Individual investors hoping to capitalize on merger arbitrage (definition below)* strategies can elect to buy shares in target firms. Investing in target equity, or the "long side" of merger arbitrage is not arbitrage in the sense of riskless return, but has historically offered alpha for investors. Not every deal will go through, but most have.
As an alternative to buying shares in target firms, individual investors could search pending deals for option plays that could capture the deal spread. To keep things simple, deals based largely or solely in cash were chosen so that target deal prices are fixed. A survey was taken of pending all-cash deals on March 9, 2012, to see if any option plays could provide attractive ways to play each takeover:
Symbol | Target Company | Deal | Takeover Date | Options Market | Option Play |
EP | El Paso Corp. | Cash + Stock | 6/30/2012 | Yes | Married Put |
Venoco, Inc. | Cash | 6/30/2012 | Yes | Long Call | |
Medco Health Solutions, Inc. | Cash + Stock | 6/30/2012 | Yes | Call Spread | |
Advance America, Cash Advance Centers | Cash | 6/30/2012 | Yes | No - no return | |
O'Charley's Inc. | Cash | 6/30/2012 | Yes | No - no return | |
CryptoLogic Limited | Cash | 4/30/2012 | Yes | No - no return | |
Delphi Financial Group, Inc. | Cash | 6/30/2012 | Yes | No - no return | |
Goodrich Corp. | Cash | 6/30/2012 | Yes | No - no return | |
MMI | Motorola Mobility Holdings, Inc. | Cash | 3/31/2012 | Yes | No - no return |
Pep Boys - Manny, Moe & Jack | Cash | 6/30/2012 | Yes | No - no return | |
TNB | Thomas & Betts Corp. | Cash | 6/30/2012 | Yes | No - no return |
Winn-Dixie Stores Inc. | Cash | 4/30/2012 | Yes | No - no return | |
China Real Estate Information Corporation | Cash + Stock | 6/30/2012 | Thinly traded | No - no return | |
Cogdell Spencer Inc. | Cash | 6/30/2012 | Thinly traded | No - no option play | |
Archipelago Learning, Inc. | Cash | 6/30/2012 | No options | No - no option play | |
ATS Corporation | Cash | 6/30/2012 | No options | No - no option play | |
Baldwin Technology Co. Inc. | Cash | 6/30/2012 | No options | No - no option play | |
China Advanced Construction Materials | Cash | 3/31/2012 | No options | No - no option play | |
CH Energy Group Inc. | Cash | 3/31/2013 | No options | No - no option play | |
Convio, Inc. | Cash | 3/31/2012 | No options | No - no option play | |
Central Vermont Public Service Corp. | Cash | 6/30/2012 | No options | No - no option play | |
Encore Bancshares, Inc. | Cash | 12/31/2012 | No options | No - no option play | |
China GrenTech Corp. Ltd. | Cash | 6/30/2012 | No options | No - no option play | |
Harleysville Group Inc. | Cash | 6/30/2012 | No options | No - no option play | |
SeraCare Life Sciences, Inc. | Cash | 6/30/2012 | No options | No - no option play | |
SureWest Communications | Cash | 6/30/2012 | No options | No - no option play | |
Taleo Corp. | Cash | 6/30/2012 | No options | No - no option play | |
Transcend Services, Inc. | Cash | 9/30/2012 | No options | No - no option play | |
WCA Waste Corporation | Cash | 3/31/2012 | No options | No - no option play |
Of the acquisition targets with options markets, most have deal spreads that are too narrow for option plays. For example, the call market for Motorola Mobility Holdings is too rich to suggest a long call strategy. Though shares of MMI are trading at $39.75, less than the takeover value of $40.00/share, option premiums would have to decline for a recommendable option strategy to surface.
In contrast, an attractive limited-risk play is found in the takeover of MedcoHealth Solutions. Contingent on takeover, Medco shareholders will receive 0.81 shares of Express Scripts, Inc. which closed at $54.18 on Friday March 9th. They also would receive $28.80 in cash, making the total takeover value $72.69. An attractive call spread can be constructed by buying a June call with a $67.50 strike price for $5.70 and selling a June call with a $75.00 strike price for $1.45. This call spread would risk $4.25, while affording a max profit of $3.25. This would be a maximum return of 76.5%.
A simpler play is a long call on Venoco, Inc. Takeover compensation for VQ shares would be $12.50 if the deal goes through. A June call with a $10.00 strike for $1.65 has a maximum payout of $0.85. Thus, the maximum profit on this trade is 51.5%.
The proposed takeover of El Paso Corporation by Kinder Morgan is another opportunity for an option play. EP shares closed at $29.40 per share on Friday March 9th, well below their value based on acquisition terms. Upon acquisition, EP shareholders will receive $14.65 in cash, 0.4187 in KMI shares, and 0.640 of a 5-year KMI warrant with a $40 strike price. Based on the $37.52 closing price for KMI shares the stock portion of payment is worth $15.71. Each warrant was valued at $1.66 using the Black-Scholes options pricing model.
Market values for call options can be used to inform the value estimate of this warrant. January 2014 calls on KMI shares with a $40 strike most recently traded at $1.85 and have a bid of $1.25. These warrants are worth more than these KMI calls because they have a longer expiration date, and because the threat of dilution from the EP acquisition and warrant exercise should already be priced into KMI shares.
Based on a $1.66 estimate for warrant value, 0.640 of a warrant is worth $1.06. Adding the cash, stock, and warrant value gives a $31.42 deal value per EP share. Investors can try to capture the deal spread by buying EP shares and simultaneously purchasing an EP put with a $27.00 strike price for $0.69. Investors would risk a $3.09 maximum loss for a gain of $1.33, a 43% return on risk capital based on current market prices.
Notice that plays like these are not the norm. Most of the target firms lack a liquid options market or are price with deal spreads that are too narrow to pay for call premiums. These other deals might be tradable given the right circumstances, but not through simple option plays like the one listed here.
* One attractive hedge fund strategy is called "merger arbitrage" or "risk arbitrage." It involves identifying target companies that are slated to be bought out by another company, but whose prices have not quite appreciated to the take-over price. For example, if an acquiring company and a target company announced that they were striking a deal to buy the shares of the target company for $100 at a future date and the shares appreciated to $97, that $3 difference would be the deal spread that arbitrageurs would try to capture by buying shares at $97 and holding them until they were paid at $100 at the close of the deal.
Merger arbitrage can be considerably more complicated, especially when firms agree to pay for target shares with a number of acquiring company shares, or a mixture of shares and cash. Investors hoping to capitalize on the deal without any market risk would have to buy the target shares and short the acquiring shares.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
