Why Merger Arbitrage Now?

To potentially mitigate risk1, provide downside protection2 and diversify returns3

in investors’ portfolios, this alternative investment strategy is arguably more
important today than ever before.

ADVISED BY WATER ISLAND CAPITAL

Executive Summary

1
Over the last several years, the merger arbitrage strategy, like many other Reducing volatility is a common method of
mitigating risk. Two common measures of
alternative investment strategies, has struggled to deliver returns comparable
risk are standard deviation, a measure of
with those generated by U.S. stock or bond indices. The reason is simple: since the dispersion of a set of data around its
2009, financial markets have been supported by unprecedented monetary mean, and beta, a measure of the volatility
stimulus by global central banks as well as by investors’ insatiable appetite of a portfolio to the market as a whole.

for yield. These dynamics have created a market characterized by sustained

hfri merger arbitrage index
low market volatility and low interest rates. At the same time, prices for risk 3-Year Standard Deviation: 1.87%
assets, including stocks, corporate debt and sovereign bonds, marched ever 3-Year Beta vs. S&P 500: 0.10
higher, with little differentiation between good and questionable investments. 3-Year Beta vs. Barclays Agg: 0.01
As of 12/31/14. Source: Morningstar.
Against a backdrop of muted volatility and robust gains in equities and
fixed income markets, it is hard to appreciate or even recall the potential
diversification benefits of alternative strategies such as merger arbitrage. 2
Investments that outperform the broader
market during periods of stress have the
The Standard and Poor’s 500 index has tripled since its March 2009 nadir; potential to act as a ballast and provide
downside protection in a portfolio.
it has recorded six straight years of positive returns and its third consecutive
year of double-digit gains in 2014. In fact, today’s bull market is the third market peak to trough return
longest in history. While one could argue that U.S. stocks are neither cheap HFRX Merger Arbitrage Index: +3.39%
nor expensive, we believe the current bull market shall nevertheless start S&P 500: -54.89%
Date range: 10/9/07-3/9/09. Source:
to show its age. If history is any guide, equity markets are likely to be more Morningstar.
turbulent in the periods ahead as growth rates and monetary policy around
the world diverge. As for bonds, they are unlikely to be an investor’s “sleep
3
tight at night” investment much longer. Although the current Wall Street Portfolio returns can be diversified by
investing in assets that are not correlated
consensus expectation is U.S. rates will be “lower for longer,” there is a
to the broader equity and fixed income
possibility the U.S. Federal Reserve will begin to normalize rates by mid–2015. markets.
Bond prices may come under pressure should interest rate moves out-pace
market expectations. hfri merger arbitrage index
3-Year Correlation vs. S&P 500: 0.50
3-Year Correlation vs. Barclays Agg: 0.02
Given these dynamics, investors are entering uncharted territory where As of 12/31/14. Source: Morningstar.
bonds potentially fail to provide security in the face of rising rates and, after
three years of complacency, volatility returns to equity markets. All of these
concerns may make it prudent for investors to consider alternative investment
strategies as a tool to buffer portfolio volatility and to preserve wealth. Merger
arbitrage, in particular, has a proven history of providing diversifying and
positive absolute returns in all market environments.

What makes merger arbitrage even more compelling today is that we

believe the outlook for potential returns has improved significantly. Spreads
on merger arbitrage deals have widened considerably since late October
2014, due in part to several high profile deal breaks and to a rise in market
volatility from abnormally low levels. At the same time, transaction activity
continues to make a strong resurgence. As this trickles down from mega-cap
companies to the mid- and smaller-sized acquirers, the breadth of the deal
universe expands leading to improved deal selection for arbitrageurs. Taken
together, the investment environment suggests that investors reconsider the
risk-adjusted return potential of an alternative investment strategy such as
merger arbitrage.

The Arbitrage Funds Why Merger Arbitrage Now? · 2

What is Merger Arbitrage?

For decades, merger arbitrage, also commonly known as risk arbitrage, has been
a meaningful component of institutional investors’ portfolios. This investment The merger arbitrage
strategy focuses on profiting from capturing the discrepancy between the strategy has been
acquisition price and the price at which the target’s stock trades before able to deliver
consummation of a merger. This is commonly known as the “spread”. A spread consistent, absolute
strategy is intended to deliver returns that are isolated from the fluctuations of returns because of
broader markets. Historically, investors added an allocation to merger arbitrage how the strategy is
strategies to their portfolios to preserve wealth, dampen market risk and constructed.
potentially augment and diversify return streams.

During the wrenching tumult of the financial crisis of 2008 to 2009, when the
S&P 500 index dropped by over 50% peak to trough, a thoughtfully constructed 4
The HFRX Merger Arbitrage Index
portfolio of merger arbitrage holdings generated returns that were not only returned +3.39% from October 7, 2007
independent of the market’s performance, but actually helped to preserve through March 9, 2009, a period during
wealth by generating absolute positive performance.4 Post financial crisis, which the S&P 500 Index lost -54.89%.
Source: Morningstar.
and in a zero interest rate environment, merger arbitrage has been embraced
by investors seeking alternative sources of returns while also managing risk.
5-year return
5

Even though many merger arbitrage investors predominately utilize equities HFRI Merger Arbitrage Index: 3.05%
as the primary instrument to employ their strategy, and although most merger HFRX Merger Arbitrage Index: 2.12%
arbitrage portfolios focus on total return versus generating a steady stream of BAML 3-Month T-Bill Index: 0.10%

income, the risk/reward ratio of a diversified merger arbitrage portfolio is similar

5-yr standard deviation
to short-term fixed income investments.5 These characteristics have led some HFRI Merger Arbitrage Index: 2.05%
asset allocators to view the strategy as a fixed income alternative. HFRX Merger Arbitrage Index: 2.48%
BAML 3-Month T-Bill Index: 0.04%

5-yr sharpe ratio

HFRI Merger Arbitrage Index: 1.44
Building Blocks of a Merger Arbitrage “Spread” HFRX Merger Arbitrage Index: 0.83
BAML 3-Month T-Bill Index: 0.80

Timing to Close

}
All figures are annualized. As of
• Steps in Process 12/31/14. Source: Morningstar.
• Approvals Needed

Deal Risk
deal spread

• Regulatory Risk Premium + Risk-Free Rate

• Financing =
• Shareholder Votes
Deal Spread (i.e., Profit Potential)
• Other Approvals
or Consents

Risk-Free Rate
• Short-Term
Treasuries

Figure 1.

The Arbitrage Funds Why Merger Arbitrage Now? · 3

What has happened since the Financial Crisis?

Since late 2009, financial markets have been

Growth of $10,000 (1/1/95–12/31/14)
supported by unprecedented monetary stimulus
by central banks coupled with investors’ insatiable $70,000
appetite for yield. These dynamics have created $60,000
markets characterized by historically outsized
$50,000
returns, sustained low volatility, low interest rates and
an increasing appetite for risk. To put that in context, $40,000
between 1928 and 2011, the S&P 500 has typically $30,000
experienced a 10% decline once a year, according
$20,000
to Ned Davis Research. While there have been
several episodes of market volatility during the past $10,000

three years, none have resulted in a peak to trough $0

market decline of more than 10%, and any decline Dec 1994 Dec 1999 Dec 2004 Dec 2009 Dec 2014
of significance has not lasted more than a few days. HFRI Merger Arb Barclays Aggregate S&P 500
What’s more, the S&P 500 index has gained 100%
from October 2011 through December 2014, and in Figure 2. Source: Morningstar. As of 12/31/14.
Past performance is not a guarantee of future results. Index performance is not
2014 alone, it recorded 50 new highs. Meanwhile, for
indicative of fund performance. One cannot invest directly in an index.
the past 30 years bond investors have experienced a
near perfect environment of strong price appreciation.
Since the Great Recession of 2008, yields have fallen 10-Year US Treasury Yield (1954-2014)
to historically low levels. Under such a backdrop,
15%
it is not surprising that alternative strategies have
struggled to deliver returns that are competitive to
those generated by U.S. equity or bond indices.
10%

Subdued Results During Bull Runs, Ballast During

Volatile Markets 5%

Not surprisingly, the recent environment has not

been ideal for investment strategies that seek 0%
to generate returns independent of the broader 1954 1964 1974 1984 1994 2004 2014
markets’ performance. This is because in periods
Figure 3. Source: US Federal Reserve. Date range: 1/1/54-12/31/14.
when prices for risk assets march ever higher without Past performance is not a guarantee of future results. Index performance is not
any sustained pullbacks and valuations become indicative of fund performance. One cannot invest directly in an index.
stretched, returns for alternative strategies are likely
less attractive relative to the market.
Bull vs. Bear Market Annualized Returns
Most alternative strategies, such as merger arbitrage, HFRI Merger Arb S&P 500 Barclays Agg
are meant to capture returns that are more subdued Bull 1: Dec 94-Aug 00 15% 26% 8%
than the market’s upside performance. On the Bear 1: Aug 00-Sep 02 2% -25% 11%
other hand, when markets decline, an alternative Bull 2: Sep 02-Oct 07 8% 16% 4%
strategy may potentially mute portfolio losses. Bear 2: Oct 07-Feb 09 -5% -41% 5%
Merger arbitrage strategies specifically should Bull 3: Feb 09-Dec 14 4% 22% 5%
provide investors with protection from market
Figure 4. Source: Morningstar. As of 12/31/14.
shocks, thereby preserving wealth across market Past performance is not a guarantee of future results. Index performance is not
environments. indicative of fund performance. One cannot invest directly in an index.

The Arbitrage Funds Why Merger Arbitrage Now? · 4

Rates and Returns

The risk-free rate (typically defined as the yield on the U.S. Government
3-Month Treasury Bill) is a critical component of merger arbitrage 2014 highlighted why it’s
returns (see Figure 1). As a corresponding rule, unlevered merger important to differentiate
arbitrage investors have traditionally sought to capture returns of 2-3 between merger and
times this risk-free rate. acquisition activity and the
merger arbitrage strategy.
While impossible to predict future interest rates, we can say with no
uncertainty that this historic yardstick of merger arbitrage returns
has been artificially dislocated in the post-2008 era due to Central
Bank policy.
Historical Deal Flow
2,000 2,000
The Difference Between Deal Flow and Merger Arbitrage

Deal Volume (#)

Deal Value ($B)
1,500 1,500

Another component of merger arbitrage returns is the number of 1,000 1,000

transactions available in which to invest. The greater the number of 500 500
deals spread across different industries and market capitalizations,
0 0
the greater the opportunity set—which allows for a wider selection

2002
2004
2006
2008
2010
1996
1998

2012
2014
2000
of high quality, strategic deals and lowers the potential for investing
Deal Value Deal Volume
in transactions that don’t close. Since mid–2009, the nadir of the
Figure 5. Source: Dealogic. As of 12/31/14.
Great Recession, deal flow—in number, breadth and value—has been Past performance is not a guarantee of future results.
lackluster and concentrated in a select few industries. However,
2014 highlighted why it’s important to differentiate between a robust
environment for merger and acquisition (M&A) activity and an ideal
landscape for the merger arbitrage investment strategy. In terms of the
dollar value of transactions, 2014 was the most active year since 2007.
According to Dealogic, $3.6 trillion in transactions were announced
globally in 2014. While we finally witnessed the return of animal spirits
to corporate boardrooms, the headline number belies the fact that
only a few industries (namely Health Care, Telecommunications and
Media) have dominated deal flow and that most of the activity has
been centered on mega-cap transactions—$20 billion plus—which
usually have greater hurdles (primarily regulatory) for completion.
What’s more, in 2014, nearly one-fifth of proposed mergers and
acquisitions were terminated this year, representing about $700
billion in failed deals—the second most ever, according to Dealogic.

An ideal environment for a merger arbitrage investment strategy

would be characterized by a wide breadth of deal flow in mid and
small market capitalization companies and participation across many
sectors. This would lead to greater selection of high quality deals and
more compelling spreads given greater market inefficiencies across
capitalization levels.

The Arbitrage Funds Why Merger Arbitrage Now? · 5

The Outlook for Mergers and Acquisitions

The outlook for transaction activity and deal spreads

Cumulative Return from Market Peak to Trough
improved markedly in the fall of 2014. As the
(10/31/07–2/28/09)
efficacy of buybacks, dividend payouts, and other
0%
corporate actions plateau, strategically-sound M&A
-10%
transactions should become the preferred maneuver
-20%
to spur share price increases. Meanwhile, deal
-30%
spreads, an indication of the potential performance
of the merger arbitrage strategy, are wider (i.e., more -40%

attractive) than they have been in the past three -50%

years. In the spring of 2014, deal spreads averaged -60%

10/07 2/08 6/08 10/08 2/09
4% on an annualized basis. At the end of 2014, deal
HFRI Merger Arb HFRI Composite S&P 500
spreads are annualizing at nearly 9%, according to
Figure 6. Source: Morningstar. Date range: 10/31/07-2/28/09.
UBS research. Accelerating market volatility and a
Past performance is not a guarantee of future results. Index performance is not
few, high profile, terminated transactions expunged indicative of fund performance. One cannot invest directly in an index.
much of the speculation from the space.

Furthermore, as the U.S. strengthens and the global Cumulative Return from Market Peak to Trough
economy stabilizes, boardroom confidence around (4/30/11–9/30/11)
the world usually grows. This should result in more
0%
transactions, across a wider swath of industries,
-4%
geographies and market capitalizations, leading
to a broader opportunity set of attractive, high- -8%

quality M&A situations upon which arbitrageurs can -12%

capitalize.
-16%

-20%
Why Invest in the Merger Arbitrage Strategy 8/11
4/11 5/11 6/11 7/11 9/11
Now? Potential Wealth Preservation and Return HFRI Merger Arb HFRI Composite S&P 500
Diversification
Figure 7. Source: Morningstar. Date range: 4/30/11-9/30/11.
Past performance is not a guarantee of future results. Index performance is not
The merger arbitrage strategy has typically been indicative of fund performance. One cannot invest directly in an index.
embraced for its wealth preservation and return
diversification attributes. In the two most recent
periods of extreme volatility, when equities last fell Average Annualized Deal Spreads
by double digits (see Figs. 5 and 6), merger arbitrage 14%
strategies performed better than both the broad 12%
equity market and the broader hedge fund universe. 10%
8%
Given that today’s bull market is the third longest
6%
in history, investors may want to revisit the role of 4%
alternatives in their portfolios. The properties that 2%
make the merger arbitrage strategy an essential 0%

component of well-diversified portfolios are arguably Dec 13 Feb 13 Apr 13 Jun 14 Aug 14 Oct 14 Dec 14

more important than ever. Figure 8. Source:UBS Research. Date range: 12/31/13-12/31/14.
Past performance is not a guarantee of future results.

The Arbitrage Funds Why Merger Arbitrage Now? · 6

Final Word

Investors are entering uncharted territory where bonds potentially fail to

provide security in the face of rising rates, and, after three years of double- It is always prudent for
digit gains, equities become more volatile in response to divergent growth investors to consider
rates and monetary policies around the world. In light of this, it is prudent for alternative investment
investors to consider alternative investment strategies as a potential tool to strategies as a potential
buffer volatility and to preserve wealth. Merger arbitrage, in particular, has a tool to buffer volatility
history of providing diversifying and positive absolute returns during periods and to preserve wealth.
of market stress. Merger arbitrage, in
particular, has a history
What makes merger arbitrage even more compelling today is the outlook for of providing diversifying
potential returns has improved significantly. Spreads on merger arbitrage and positive absolute
deals have widened considerably since late October 2014, due in part to returns across all market
several high profile deal breaks and a rise in market volatility to normalized environments.
levels. At the same time, deal-making activity continues to make a strong
resurgence. As this trickles down from mega-cap companies to the mid- and
smaller-sized acquirers, the breadth of the deal universe expands leading to
improved deal selection for arbitrageurs.

Taken together, the investment environment strongly suggests that investors

take another look at the risk-adjusted return potential of an alternative
investment strategy such as merger arbitrage.

MERGER ARBITRAGE NOW

We expect the following factors could have an impact on future returns generated by the strategy:
volatility
• In the recent low volatility environment, many investors have been willing to accept suboptimal returns relative to the
risks they bear.
• An increase in volatility in the fall of 2014, and a few, high profile terminated M&A transactions have expunged much of the
speculation from the space.
• Increased volatility will highlight the importance of deal selection.
• The recent increase in volatility has provided the most attractive entry points for arbitrageurs seen in past three years.
interest rates
• Given the attempts by their respective central banks to stimulate the economies of Europe, Japan and China, non-U.S.
interest rates are likely to stay low for the foreseeable future.
• In the U.S., the Federal Reserve has indicated it may begin to increase interest rates by mid–2015.
deal flow
• With $3.6 trillion in announced deals, 2014 was the most active year for mergers and acquisitions since 2007.
• As increases in deal activity trickle down from upper tier companies to mid/low tier acquirers, the breadth of the deal
universe expands leading to improved deal selection for arbitrageurs.
• Smaller cap deals also tend to have more certain timing and less regulatory risk, leading to higher quality investment
opportunities
• Deal flow will continue to increase as acquisitions become a preferred tool for share price appreciation replacing share
buybacks, dividend increases and cost-cutting efforts.
• Deal spreads, an indication of future potential performance of the strategy, are as wide, (i.e., attractive) as they have been
in the past three years.
In sum, the investment environment strongly suggests prudent investors consider the risk-adjusted return potential of an
alternative investment strategy such as merger arbitrage.

The Arbitrage Funds Why Merger Arbitrage Now? · 7

GLOSSARY
basis point: A unit that is equal to 1/100th of 1%.
bear market: A market condition in which the prices of securities are falling, and widespread pessimism causes the negative
sentiment to be self-sustaining.
beta: A measure of the volatility of a portfolio in relation to the market as a whole, indicates the tendency of a portfolio to respond
to swings in the market.
bull market: A financial market characterized by optimism and investor confidence, in which prices are rising or are expected to
rise, with expectations that strong results will continue.
correlation: A measure of how two securities move in relation to each other, ranging from -1 to +1. A correlation of 0 means the
relationship between the two securities is completely random, while +1 indicates a perfect positive relationship and -1 a perfect
negative relationship.
DOJ: The United States Department of Justice is a department of the federal executive branch, headed by the attorney general,
which administers the Federal Bureau of Investigation, prosecutes violations of federal law, and is responsible for enforcing all civil
rights legislation.
FTC: The Federal Trade Commission is an independent agency of the U.S. government with a principal mission of promoting
consumer protection and the elimination and prevention of anticompetitive business practices, such as coercive monopoly.
SEC: The Securities and Exchange Commission is a U.S. government commission created to regulate the securities markets and
protect investors. In addition to regulation and protection, it also monitors corporate takeovers in the US.
Sharpe ratio: A measure of risk-adjusted performance, calculated by subtracting the risk-free rate from the rate of return for a
portfolio and dividing the result by the standard deviation of the portfolio returns.
standard deviation: A measure of the degree of variation of returns around the average return.

IMPORTANT INFORMATION

The Arbitrage Fund seeks to achieve capital growth by engaging in merger arbitrage.

An investor should consider the Fund’s investment objectives, risks, charges and expenses carefully
before investing. The current prospectus contains this and other information about the Fund. To obtain
a prospectus, please call (800) 295-4485 or visit our website at http://arbitragefunds.com. Please
read the prospectus carefully before investing.

RISKS: The Fund uses investment techniques with risks that are different from the risks ordinarily associated
with equity investments. Such techniques and strategies include merger arbitrage risks, high portfolio turnover
risks, options risks, borrowing risks, short sale risks, and foreign investment risks, which may increase volatility
and may increase costs and lower performance. Past performance is not a guarantee of future results.

There is no guarantee that the strategy objectives will be met.

The Standard and Poor’s 500 Index (“S&P 500”) is a capitalization-weighted index of 500 stocks designed
to measure performance of the broad domestic economy. The Barclays Capital U.S. Aggregate Bond Index
(“Barclays Agg”) covers the U.S. investment grade fixed rate bond market. The Bank of America Merrill Lynch
Three Month U.S. Treasury Bill Index (“BAML 3-Month T-Bill”) measures the performance of short-term U.S.
government treasury bills. The HFRI and HFRX Merger Arbitrage Indices (“HFRI Merger Arb”/“HFRX Merger
Arb”) include funds which employ an investment process primarily focused on opportunities in equity and
equity related instruments of companies which are currently engaged in a corporate merger or acquisition
transaction. The HFRI index is priced monthly, while the HFRX index is priced daily. The HFRI Fund Weighted
Composite Index (“HFRI Composite”) is an equal-weighted index of over 2000 constituent hedge funds that
invest over a broad range of strategies. Indexes are unmanaged and one cannot invest directly in an index.
Index performance is not indicative of Fund performance.

Distributed by ALPS Distributors Inc, which is not affiliated with the Water Island Capital (“the Adviser”) or any
affiliates of the Adviser, Dealogic, Ned Davis Research, or UBS Research. [ARB000705 2016-05-01]