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
Showing posts with label Speculation Spreads. Show all posts
Showing posts with label Speculation Spreads. Show all posts
Thursday, September 3, 2015
Thursday, August 21, 2014
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
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, 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
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
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