Risk Arbitrage

Risk arbitrage is the investment in securities involved in and affected by mergers, tender offers, exchange offers, liquidations, spin-offs, and corporate reorganizations, with mergers being the most well known and analyzed of these strategies. This is a brief overview covering mergers, perhaps in a later post I will cover the transaction types in the strategy.

Once a transaction is announced, as much information as possible is collated and analyzed to help estimate the transction’s risk, reward and probability of culmination. Once your analysis is complete, the strategy is to buy the stock of the company being acquired (“the target”) while selling short the stock of the acquiring company (“acquirer”). Normally the acquirer will offer a premium in order to purchase the target company.

After a merger deal is announced, the price of the target company usually moves substantially higher to reflect the premium in value being paid by the acquiring company. Despite this increase, the target’s stock may still trade at a relative discount to the final merger value. The discount spread is the profit opportunity which the risk arbitrageurs attempt to capture.

It is important to note that merger arbitrage is not a complete risk free strategy. There are a number of risks such as the probability of a deal failing, shareholders voting down a deal, revising the terms of the merger, potential lawsuits etc. In addition the trading discount captures the time value of money for the period between the announcement and the closing of the deal. Again the arbitrageurs face the risk of a deal being prolonged and achieving smaller rate of return on an annualized basis.

The size of the arbitrage spread is usually a good indicator of the probability of success assigned by the market participants for each deal. A deal that is perceived as riskier will trade at a bigger discount compared to other deals, therefore offers better returns for the traders willing to take the risk. The arbitrage spreads will change with time and as new information become available. As the closing date of the merger approaches, the spread should eventually converge to zero.

There are three types of mergers - all cash, all stock, and combination cash and stock.

Cash Merger
This is the simplest deal to understand and calculate – For example, on October 6th 2008, ImClone Systems and Eli Lilly announced definitive merger agreement according to which Eli Lilly will acquire ImClone for $70 per share in cash for a total purchase price of $6.5 Billion.
Lets say after the announcement, ImClone trades at $65 per share, therefore the arbitrage spread is $5 or 7.14%. You buy ImClone at $65 and hope Eli Lilly pays you $70 for it.

Return = gross spread / investment. Gross spread = deal price – target co. stock price
$70-$65 =$5                $5/$65= 7.14%

Let’s assume this deal is scheduled to close in 7 months. This trade will yield 12.24% on an annualized basis.

Annual return = (gross spread/ Investment)  x  (360/210).

The reason this is a simple deal as you don’t have to sell the acquirer, merely buy the stock being bought and wait for the spread to close. These assumptions are all on an unleveraged basis.
Stock Merger
Mergers involving stock are simple deals with a twist and may require more analysis. The Acquirer will offer some of their shares in exchange for shares in the target company. An example is the recently completed merger. On June 28th 2008, Republic Services (RSG) announced it was merging with Allied Waste (AW) in an all stock transaction for 0.45 shares of Republic. The transaction valued Allied at $15.23 based on Republic’s share price of $33.84 at the time of the announcement.
The main catch here is that the implied value of the merger becomes a function of the stock price of the acquirer. If the Republic’s share price fell, then the value of the deal would fall.
The trading strategy was to purchase Allied and sell Republic short using the merger ratio. In this example it would a long position of 100 shares in allied and a short position of 45 shares in Republic. By doing this the trader will be locking in the arbitrage spread. Regardless of which direction the price of the Acquirer goes one side of this trade will lose and the other side will profit. The ultimate profit will be at the time the spread converges to zero.  
Calculating the return here gets tricky, as you need to account for the cash flows. There are financing costs for the borrow to short the shares. You might get paid short interest credit and you have to account for dividends you might receive on targets shares and or dividends you might have to pay on shorted shares.
The calculation would look like this:
Gross Spread = Deal price – Curr target Stk price
Net Spread = Gross Spread + Dividends (target) – (Dividends (acquirer) x Ratio) + SI
Using numbers:
Tgt px=10, Acq px= 50, Ratio=0.35, Div (tgt) = 0.25, Div (acq) =0.65, Broker Int 2%, Days 90
Gross spread = (50 x 0.35) – 10 = 7.50
Net Spread = 7.50 + 0.25 – (0.65 x 0.35) + ((50 x 0.35) x 0.04 x (90/360)) = 7.6975
From there you calculated expected return and expected annual return.

Stock and/ or Cash Merger
Now we come to the complex deal in Risk arb, and we haven’r touched regulatory approvals or divestures yet. This deal structure mixes part stock and part cash or gives you the choice of stock or cash. For this example, I use the Kraft/Cadbury merger – where Kraft Foods initially proposed to acquire Cadbury for 300 pence and 0.2589 Kraft and finally offered 500 pence and 0.1874 Kraft Shares. Cadbury also had a dividend of 10 pence.
The return analysis would simply insert the cash element and proceed as in the stock merger. Normally there is a stipulation i.e 500 pence in cash up to 25% and for each remaining share, 0.1874 Kraft share. Then the deal price becomes:
 (.25 x 500pence) + (.75 x (0.1874 x krafts’ sotock price))  
Research and Analysis
 As you gather, the announcement is just stage one in the process.  There is quite a bit of work yet to be done before jumping in to a merger arb deal. Remember you don’t make anything until the deal closes.
There is still regulatory approval, state approval overseas approval if entities have overseas operations. The shareholders have to agree to the deal too.The first place  start is the offer document which has to be filed with the SEC. Most of the information that you require would be in there. Listen to conference calls, check out past deals, get research reports. Assess the regulatory climate. Sound like work right?
It is, but on a good deal it is well worth the time!
Happy Trading