing, but we have very strong M&A laws in this country. The example I always give is Elon Musk buying Twitter, now X, right? He made a proposal in a somewhat joking manner, and then Delaware law forced him to buy Twitter, right?
So it’s very hard to get out of these deals once they’re announced. And so when you look at a diversified merger arbitrage portfolio, you’re talking about a diversified set of idiosyncratic risks, versus when you look at credit, you tend to be looking at something that is far more cyclical and tends to have a lot more correlation to equity markets, because it’s a pseudo-proxy for what’s happening in the economy.
And so it’s not to say there isn’t some sort of economic similarity to them. Again, that correlation is about a 0.5, but it’s not perfect, and you tend to find that M&A strategies, merger arbitrage strategies have far less downside correlation to equities than credit does.
I think what you find with a traditional merger arb strategy, if you’re just buying an off the shelf merger strategy, this is typically like a short duration bond fund. The way we are putting together our bonds and merger arbitrage strategy is it’s going to be something much more an intermediate-term credit fund. You’re just generic investment grade credit strategy, we are taking a diversified portfolio of Treasury exposure, from 2 year, 5 year, 10 year out, to U.S. long bond Treasury exposure, and then stacking on top of that the merger arbitrage risk premium. That’s our ambition at least. And so when you put those two things together, you get something that looks a lot more like investment grade corporate bonds.
And so that’s where we would recommend people fund this allocation from it. They should sell some of their core investment grade corporate bonds, buy some of a portfolio like this, the bonds plus merger arbitrage strategy, and in doing so, we think over the long run you get a very similar return profile.
I actually think merger arbitrage has historically been more attractive than the credit risk premium. But let’s say it’s the same. The benefit there really is then the diversification, right, that you’re just adding yet another risk premium to your portfolio and helping spread your bets into unique places that you should get paid for allocating your money.
When we think about beating the market there’s very few ways in which you can actually do that. You can, right, pick securities better. Maybe you go into your stock allocation and pick stocks better to beat the market, or you do that in your bond allocation. You can do tactical asset allocation, right? Switch between stocks and bonds. But these approaches typically rely on one person winning and one person losing, right? They’re more typically relying on behavioral phenomena. What’s really interesting about merger arbitrage as a strategy is that we really think it’s a risk premium. That by investing in merger arbitrage, you should expect to earn a return, because you are bearing a risk the same way you should expect to earn a return for bearing credit risk.
The same way you should expect to earn a return for just bearing bonds, the bond risk premium, or expect to earn a return. Why do equities go up the equity risk premium? And so for us, from a conviction perspective, right, what do we think will continue to work over the long run? We have very high conviction in risk premium, and we think merger arbitrage is a very strong risk premium from both an empirical and theoretical basis.
And so when we look at continuing to diversify our portfolio or adding novel return streams on top of our portfolio, to me it makes a lot more sense to try to focus on those areas that we really think are risk premium, before we start to explore these other approaches to beat the market.
When you look at merger arbitrage as a category, you don’t tend to see a huge amount of allocation to merger arbitrage among financial advisors. So again, it goes back to this problem of clients aren’t starting with a blank canvas. They’re typically mentally, behaviorally anchored to what’s happening with stocks and bonds.
And if you can’t keep up with stocks and bonds, which merger arbitrage has not kept up with stocks and bonds, they typically just want to get rid of it, because it tends to be higher costs, less tax efficient, more opaque. It’s just not something they understand. And so to me, what’s so compelling about our approach is you’re getting the core bonds back.
You’re stacking the merger arb, this novel risk premium on top. I think it’s a very compelling risk premium over the long run and what you’re creating through that combination is something that’s going to look a lot like investment grade corporate bonds to a client, and that’s something that I think clients can hold onto for the long run.
Wow. Harvesting those diversification benefits. When we’re looking to build a portfolio, we should be looking for that breadth, particularly that breadth of risk premium, right? People allocate to stocks because there’s a risk premium. They allocate to bonds because there’s a risk premium. They allocate to corporate bonds because there’s a credit risk premium. Merger arbitrage is very defensively to me, a risk premium, and yet almost no one has it in their portfolio because I think the way it’s typically packaged, which is basically a cash + strategy. You’re earning T-bills plus the merger risk premium is just less, especially over the last decade where T-bills were giving you nothing, is just less attractive from a total return basis.
And from that line item perspective is going to stick out to clients. When you take the return stacking approach like we do, where we carve off the risk premium element of merger arbitrage and stack it on top of the bonds, and you put that in a single line item, I think the return of that line item is a lot easier to hold for investors over the long run, is going to rhyme a lot more with what they expect to see in their portfolio, but still gives you that potentially really benefit skew breadth, right, expanding the set of risk premium that a client is allocated to.
And so again, particularly in an environment like today where you are seeing credit spreads compressed to multi-decade lows, I think it’s a timely period to explore how you can diversify beyond the credit risk premium.
These ideas that we’re bringing are nothing new or novel, and they’re something that’s existed in the institutional space and been used with great success for a long time. And so all we’re hoping to do is take that idea and bring it down and make it available for lack of a better phrase, to democratize access to the idea.
So going back to this idea of how do you find diversification in your portfolio? We’ll use the cliche example of a 60/40 investor. A lot of people over the last decade have pushed from moving from a 60% stock, 40% bond portfolio to something that’s 50% stock, 30% bond, 20% alternative. And it may look great on paper over a multi-decade period, but the reality is, behavioral time is a lot more like dog years.
You underperform for 3 years in a row and to the client it’s going to feel like 21, and it’s hard for them to stick with. And it’s why you tend to see these really big measured behavior gaps in these alternative asset class categories, where the investment return tends to be several hundred basis points higher than the realized investor return, because they end up performance chasing in and out of these categories, because it’s hard for them to stick with.
Return Stacking is just an idea that came from the institutional space, called portable alpha, that’s been around for 40, 45 years. And what we’re ultimately trying to do is use the capital efficiency that exists in a lot of these strategies, whether it’s managed futures, or merger arbitrage or carry or whatever it is, to layer those alternative strategies on top of the core stocks and bonds, so that instead of going from a 60/40 to a 50/30/20, they can go from a 60/40 to a 60/40/20.
And now the number sums up to more than a hundred, and they’re adding these alternatives as an overlay to the core stocks and bonds that they expect to retain, which can help reduce the tracking error of their portfolio to those things that clients are most behaviorally sensitive to.