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

What the F@#$&&* Just Happened (Again)?

The financial markets had a wild ride over the past week with many investors having CTJM (come to Jesus moments). Things seem to be settling down (I hope). Nonetheless, episodes like this can have some lingering effects-especially in the VC and M&A deal markets.

Consider the following:

1)     Volatility Index (VIX): had been hovering in a narrow band of 10-15 before August suddenly spiked to over 40.This is below the record 80 during the financial crisis but still significant. Remember, the Russian, Asian and Greek crises had similar spikes and we all know how much fun those were. Usually, an unexpected event (e.g. Chinese devaluation?) inconsistent with investors’ views causes them to reassess their portfolio risk profile. They recognize their new profile now exceeds their risk appetite. They attempt to rebalance their portfolios (de-risk) all at the same time triggering a panic flight to quality.

2)     S&P 500: fell from 2090 to 1870 between 8/14 and 8/24 or 11% (exceeding the 10% definition of a “correction”) within 10days before recovering somewhat. Again mild compared to the big one in 2008 when it fell over 50%, but not too shabby. Also, some investors experienced dreaded margins calls-the mother of all CTJM.

3)     Equity Risk Premium the ERP reflects a market price of risk. I favor a forward implied ERP v the academic historical premium of 5-6%. Damodaran calculates the ERP jumped by over 70 bps or 12% from 5.9% to 6.6%.

4)     Credit Spreads:  widened based on the increase in the BBB-treasury spread.

Now let’s think thru some possible implications of these developments:

1)     IPOs: likely to be delayed as most investment bankers/ underwriters are reluctant to price and bring deals to market when the VIX exceeds 20 and stays there; as they demand a higher return/lower pricing for perceived increased risk. This could have ripple effects on so-called “private IPO” late stage follow-on capital raising rounds. May even trigger a down financing round in which the capital is raised at a lower value than in previous rounds. This could break the VC culture of optimism (AKA culture of denial) and impact VC pricing/valuation momentum.

2)     M&A: pending deals may have some trouble closing. This is reflected in widening arb spreads. Furthermore pricing new deals becomes more complicated. What base should buyer’s use to base their premium? Most seller’s anchor on their 52 week high and may resist offers based on current lower prices. Buyer confidence may decline leading to postponed deals. Finally, banks and credit markets in general may tighten credit terms.

3)     Hedge and Activist Funds: many suffered some significant losses and may be reluctant to initiate new takeover contests.

4)     WACC: increased ERP and credit spreads will increase WACC affecting stock prices and future investments.

The sky is not falling, but clearly something happened. You can choose to ignore and see the downturn as a buying opportunity. Others may want to pause and reassess the market and their strategies before proceeding. In any event the effects will ripple thru the deal and financing markets with possible more shoes to drop. So keep your seat belts fastened.

J

The Merger Fund

I've been an investor in the Merger Fund for a long time both for the risk adjusted returns it produces and for the wonderful discussions about merger activity in the most recent quarter.

The Merger Fund engages in merger arbitrage - betting on the outcome of deals.  Sound risky?  Not so fast.  The Merger Fund, like most arbs in mergers, hedges its bets, trying to lock in returns while minimizing risk.  The strategies that can be employed to do this can be complex, but let's just consider a simple example:

A target is trading for 30 euros and a bidder offers a stock deal suggesting a 40 euro bid price.  Right after the deal announcement, the price of the target rises to 38 euros, while the price of the acquiring firm settles at 60 euros.

We've talked elsewhere about the fact that the information above implies that, under simplifying assumptions, the probability of the deal being completed at 40 euros can be estimated to be about 80 percent.  But that is beside the point here.  A simple arbitrage strategy would be to short the appropriate amount of the bidder's stock and go long the target.  Assuming both stocks face similar market risks, this effectively hedges against market movements.

The hedge described is quite simple and not foolproof.  If the bid is abandoned and the target price returns to 30, the investor faces a substantial loss.  (There are other ways to hedge this, but we'll keep things simple here.)  More than likely, if this bidder loses, another bidder completes the deal at a higher price producing an even larger gain on the target than the 2 euro spread.  The original bidder would probably also experience price adjustments, perhaps gaining a bit and producing a slight loss for the investor.

But consider the returns if the deal is completed in, say,  two months: a 2 euro gain with little investment - in just a two month period.  

Now to be sure, many risks remain, but you get the idea. If you study the Merger Fund, you'll note that while its historical performance is below the S&P 500, so is it's volatility (and Beta).  It's Sharpe ratio is high.

Regardless, I offer the Merger Fund to you for the interesting commentary on deals.  See, in particular, The Quarterly Review.

All the best,

Ralph