Merger Arbitrage

Merger arbitrageurs make money by writing insurance against failed merger attempts. When a merger is announced, the targets stock price typically appreciates by 20% or more. Yet even with the substantial price increase, the targets stock usually trades at a 1% to 3% discount to the price offered by the acquiring company. The reason for the discount is that there is a nonnegligible probability that the announced merger will fail to be consummated.

There are many reasons why a merger might be called off. Government regulators charged with preventing monopolies might determine that the merger would adversely affect competition, and they might file a lawsuit to block the merger. Industry conditions might change, altering the economics of the business combination and causing the target or acquirer to cancel the deal. Shareholders, concerned that the merger is not in their best interest, might vote against the merger.

Whatever the reason for aborting the deal, the effect on the targets stock price is usually the samea significant decrease, usually on the order of 25%. Shareholders of target companies that are the subject of a takeover thus face a choice. They can continue to hold the targets stock, in the expectation of obtaining the full consideration offered by the acquirer, but bearing the risk that the announced merger will not occur. Or they can insure against the risk of the merger being cancelled prior to consummation by selling the stock and locking in the current price. Those who decide to sell and avoid the deal risk sell to merger arbitrageurs.

Merger arbitrageurs specialize in assessing the probability of deal consummation. Arbitrageurs bear the risk that the deal will be called off, causing a dramatic decline in the targets stock price and a commensurate loss for the merger arbitrageur, in exchange for the 1% to 3% price appreciation that successful completion of the merger will bring. Far from being catastrophes for merger arbitrageurs, deal failures are what allow arbitrageurs to profit from their strategy. If announced mergers were always completed, the difference between the targets stock price and the merger consideration would simply reflect the risk-free rate of return, and the investment opportunities for merger arbitrageurs would vanish. Like an insurance agent, merger arbitrageurs will demand a premium that provides adequate compensation for bearing the risk of loss associated with deal failure. This premium is the arbitrage spread, or the difference between the price at which they can purchase the stock and the price they anticipate receiving upon successful completion of the deal.

For some types of insurance, the risk of loss is idiosyncratic. The probability that one house will burn to the ground is usually uncorrelated with the probability that a house down the street will burn down. For other types of insurance, such as hurricane insurance, risks are concentrated; the probability that one house will be destroyed is highly correlated with the probability that the house down the street will be destroyed. Because idiosyncratic risk can be costlessly eliminated through diversification, understanding the correlation between various risks is critical to determining the appropriate price for insurance.

Merger arbitrage is similar. Often, the risk that one deal will fail is uncorrelated with the risk that other deals will fail. Furthermore, the risk of deal failure is usually, but not always, uncorrelated with overall stock market movements. For this reason, merger arbitrage is often referred to as a market neutral investment strategy. The degree of market neutrality will be discussed later in this chapter. For now, the important point is that merger arbitrage investors must maintain a portfolio perspective and understand the correlations between their individual investments, as well as the correlation of their portfolio returns with overall market returns.

This chapter begins by describing common types of mergers and the trades arbitrageurs use to capture the arbitrage spread. The precise trades used depend on the structure of the merger. The chapter then proceeds to describe the returns and the risks that are characteristic of portfolios of merger arbitrage investments.

MERGER ARBITRAGE TRADES

The trades used by merger arbitrageurs to assume deal risk and capture the arbitrage spread depend on the type of consideration being offered by the acquiring company. The most straightforward situation occurs when the consideration is cash. More complicated trading strategies are required when the acquirer offers securities (typically its own stock) in consideration for target shares. Descriptions of common trading strategies, and examples of common deal structures, are presented below.

Cash Mergers and Cash Tender Offers

The merger arbitrage trading strategy is most straightforward when the corporate acquirer offers cash for each share of the target company. Cash offers come in two flavorstender offers and cash mergers. In a tender offer, the acquirer offers to buy target shares directly from target shareholders. In a cash merger, the acquirer makes a cash payment to the target company, and the target company distributes the cash to shareholders to retire the outstanding shares. While there are some important legal and tax-treatment differences between tender offers and cash mergers, the primary difference from the merger arbitrageurs perspective is that cash mergers take longer to complete than tender offers.

In both tender offers and cash mergers, the arbitrageurs trade is straightforward: buy the target companys stock after the deal is announced and hold it until the merger is consummated. Upon consummation, the target shares are exchanged for the merger consideration, generating a profit equal to the difference between the merger consideration and the price at which the target shares were purchased.

Coca-Colas takeover of Odwalla, Inc. a distributor of juice drinks and snacks, provides an example of a cash tender offer. On October 22, 2001, rumors surfaced that Coca-Cola, Inc. was negotiating the purchase of Odwalla. Odwallas stock price closed at $10.05 on the 22nd, an increase of 48% over its previous days close of $6.80. Over the next five days, Odwallas stock price drifted up to $11.83 as speculators assessed the probability that a definitive agreement would be reached and guessed at the terms of the transaction.

On October 30, 2001, Coke announced that it had reached a definitive agreement with Odwallas board of directors whereby Coke would acquire all of Odwallas publicly traded shares for $15.25 a share in a cash tender offer. The $15.25 represented a 29% premium over Odwallas stock price on the day before the merger was announced and a 144% increase over Odwallas stock price in the days before rumors of the deal surfaced. At the close of trading on the day immediately following the announcement, Odwallas stock traded at $15.13, a 0.79% discount to the tender offer price.

Merger arbitrageurs could have invested immediately after rumors of the Odwalla deal surfaced. An arbitrageur (wishing to write insurance against negotiations falling apart) could have purchased Odwallas stock for $10.05 a share, hoping that a definitive agreement would materialize at a higher price. If an agreement were not reached, Odwallas stock price would likely have dropped significantly, causing a substantial loss for the arbitrageur. As it turned out, a definitive agreement was reached at a price substantially higher than $10.05 a share, so the arbitrageur would have made a return of 51% in six days.

This example shows that investing in rumors can pay off handsomelyor generate substantial losses. It is difficult to gauge both the probability that a definitive agreement will be reached and the price that will be offered if the agreement is reached. Many arbitrageurs therefore avoid investing in rumors, choosing instead to wait for the announcement of a definitive agreement.

An arbitrageur who waited for the announcement before investing in Odwalla would have purchased shares for $15.13 a share, hoping to exchange them for the $15.25 offer price, thereby capturing the 0.79% arbitrage spread. As Cokes tender offer for Odwalla was successfully consummated on December 11, 2001, 30 trading days after the definitive agreement was announced, the arbitrageurs 0.79% spread would have generated an annualized return of 6.8%.

Had Cokes tender offer for Odwalla been unsuccessful, Odwallas stock price would most likely have dropped by several dollars. Given the severely asymmetric payoff to the merger arbitrage trade (i.e. make $0.12 versus lose several dollars), the probability of successful completion of the merger would have to be much greater than the probability of failure for the arbitrage investment to have an expected return in excess of the risk-free rate. The arbitrageur can back out the markets assessment of the probability of deal failure by plugging estimates of both Odwallas stock price in the event of deal failure and the time to deal completion into the following equation:

Here p is the probability that the tender offer fails, rf is the risk-free rate, and T is the estimated time required to complete the tender offer.

For example, assume an annual risk-free rate of 5%. If we then estimate that Odwallas stock would trade at $12 if the tender offer fails and that the deal will be completed in one month, the implied probability of deal failure is 1.8%. If instead we assume deal failure would result in a $10 stock price, the implied failure probability falls to 1.1%. Like the writer of insurance policies, the merger arbitrageur will invest in the merger only if the arbitrage spread (the insurance premium) provides adequate compensation for bearing the risk of loss. Stated differently, the merger arbitrageur will buy Odwallas stock only if his or her estimate of the probability of deal failure is lower than the probability reflected in market prices.

In this example, the expected cash flows from the investment in the Odwalla merger are discounted at the risk-free rate. The implicit assumption in this calculation is that the risk of deal failure is uncorrelated with overall market movements. Whether this is a good or bad assumption is treated later in this chapter.

Although the trades required to capture the arbitrage spread are more complicated when something other than cash is used as the merger consideration, the same basic principles apply. Merger arbitrageurs attempt to lock in the arbitrage spread when the spread provides adequate compensation for the risk of deal failure. The trades used to capture the spread when the acquirer offers stock instead of cash are described below.

Fixed Exchange Ratio Stock Mergers

On September 3, 2001, Hewlett Packard and Compaq Computer announced that they had reached an agreement whereby HP would acquire Compaq in a stock-for-stock transaction. The merger agreement specified that, upon consummation of the merger, each share of Compaq would be exchanged for 0.6325 share of HP. Because the 0.6325 exchange ratio was specified in the merger agreement and was not contingent on future events (e.g. changes in the acquirers stock price), this type of merger is referred to as a fixed exchange ratio stock merger.

Capturing the arbitrage spread in a fixed exchange ratio stock merger requires a more complicated trading strategy than capturing the spread in a cash merger or tender offer. In addition to buying the target companys stock, the arbitrageur must sell short the acquiring firms stock. In the HP-Compaq example, the arbitrageur would sell short 0.6325 share of HP for each share of Compaq purchased.

On September 4, 2001, one day after the merger was announced, Compaq closed at $11.08 and Hewlett Packard closed at $18.87. The arbitrageur would sell short 0.6325 share of HP, generating $11.94 (0.6325 $18.87), and purchase one share of Compaq, costing $11.08. The $0.86 (7.8%) difference is the arbitrage spread. Upon successful consummation of the merger, each of the arbitrageurs Compaq shares is replaced with 0.6325 HP share. The arbitrageur would then be long 0.6325 share of HP and short 0.6325 share of HP. The long and short positions cancel out, leaving the arbitrageur with a profit equal to the original spread.

The example above ignores three cash flows that affect the ultimate profit generated by the merger arbitrage trade. First, the arbitrageur is long one Compaq share, hence is entitled to receive Compaq dividends. Second, the arbitrageur is short 0.6325 HP share, hence is obligated to pay HP dividends on 0.6325 share to the lender of HP stock. Third, the arbitrageur earns interest on the proceeds obtained from shorting HP stock. Interest is typically paid to the arbitrageur at a rate 25 to 50 basis points less than the federal funds rate and accrues over the period of time that the stock is shorted. Interest payments on short proceeds are often referred to as short rebate.

Exhibit 7.1 shows the cash flows from the Compaq-HP arbitrage trade, assuming deal completion. An arbitrageur that placed the necessary trades on September 4 would have expected to earn a return of 7.8% if the merger was successfully consummated. Assuming an expected time to completion of 3.5 months, which is typical for fixed exchange ratio stock mergers, this would generate a 29.4% annualized rate of return. This may seem like a very high rate of return. However, at the time of the merger announcement, there was concern that the Federal Trade Commission (FTC) would block the merger on the grounds that it would adversely affect competition in the market for personal computers. If this were to happen, the arbitrageurs loss would far exceed the anticipated 7.8% gain. The arbitrageur would have estimated the expected return at the time of the deals announcement as the weighted average of the positive return that would be realized upon deal completion and the negative return that would be realized upon deal failure, where the probabilities of consummation and failure are used as the weights.

As things turned out, the FTC was little more than a warm-up act. On November 6, 2001, Walter Hewlett, son of HP founder William Hewlett and member of the HP board, made history by publicly announcing his intention to vote the shares under his personal control against the merger, and by commencing an aggressive proxy battle to block the merger. This particular proxy battle was uncommon because, as an HP board member, Walter Hewlett had voted for the merger. Hewletts decision to personally fight the merger set the stage for a very public, often colorful, and frequently hostile debate between Hewlett and HP CEO Carly Fiorina. Both, for example, used daily Wall Street Journal advertisements to sway the shareholder vote.

For an arbitrageur, Hewletts decision to fight the merger was unexpected and painful. On the day that he announced his opposition, HPs stock increased by $2.92 and Compaqs shares dropped $0.44. The arbitrage spread, originally 7.8%, immediately jumped to 47.4%. The arbitrageurs initial investment, originally worth $100, was now worth $72.

Exhibit 7.2 tracks both the arbitrage spread and the value of the arbitrageurs $100 initial investment from the time the merger was announced through consummation, eight months later. Throughout the process, the arbitrage spread expanded and contracted as arbitrageurs updated their beliefs about the likelihood of the merger being completed. This exhibit shows the direct relationship between the arbitrage spread and the arbitrageurs profits. When the arbitrage spread widens, the arbitrageur loses money on an arbitrage position that is already in place, and when the spread contracts, the arbitrageur makes money.

Ultimately, on May 3, 2002, after accusations of vote-buying, lawsuits, and millions of dollars of advertisements, the Hewlett PackardCompaq merger was completed. Including dividends paid on the HP short position, dividends received on the Compaq long position, and interest on short proceeds, the original arbitrage trade generated a return of 8.9%, for an annualized return of 14.0%.

Contingent Exchange Ratio Stock Mergers

In a fixed exchange ratio stock merger such as Hewlett Packard-Compaq, the number of shares of acquirer stock to be exchanged for each target share is determined ex ante. In a contingent exchange ratio stock merger, the number of shares to be exchanged depends on the acquirers average stock price over a prespecified period, usually close to the merger closing date. The period over which the acquirers stock price is measured is referred to as the averaging period or pricing period.

Contingent ratio mergers take many forms. Exhibit 7.3 illustrates three common forms. The top plot shows the structure for a floating exchange ratio stock merger, where each target share is promised a prespecified value of the acquirers stock. The actual number of shares ultimately exchanged for each target share is determined by dividing the promised consideration by the acquirers average stock price over the pricing period. If this average price is low, target shareholders receive a relatively large number of acquirer shares, whereas, if the price is high, target shareholders receive fewer shares. The variation in the number of shares maintains the value paid to target shareholders at a constant level.

Before the pricing period begins, floating exchange ratio mergers are like cash mergers, as the dollar value per target share is independent of the acquirers stock price. The merger arbitrageur therefore buys the target stock but does not short the acquirers stock. After the pricing period ends, when the number of acquirer shares to be paid for each target share has been determined, floating exchange ratio mergers are identical to fixed exchange ratio mergers. In order to capture the arbitrage spread and create a payoff that is independent of the level of the acquirers stock price, the merger arbitrageur must establish a short position in the acquirers stock. Thus, during the pricing period, the arbitrageur shorts the acquirers stock and transforms the arbitrage investment from one that is like an investment in a cash merger into one that is like an investment in a stock merger.

For an acquirer, a major risk of entering into a floating exchange ratio merger agreement is that the number of shares that must ultimately be issued can be very large. To mitigate this risk, merger agreements often augment the floating exchange ratio structure by placing limits on the number of shares that must be issued. These types of mergers are often referred to as collars. The middle plot in Exhibit 7.3 illustrates a merger where each target share receives $10 worth of acquirer shares as long as the acquirers average price over the pricing period is between $20 and $30. If the average price falls below $20, target shareholders receive a fixed consideration of 0.50 share. If the average price rises above $30, the ratio is fixed at 0.33.

The bottom plot in Exhibit 7.3 depicts a different type of collar structure. Here a fixed number of acquirer shares is promised per target share as long as the acquirers average stock price over the pricing period stays between $30 and $50. If the average price falls below $30, additional shares will be issued to maintain a value of $10 per target share. If the average price exceeds $50, the value per target share is capped at $20.

Collars often come with colorful labels. The collar depicted in the middle plot of Exhibit 7.3 is sometimes referred to as a Travolta, a name that refers to the placement of John Travoltas arms when disco dancing in the movie Saturday Night Fever. In a similar vein, the collar depicted in the bottom plot is sometimes referred to as an Egyptian, a reference to the way arms are drawn in ancient Egyptian hieroglyphics.

Collar mergers share attributes of both fixed exchange ratio stock mergers and floating exchange ratio stock mergers. Although they appear to be complicated, the payoffs to target shareholders in collar mergers can be replicated by portfolios of options on the acquirers stock. Insulating the payoff from movements in the acquirers stock price can be accomplished by hedging the payoff in the same way that option portfolios are hedged, namely, by trading in the option market or delta hedging using the acquirers stock. Describing in detail the hedging strategies that can be used in collar transactions is beyond the scope of this chapter. However, the basic approach can be found in most derivatives textbooks.2

More complicated deal structures can involve preferred stock, warrants, debentures, and other securities. From the arbitrageurs perspective, the important feature of all these deal structures is that returns depend on mergers being successfully completed. Thus, the primary risk borne by the arbitrageur is that of deal failure.