There have been numerous surprises in the M&A world this year. There was the giant $16 billion takeover of Beam (BEAM) by Suntory Holdings in January. Around the same time, there was another rumor of a takeover of T-Mobile (TMUS) takeover by Sprint (S). However, the most shocking M&A announcement came quietly last Wednesday night when Comcast (CMCSA) announced it decided to spend $45.2 billion to purchase Time Warner Cable (TWC), snatching away Charter Communications' (CHTR) dance partner.
The announcement caught almost everyone by surprise. Brian Roberts, Comcast's CEO, employed a tactic that mirrors one of the famous 36 stratagems used in ancient China: loosely translated as "Make a sound in the east, then strike the west." Roberts discussed with Charter a plan to split TWC's assets while secretly worked on his own bid for the entire company. Now the $45.2 billion deal is announced and confirmed, can investors still profit by buying TWC? A strategy used by many event-driven hedge fund is called risk arbitrage or merger arbitrage. With TWC's stock price trading at $146.00 vs. Comcast's proposed price of $154.39, investors can attempt to capture the $8.39 spread through risk arbitrage, although it is not risk free like other arbitrage operations. I will explain the strategy in more detail and explain how investors can capture the $8.39 spread. Advance readers can skip the next section and go to "How to Evaluate a Risk Arbitrage Situation."
What is Risk Arbitrage?
According to Investopedia, risk arbitrage is "a type of arbitrage that contains an element of risk." In case of a merger related risk arbitrage, the two main risks investors face are the possibility of the deal not going through and the possibility of the deal being delayed. Readers should note that there is no exposure to market risk involved in risk arbitrage, which enhances the attractiveness of the strategy by avoiding beta exposure.
In a merger related risk arbitrage, investors are attempting to capture the spread between the offered price and the current market price after a deal announced. In a cash deal, investors would simply buy the stock of the target company. In a stock deal such as the Comcast/TWC deal, investors would buy the target and short the acquirer according the announced exchange ratio in the deal. For example, Comcast is offering shareholders of TWC 2.875 shares for each TWC share owned. Therefore, for every TWC share bought under the risk-rbitrage strategy, investors need to short 2.875 shares of Comcast. If the deal goes through, each TWC is converted into 2.875 shares of Comcast and the risk arbitrage investors can cover their short positions in Comcast, capturing the $8.39 spread in the entire operation.
Assuming the deal goes through, the current risk arbitrage spread is $8.39 per TWC share. Investors should note that the spread is not $12.82 ($158.82-$146.00) because the $158.82 offer price stated in the official press release is not actually valid at the momentum since Comcast's shares dropped after the deal announcement. Using exchange ratio of 2.875 and the current price of Comcast at $53.70, the effective takeover price of TWC is only $154.39.
There are risks that the deal doesn't go through. In the Comcast/TWC deal, the main risk is regulatory risks due to anti-trust issues. If regulators block the deal, TWC's shares may drop back to near the $135.00 level (7.5% below the current price of $146.00) and Comcast's shares may receive a small boost from short covering by other risk arbitrageurs.
How to Evaluate a Risk Arbitrage Situation
Whenever I'm assessing a risk arbitrage situation, I reference back to the guidelines that Buffett wrote in Berkshire Hathaway's (BRK.A)(BRK.B) 1988 Annual Report. Under the arbitrage section, Buffett clearly provided readers with 4 important guidelines:
To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?
Let's go over each of the criteria one by one. Under (1), investors must determine the probability of the deal closing, which is subject to the review of regulators. Given Comcast already has experience dealing with large acquisitions in the past, such as the purchase of NBC Universal, I expect the probability of the deal closing is high. Brian Roberts already made a concession by divesting 3 million subscribers so the new combined entity will possess market share below the 30% guideline. During the conference call, Comcast's CFO pointed out that Comcast and TWC does not compete in a single zip code across the country. Also, Roberts stated that the combined entity will enhance customers' experience and is pro-consumer. Even if the deal cannot pass in its current form, Roberts may offer additional concessions in order to get the deal done. For criteria (2), the press announcement stated that the deal is expected to close "at the end of the year", implying risk arbitrage investors will have their money tied up for about 9-10 months. If the deal gets delayed, then the returns for this risk arbitrage operation will decrease. For criteria (3), there is no better alternative outcome given Charter is unlikely to outbid Comcast since Charter has a much weaker balance sheet. Finally, criteria (4) is key because there is a chance of the deal not closing, mainly due to anti-trust problems. Nonetheless, even if the deal doesn't close, at least there is another suitor who is still willing to buy TWC. I suspect Charter will resume its interest in TWC if the Comcast deal is blocked and may even sweeten its original $132.50 slightly in order to close the deal.
The Graham Formula and the TWC Example:
Buffett was very successful in his risk arbitrage operations because he learned the basics of risk arbitrage from Ben Graham, who was Buffett's mentor and wrote the investment textbook Security Analysis. In the 1951 edition of Security Analysis, there was a hidden, but valuable section on arbitrage on page 729-734 titled "Special Situations." In that section, Graham presented a formula, shown below, that calculates a probability-weighted return for any special situations operation.
In my base case, I assume there is a 75% chance of success and the time to closing is approximately 0.75 years (9 months). The probability-weighted return, annualized, is approximately 3.2% vs. the 7.6% return if investors assume a 100% chance of success. Please see the sensitivity table below. Although the probability-weighted return of 3.2% may not appear attractive, risk arbitrage investors have zero market risks and low volatility. Also, the 3.2% assumes TWC's share price will fall back to the $135 level before Comcast announced its move. Nevertheless, TWC investors may receive a sweeten bid from Charter that may be slightly higher than $135.00 per share (i.e. $140.00-145.00).
Table 1: Sensitivity table with assumption that TWC share will fall to $135.00/share in event of failure
Although the spread of $8.39 looks attractive, risk arbitrage is not risk free and can be disastrous if the deal doesn't go through. However, TWC investors can feel somewhat safer that Charter will resume its bid for TWC if Comcast fails to clear the necessary regulatory hurdles. Risk arbitrage is not a strategy everyone should try but I hope this article provided more details to those who wish to try out the strategy. Although the Comcast/TWC deal faces major anti-trust hurdles, I believe Brian Roberts is capable of closing the deal, even if he has to make additional concessions.
Additional disclosure: This article is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the article. The strategy presented in this article is risky and not suited for certain investors. Readers are recommended to conduct further due diligence before committing capital to any investment.