Friday, January 14, 2011

Risk Arbitrage back on?

A NYtimes DealBook article, Return of the Risk Arbs, declared betting on mergers is back from the dead in November 2010:

We're seeing people dip their toe back in the water and participate, said Keith M. Moore, a managing director at MKM Partners in Stamford, Conn.

Many investment banks echo'd that sentiment in their 2011 outlooks, proclaiming mergers will return with a vengeance in 2011, with the rationales being:

  • Healthy corporate balance sheets with access to accommodative financing and reasonable or some might say cheap valuations.
  • The need to buy growth.
  • Product and or geographic extension.
  • Cost rationalization.
I would, however be remiss in not including the improving swagger of CEOs with an appetite for destruction, deal making.

With mergers being back in fashion, we might see the re-emergence of risk arbitrage or merger arbitrage, one of the most popular hedge fund strategies. So time to brush up on the strategy, review any new FTC guidelines and crank up "ye olde arb spreadsheet".

So, what is risk arbitrage? I can tell you it is not buying stock in a company because uncle Vito said “something’s gonna happen, so get stuck in”. Although, it would probably be highly profitable, it is not arbitrage and can be illegal. Along the same lines is rumortrage – it means just what you think it does -, those in the market know what I mean – particularly the denizens of Foreign Exchange trading. Sometimes rumortrage works but more often than not that “strategy” results in loss or break even at best minus costs, of course.

Risk arbitrage is the systematic arbitrage of corporate events, wherein the terms of the event specify exactly what investors will receive in exchange for their holdings when the operation effectively closes. These corporate events include mergers, tender offers, exchange offers, liquidations, spin-offs, and corporate reorganizations. For a more detailed discussion of risk arbitrage click here.

One such corporate event was announced on Monday January 10th. Duke Energy (DUK) and Progress Energy (PGN) announced that their board of directors have agreed to merge the two companies, with DUK offering 2.6125 shares of Duke for every one of PGN, in a deal valued at $38 billion (inclusive of $12 billion in debt).


  • The pricing represents a 7% premium for PGN Shareholders to the stock price on January 5th and a 4% premium to the January 7th close.
  • It would also represent a 3% dividend increase for PGN Shareholders, based on DUK’s current dividend.
  • Both companies expect the deal to be accretive in its first full year and expect the deal to close by year-end 2011.

Approvals & Timing

  • Completion of the merger is conditioned upon, among other things, the approval of the shareholders of both companies, as well as expiration or termination of any applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.
  • Other necessary regulatory filings include: Federal Energy Regulatory Commission (FERC), Nuclear Regulatory Commission (NRC), North Carolina Utilities Commission (NCUC) and South Carolina Public Service Commission (SCPSC).
  • DUK’s current northern states (IN, KY, OH ) as well as PGN’s FL jurisdiction only require notice and will not have to approve the deal.

On the conference call discussing the merger, Progress CEO Bill Johnson shed some light on the merger rationale, that of reducing costs and improving the company’s credit rating to meet new environmental regulations.

With the current spread at $2.07 with a retrurn 4.6% (Duke has a dividend due on 2/9/11 of $0.245, which puts the current spread at $1.43 and the return at 3.23%).

As with the Cinergy merger in 2005, the timing for deal closure will be between 12 and 18 months. Which should keep thr annualized return in the 3.25% - 3.30% ball park based on current spread of $2.07($1.43 - DUK dividend).

Not super sexy, yet nothing to sneeze at considering 5 year treasury is yielding 1.96%.

I will update the blog, once the offer document is released and I have had time to go over it.

Happy Trading

(Full disclosure, I have a position on at $2.05 spread.)

Duke Energy and Progress Energy Service Territories.

J.P. Morgan served as lead financial advisor and provided a fairness opinion to Duke Energy, and BofA Merrill Lynch also provided a fairness opinion to Duke Energy. Lazard Frères served as lead financial advisor and provided a fairness opinion to Progress Energy, and Barclays Capital also served as a financial advisor and provided a fairness opinion to Progress Energy. Wachtell, Lipton, Rosen & Katz served as legal counsel for Duke Energy. Hunton & Williams LLP served as legal counsel for Progress Energy.


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