Wednesday, December 19, 2012

Speculation Spreads and the Market Pricing of Proposed Acquisitions: Part I

A useful tool in merger analysis is what we have termed the Speculation Spread.  Simply put, it is the percentage difference between an announced bid price and the current market price of a stock.

Speculation Spread = (BP - P1)/P1

where BP is the bid price offered for a target and P1 is the price at some point after the announcement, say one day later.  Let's take a simple example:  Consider a stock trading at 20 euros.  There is a surprise announcement by a bidder offering 30 euros in a deal to be completed in a month (if all goes well).  What happens to the stock price the day after the announcement (or more likely 30 seconds after announcement )?  Typically the stock price would move to 29, 29.50, or even 29.80.  Thus, the Speculation Spread is either 3.4%, 1.7% or 0.7%.  This is the return you would earn if you purchased the stock the day after the announcement and it was completed as announced, without revision in the price.  Your actual return would depend on price revisions, whether the deal was completed and, if you are concerned about the time value of your investment, how long it took to complete the deal.  For example, if the stock price is revised upward by the current bidder or another bidder, your gains would be greater.  (Interestingly, bids are occasionally revised down as well.)  If the deal falls through, your returns would depend on the post deal stock price.  If you add holding costs in the equation, deals that take longer to complete reduce your return.

Some simple examples are illustrative.  First, rule out any possibility of bid revision.  In that hypothetical world movements of the post-announcement price to 25, 27, or 30 euros indicate the probability of deal completion at 50%, 70%, or 100%.  Thus, the market is predicting the probability of deal success.

Jan Jindra and I analyzed these topics in a paper published nearly a decade ago in the Journal of Corporate Finance. A version of the paper can be found at Speculation Spreads and the Market Pricing of Proposed Acquisitions.

In about a fifth of the cash tender offers we analyzed, the price after the announcement exceeded the bid price!  For example, suppose the market price goes to 31 euros after the announcement.  This represents a Speculation Spread of  negative 3.2%.  Why would this occur?  Obviously, the market thinks the deal will be revised to a higher price.

In our analysis, we tested for the information actually contained in the Speculation Spread.  Our results indicated that the market prices not only the probability of completion, but the probability of deal revision and the length of time until offer completion.  Thus, a great deal of information is contained in the Speculation Spread.

Moveover, the  movement of the Speculation Spread over the course of a deal is very informative about the prospects of the deal.  More of that in Part II.  For now, we note that in recent news, the Canadian miner, First Quantum Minerals, LTD. has made a hostile bid for Inmet Mining Corp.  The offer is for C$72 per share or about $73 US.  (The offer is 50% in stock which complicates the analysis a bit.)  The original offer was in October for C$62 per share although it apparently wasn't announced publicly.  Consistent with this, the stock price didn't close above C$60 until the week of November 26.  It is currently trading at US $73.83 off just a bit from its previous close of us $74.11.

After our paper was published, someone became enamored of the potential risk arbitrage opportunities and contacted me about setting up a hedge fund.  Another person, also interested in the concept started a blog,  I've resisted the commercial aspects of the concept.  As the paper notes, and as I warned these individuals, there are considerable risks associated with the concepts inherent in arbitraging the position - risks that deserve much more scrutiny and analysis before committing funds.  Still, the concepts are intriguing, particularly when one considers stock exchange offers.  More on that in Part II of this post which will come out sometime in the next few weeks, but the curious may want to take a look at the MergerFund (MERFX) that has been doing this professionally for some time.

All the best,


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