Market Swings and Mergers: Protecting the Deal and Arb Opportunities

The recent market swings and declines impact mergers in many ways.  Let's consider two.  First, we have the parties involved in making a deal.  These are numerous, but for convenience let's just focus on the firm to be acquired (target) and firm doing the acquiring (bidder).

If cash is the form of payment and a fixed price is set, target shareholders are in a fairly secure position.  I say fairly, because extreme swings can threaten any deal (e.g. Dow Chemical's Acquisition of Rolm and Hass right after the 2008 market crash).  The bidder may nevertheless squirm as market shakeups impact the value of the target and the related projection of future cash flows.

In stock deals, things get more interesting.  Suppose, for example, a deal is set with a one to one stock swap.  If the price of the target changes relative to the price of the bidder, the value received and paid can be quite different than originally envisioned.

One way to mitigate this risk is the use of collars - essentially boundaries framing a range of values in which a deal will take place, depending on the price of the shares at closing.  This can offer upside protection to a bidder (a maximum payment or ceiling) and downside protection to a target (a minimum payment or floor).  For more detail on this, see our previous post Acquisition Risk, Collars, and the Time Warner Deal.

Another group active in mergers and affected by market swings are merger arbs, essentially trying to buy at one price, sell at another and minimize the risks.  For example, the Beta of The Merger Fund (MERFX) is 0.08 - taking close to zero market risk.  Again, see our related post Speculation Spreads and the Market Pricing of Proposed Acquisitions.

However, volatility and market dips can widen spreads and make arbitrage opportunities more attractive.  This works particularly well if, as mentioned, the arbs can appropriately hedge market (and where possible, deal) risk.  An interesting example of this comes from The Deal's post Stock Market Volatility Creates Opportunities for Merger Arbs.

All the best,

Ralph

Venture Capital Prices: Real or Make Believe?

Market efficiency and discounted cash flow analysis are important M&A concepts and tools. Their usefulness is questionable in the sometimes surreal realm of venture capital. Current venture capital valuation based on financing rounds keeps rising with the number of unicorns (private early stage firms with implied $1B+ values) at record levels. Reverse engineering the operating performance needed to justify such lofty values leads to some hard to believe let alone justify sales and margin estimates.

A possible explanation is the prices reflect the value of special downside protection features like liquidation preferences available to venture fund investors. The extra value for those features does not seem large enough to explain the huge current price run up.

This leads to another explanation; namely, the prices and implied values are an illusion. Unlike public shares you cannot short sell private investments if you believe they are overvalued. Absent short sales or some other mechanism prices take on a life of their own. All that is needed for a self fulfilling momentum based pricing cascade are optimistic investors and liquidity. The uptick in prices draws additional investors and the beat goes on. Disbelieving investors are unable to bet against the “excessive” prices. Thus, an apparent arbitrage opportunity goes unanswered.

It appears venture capital markets are inefficient-their prices do not reflect available information and views. Instead, they resemble lotteries-relatively low ticket prices for negative expected value investments with a large positively skewed payoff distribution. Venture funds and other investors are pressured to participate even at higher prices. They fear missing out in getting a winning ticket, and suffering a relative performance drop, which impacts their fund raising efforts. These types of one way markets can remain inefficient for long periods until some event occurs causing a revaluation. Optimistic momentum venture investors with sufficient liquidity will keep bidding up implied finding round valuations.

Interesting to see what values, if any, are realized once surviving start-ups are taken public and begin trading in a market where short sales are possible. I predict IPO investors will be in for a wild ride. Optimists will keep setting venture values until we run out of optimists. Sounds like a game of musical chairs-you do not want to be the last one standing when the music stops.

J

Arbs - Smart, Influential, or Both?

Consider several interesting, stylized facts about the role of arbitrageurs in acquisitions:

• Once a firm is in play, the new shareholder base is likely to be the arbitrageurs as existing shareholders sell out to lock in the jump in price surrounding the announcement of the deal and avoid the risk of deal failure.
• Arbs make a living taking this risk of deal failure.
• Most arbs don't try to predict who will be a target but take a position after a deal has been announced
• The risk profile of arbs is very low - arbs hedge their positions to minimize as much risk as possible.   In a stock deal, for example, they might go short the acquiring firm and go long the target, locking in the spread between the post announcement price and the offered price - usually a few percent.
• Arbs favor the rapid completion of a deal and when deals close quickly the few percent gained in the spread becomes a very high return when annualized.
• Arbs can lose their shirt if a deal collapses or they are not properly hedged.
• Arbs tend to earn superior returns around acquisitions.

So lets take the last point.  It has been known that arbitrageurs can earn abnormal returns around mergers.  What hasn't been clear is why.  There are two theories - one that arbs play a passive role and the other that they play an active role in facilitating deal completion.

The passive theory is that arbs are better at predicting deal success - studying the dynamics of a deal, the positions of the players and the likely regulatory positions.  They then take a position when the odds are in their favor.

The active theory is that arbs actually influence the outcome of a deal - that their shareholdings help tip the balance of power and facilitate deal completion.

In that article below, published in the Journal of Financial Economics co-author Jim Hsieh and I find evidence supporting both theories.  The abstract is below.  A copy of the published article is available through the link above.  A copy of the working paper is available here.

Determinants and Implications of Arbitrage Holdings in Acquisitions

Abstract:      

This study investigates arbitrage activities and their impact on acquisitions. The literature contains arguments for both passive and active roles of arbitrageurs during the takeover process. Larcker and Lys (1987) suggest that arbitrageurs are passive, having superior ability to predict offer success. Cornelli and Li (2002) and Gomes (2001) model arbitrageurs as active, influencing the terms and outcome of offers. We find evidence supporting both arguments. Using a simultaneous-equations framework to recognize endogeneity, we analyze 608 acquisition bids over the 1992-1999 period. Consistent with the passive arbitrage argument, the change in arbitrage holdings is greater in successful offers. However, changes in arbitrage holdings are also shown to be an important determinant of the probability of success, bid premia, and arbitrage returns. In addition, the change in arbitrage holdings is positively associated with both revision returns and the occurrence of subsequent bids within one year after initial bids are terminated. Overall, we find that merger arbitrageurs play an important role in the market for corporate control.

All the best,

Ralph

Valeant, Allergan and the Market Pricing of Proposed Acquisitions

We've written  before about the information implicit in the speculation spread, the percentage difference between an offered bid price and the post announcement stock price.  As we have said, if a stock is trading for $20, a bidder offers $30 and the post announcement price moves to $25, that represents a 16.7% speculation spread.  If you bought the stock at $25 and the deal closed at the bid price of $30, you'd earn 16.7%.  We've also noted that the market's perception of deal completion and revision are implicit in the speculation spread and in the post announcement move of the target's stock price.  In the example above (ignoring a few simplifying assumptions), the market is predicting that there is a 50% chance the deal will go through.  (The $25 post announcement price represents a weighted average of a 50% chance the price would return to $20 and a 50% chance it would rise to $30.)  If the deal was certain to be completed, the post-announcement market price would rise to approximate $30.

In our research, we found that the average speculation spread in deals is about 2%, but that the variation in this spread is large and significantly predicts deal outcomes and time till the deal closes.  Time till deal closes is important as it impacts the rate of return earned by arbitrageurs.  The fact that speculation spreads are significantly related to time to closing is testimony to the importance of this time period and to the wisdom of the market.

In our research, 23% of the speculation spreads were negative meaning that the post acquisition price exceeded the offered bid price.  (In our opening example, this would mean the price rose to more than $30.)  What is implied by a negative spread?  You guessed it - a revision in the bid price by the initial bidder or another bidder.

The Allergan saga continues to provide an interesting example of speculation spreads.  Notice the rapid increase in stock price in the chart below.  The price rises before the deal is announced, probably on speculation and dramatically when a bid is announced and Allergan adopts a defensive measure (the poison pill).

The speculation spread, shown in the chart below, is also informative.  Notice the negative spread, implying bid revision.  It continues to be negative until - the bid is revised.

Of course, the Allergan saga is not over.  Allergan management has implemented many of the ideas espoused by Valeant, yet the stock price remains below the highest offer by Valeant and the speculation spread remains positive indicating the uncertainty that a deal would close.  Meanwhile, news has surfaced that Allergan also thought about merging with Salix Pharmaceuticals in a defensive move.

It will be interesting to follow this one going forward.

All the best,

Ralph

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, cashtenderoffer.com.  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,

Ralph