In my previous post on the Allied-Ares merger arbitrage opportunity, I introduced a topic which I realized I’ve never quite talked about here. As I intend this blog for both beginning investors and seasoned investors alike, here’s a run down on the concept of merger arbitrage.
What is arbitrage?
Rigorously speaking, arbitrage is the practice of taking advantage of a price differential between two markets which allows the arbitrageur, or person taking advantage of the arbitrage, to obtain a risk-less profit.
Technically speaking, an arbitrage refers to a situation where the same asset sells for a different price in two markets. For example, a textbook in the U.K. selling for $20 and a textbook in the U.S.A. selling for $100. The arbitrageur would buy the U.K. textbook and simultaneously sell the U.S.A. textbook and pocket the $80 difference. The simultaneous stipulation is sort of a idealized hypothetical case. This act would imply a completely riskless arbitrage since there’s no risk of being able to execute one transaction or another or risk of pricing changing at any instance in time.
There’s no such thing as a true riskless opportunity in real life is there? In fact, in today’s world of increasing information parity and quickening execution times, can arbitrage opportunities exist? Well, there’s one regular kind of transaction structure which creates potential arbitrage opportunities all the time – merger transactions!
When an acquiring company chooses to purchase a target, the stocks of the two businesses will continue to trade independently for a period of time as the deal works out regulatory and other issues before closing. During this period of time, there remains risk that the transaction will not close or any number of other events could prevent the transaction from closing. Provided the transaction does close, however, the merger transaction establishes an accepted price for the stocks in question and gives an investor the opportunity to extract value from variations to the closing price.
Five Opportunities if you’re interested
Here are five pending merger transactions right now. (Click to enlarge)
The classic merger arbitrage opportunity is the all stock merger. In the above chart, you can see it with Black & Decker (BDK) and Stanley Works (SWK). Here, the proposal is that Black and Decker shareholders will receive 1.27 SWK shares per Black & Decker share. Here, we know that at closing day, there is an established exchange rate for the two stocks. Yet, at closing prices, SWK’s closing price of $50.17, Monday, the exchange of 1.27 shares would yield an implied value of $63.72/share to Black and Decker shareholders versus Black and Decker’s closing price of $62.27 Monday. This is the arbitrage opportunity. As time passes, we know that the valuation gap must close since the stocks of each company technically represent the same combined entity (assuming the merger closes). As we don’t know how exactly the gap will shrink, we can buy the BDK at $62.27 and short SWK at $50.17 to lock in the spread that we have identified.
The second kind of merger transaction is the all cash deal. This is simple enough. For example, Oracle (ORCL) offers Sun Microsystems (JAVA) $8.50/share in cash. In this case, there isn’t really an “arbitrage” opportunity as you won’t be buying and selling the shares on each side of the transaction. The $8.50 simply sets the exchange value and purchasing the target’s shares (JAVA in this case) allows you to profit from any spread.
Finally, there’s the Pepsi (PEP) and PepsiAmericas (PAS) deal where you see that consideration is given in 50% stock and 50% cash. This is simple enough. Calculate the spread as though the transaction were 100% stock. Then, average that with the value of the cash exchange. And, voila, the implied price!
Full disclosure: No position in the stocks mentioned in this post.