Merger Arbitrage PGP

I IM INDORE

Merger Arbitrage •Event driven trading strategy • Also called - Risk arbitrage

•After an announcement (M&A deal), target’s stock price jumps up to trade at levels near to the offer price • But not exactly at the level: Target’s share price trades at a discount (1% to 2%)

• The difference between Offer Price & Stock Price = Deal Spread

•Deal spread reflects: • Time value of money: time to effective date (deal signing)

• Probability of merger failure: Deal is announced, not completed

Deal Spread & Risk Arbitrage •The arbitrageur will translate the deal spread into annualized return • Then estimate the possibility of deal failure

• Consider an appropriate rate for time value

• Estimate: if the spread compensates for both, and yet leave a margin • Then buy target company’s stock

•Counter parties to arbitrageurs • Investors holding target stock • Have just received a windfall

• And want to lock in gains

• If these investors hold stock till end • Face the risk of losing the previous gains if merger talks fail

Merger Arbitrage in Cash Deals: An Illustration •On May 13, 2002, Sears announced that it plans to acquire Lands’ End, Inc. (LE) • Offer: $62 / LE’s share

• Pre-announcement Stock Price of LE: $51.02

• Post-announcement Stock Price of LE: $61.73

• Gross Deal Spread – $0.27 (Post-announcement Price– Offer Price)

•Deal spread suggests that there is a room for an arbitrageur to step in • If 27 cents exceed (Time value of money and Loss due to Probability of Failure)

•Mechanics of the arbitrage: • Commission costs (for buying target share): 2 cents

• Expected time to deal closure: 40 days

Merger Arbitrage •Estimate the probability of Deal Failure • Given the descriptive information

• In this case, Probability of deal failure – 1%

• Expected Return = 99% * ($62/$61.75 – 1 ) + 1% * ($51.02/$61.75 – 1 ) = 0.227%

• Annualized Expected Return = 1.00227365/40-1 = 2.09%

•To invest or not: compare the expected return with the opportunity cost • Risk free return on short term treasury security - rate used by arbitrageurs • Since investors assume there is not beta risk

• Return on 3month treasury bill – 1.7%

•Annualized Expected return exceeds opportunity cost – scope for arbitrageurs to invest

Deal Spread can indicate the probability of Deal Failure •If p – probability of deal failure

•Current price = [ 1−𝑝 ∗𝑂𝑓𝑓𝑒𝑟 𝑝𝑟𝑖𝑐𝑒 + 𝑝 ∗𝐹𝑎𝑖𝑙𝑢𝑟𝑒 𝑃𝑟𝑖𝑐𝑒]

[1+𝑇𝑟𝑒𝑎𝑠𝑢𝑟𝑒 𝐵𝑖𝑙𝑙 𝑟𝑎𝑡𝑒]𝑇

•Same illustration as before, • Offer price $62, Failure price $51.02 (original level before announcement)

• Current Stock price $61.73

• T-bill rate – 1.7%

• Time to completion – T = 40 days

• Implied probability of Failure (using the equation mentioned above) – 1.4%

Reference •Weston, F. J., Mitchell, M. L., and Mulherin, J. H. (2009). Merger Arbitrage. Takeovers, Restructuring, and Corporate Governance. Delhi, India: Pearson Education India.

•Relevant pages for reading: 606-610