1. Merger Arbitrage 21 Chapter

2. Chapter 21-2 Characteristics  Merger arbitrage involves the purchase of a target’s stock after the merger announcement  Target’s stock price (post-announcement) typically trades at a 1-2% discount (or deal spread) to the offer of the bidder (due to time value of money, possibility deal fails)  Merger arbitrageurs: Evaluate deal spread, calculate annual return Estimate probability of deal failure If spread is sufficiently large: –Purchase shares in target firm –Short acquirer’s stock (only for stock mergers to eliminate market risk)

3. Chapter 21-3 Characteristics  Why mergers facilitate merger arbitrage Aggregate merger activity tends to be pro- cyclical with respect to stock market Mergers cluster in economic sectors Merger agreements sometimes fall apart Merger failure is typically idiosyncratic (but sometimes due to aggregate market conditions) Many forms of payment to the target which determine the trades required to capture the merger arbitrage spread  Not a form of true arbitrage – arbitrageurs make a risky investment

4. Chapter 21-4 Cash Deals  Most straightforward type of merger arbitrage  Sears offers $62 for Land’s End (5/13/02)  Spread calculation: Tender Offer for LE $62.00 less: Current Target (LE) Price– 61.73 Gross Spread$0.27 add: Target Dividends0.00 less: Commission Costs – 0.02 Net Spread$0.25  Promised return: = Net Spread / Cost of Purchase = $0.25 / $61.75 = 0.405%

5. Chapter 21-5 Scenario – Cash Deals  Assessment of deal failure risk: low Signed definitive agreement Land’s End shareholders (incl. founder, chairman) representing 55% of shares agreed to tender Both companies in good financial shape Little chance of FTC or DOJ blocking merger  Expected price of stock ProbabilityPrice Deal successful0.99×$62.00=$61.38 Deal fails0.01×$51.02=0.51 Expected price$61.89

6. Chapter 21-6 Cash Deals  Expected return = (Expected Price / Cost of Purchase ) – 1 = ($61.89 / $61.75) – 1 = 0.227%  Expected annualized return = [1 + expected return] (365/days to completion) – 1 = (1.00227) 365/40 – 1 = 2.09%  Opportunity cost of capital Benchmark return = annualized 3-month Treasury bill return = 1.70% Since expected annualized return (2.09%) exceeds benchmark return, merger arbitrageur will invest in Lands’ End

7. Chapter 21-7 Cash Deals  Market’s expectation of deal failure Alternatively, arbitrageur calculates market expectation of deal failure and compares to own estimate – invest if own estimate < market Market’s expectation of deal failure –Offer price = $62.00, failure price = $51.02, annualized treasury bill rate = 1.70%, time to completion (T) = 40 days, current price = $61.73 –Implied probability of failure = p = 1.40%

8. Chapter 21-8 Stock Mergers (Fixed Exchange Ratio)  HP offers 0.6325 shares of its stock for each share of Compaq (9/3/01)  Gross spread: Acquirer (HP) Closing Price (9/4/01)$18.87 Multiply by: Exchange Ratio× 0.6325 Offer Price for CPQ$11.94 less: Target (CPQ) Closing Price – $11.08 Gross Spread$0.86  Unhedged investment – captures $0.86 spread only if HP Price at completion of deal is $18.87  Hedged: shorts 0.6325 shares of HP for each share of CPQ purchased – captures $0.86 spread as long as deal is completed

9. Chapter 21-9 Stock Mergers (Fixed Exchange Ratio)  Net spread Gross Spread$0.86 add: Target (CPQ) Dividends0.09 less: Acquirer (HP) Dividends – 0.15 add: Short Interest Proceeds 0.19 less: Commission Costs– 0.08 Net Spread$0.91  Return = Net Spread / Cost of Purchase Offer Price for CPQ$11.94 less: Net Spread– $0.91 Cost of Purchase$11.03 Return to Arbitrageur8.25%

10. Chapter 21-10 Stock Mergers (Fixed Exchange Ratio)  Expected annualized return = [1 + expected return] (12/months to completion) – 1 = (1.0825) 12/7 – 1 = 14.6%  Assessment of deal failure risk: medium to high Large amount of public criticism High risk of antitrust intervention Resistance from HP’s large shareholders  Investment decision – arbitrageur must assess: Time to completion Risk of deal failure Risk of adjustment of deal terms Possibility of delaying investment

11. Chapter 21-11 Complex Transactions  Payment to target shareholders may include securities (debentures, preferred stock, etc.) Security may not be publicly traded Considerable market risk, difficult to hedge  Transactions in which investors have a choice in the form of payment received – may choose to receive cash or acquirer stock subject to a prorated number of shares or dollar value Arbitrageur must accurately forecast other investors’ election decision – a difficult task Potential for high market risk – if arbitrageur miscalculates investors’ decisions, may have unhedged position

12. Chapter 21-12 Complex Transactions  Many stock transactions do not have set exchange ratio at announcement date Collar stock merger example –If acquirer share price $76.20-84.22, target receives shares equal to $46 –If price under $76.20, ratio is 0.6037 –If price over $84.22, ratio is 0.5462 –Best hedge requires elements of options Floating exchange ratio –Ratio determined by stock prices of firms during specified period before merger close –Hedge – buy target stock at announcement and short buyer during pricing period

13. Chapter 21-13 Risk and Return  Merger arbitrageur – selling insurance Target shareholders can hold on to shares until deal completed, but may lose (deal fails) Merger arbitrageurs provide liquidity that target shareholders demand to avoid blow-up risk  Merger arbitrage portfolio returns – diversified across several deals so as to reduce risk Failure in one deal is often unrelated to the other deals in the portfolio, usually uncorrelated with overall stock market Risk/return in the context of CAPM: assuming efficient markets, return to portfolio should be equivalent to risk free rate

14. Chapter 21-14 Risk and Return  Merger arbitrage excess returns Large abnormal returns to merger arbitrage may suggest stock market is not very efficient at pricing merger targets Arbitrageurs are risk averse: must be compensated for bearing idiosyncratic risk Declining markets: deals more likely to fail outright, be revised, or take longer to complete – merger arbitrage may suffer large losses In flat and appreciating markets: deals may fail but failure is unique to the specific deal and not systematic – merger arbitrage yields a positive

15. Chapter 21-15 Risk and Return AuthorYearMeasureReturn Dukes et al1992Annualized Return220% Jindra, Walkling1999Ann. Excess Return102% Karolyi, Shannon1999Annualized Return26% Geczy et al2002Ann. Excess Return65% Baker, Savasoglu2002Ann. Excess Return10% Mitchell, Pulvino2001Hypothetical Portfolio Ex. Ret. 4%

16. Chapter 21-16 Do Arbitrageurs Accurately Forecast Merger Success?  Efficient merger arbitrage market – market is able to quickly distinguish between winners and losers Distinguish along dimensions of length of time to completion Distinguish along likelihood of deal term revisions  Active arbitrageurs do not outperform market Can assess on average the likelihood of failure Cannot actually avoid all failed deals Payoff profile similar to indexed approach to merger arbitrage

17. Chapter 21-17 Price Pressure Around Mergers  Explanations for acquirer’s negative stock price reaction on announcement of a merger Negative NPV merger Signal of diminishing stand-alone growth opportunities for the acquirer Signal that stock was previously overvalued Selling pressure on the acquirer stocks due to hedging the deal spread by merger arbitrageurs  Price pressure caused by merger arbitrage accounts for about half of the stock price decline associated with fixed-exchange ratio mergers on announcement day (Mitchell, Pulvino, Stafford, 2003)

18. Chapter 21-18 Merger Arbitrage in Action  Merger arbitrageurs are very active throughout the takeover process Act quickly at announcement of deal Build positions over time – depends on type of deal and relevant terms Arbitrageurs constantly monitor deal – will change portfolio due to forecast of deal timing  Managing overall portfolio Arbitrageurs do not invest all funds in one deal Arbitrageurs diversify failure risk by investing in many deals – may limit amount invested in single deal or type of deal