Individual investors hoping to capitalize on merger arbitrage* 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.
Retail investors can search pending deals for option plays that could benefit from shrinking deal spreads with limited risk. To keep things simple, deals based largely or solely in cash were chosen so that target deal prices are somewhat fixed. A survey was taken of pending all-cash deals on June 22, 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 |
GeoResources | Cash + Stock | 9/30/2012 | Yes | Costless Collar | |
Venoco | Cash | 7/20/2012 | Yes | No - no return | |
The Talbots | Cash | 9/30/2012 | Yes | No - no return | |
China TransInfo Technology | Cash | 9/30/2012 | Yes | No - no return | |
CBE | Cooper Industries plc | Cash + Stock | 12/31/2012 | Yes | No - no return |
Extorre Gold Mines Limited | Cash + Stock | 12/31/2069 | Yes | No - no return | |
Sunoco, Inc. | Cash + Stock | 12/31/2012 | Yes | No - no return | |
Interline Brands | Cash | 9/30/2012 | Yes | No - no return | |
Collective Brands | Cash | 10/31/2012 | Yes | No - no return | |
China Advanced Construction Materials | Cash | 6/30/2012 | No options | No - no option play | |
Southern Community Financial Corp. | Cash | 6/30/2012 | No options | No - no option play | |
SureWest Communications | Cash | 6/30/2012 | No options | No - no option play | |
Pansoft Company | Cash | 9/30/2012 | No options | No - no option play | |
Central Bancorp Inc. | Cash | 12/31/2012 | No options | No - no option play | |
Integramed America Inc. | Cash | 11/15/2012 | No options | No - no option play | |
Tii Network Technologies, Inc. | Cash | 9/30/2012 | No options | No - no option play | |
The Edelman Financial Group | Cash | 9/30/2012 | No options | No - no option play | |
Network Equipment Technologies Inc. | Cash | 9/30/2012 | No options | No - no option play | |
Kenneth Cole Productions | Cash | 9/30/2012 | No options | No - no option play | |
Network Engines, Inc | Cash | 9/30/2012 | No options | No - no option play | |
Benihana | Cash | 12/31/2012 | No options | No - no option play | |
PLX Technology Inc. | Cash + Stock | 6/30/2012 | Thinly traded | No - no return | |
Allos Therapeutics | Cash | 6/30/2012 | Thinly traded | No - no return |
Of the acquisition targets with options markets, all but one have deal spreads that are too narrow to justify option plays. For example, the call market for Talbots (TLB) is too rich to suggest a long call strategy. Though shares of PCBC are trading at $ 2.50, less than the takeover value of $2.75/share, option premiums would have to decline for a recommendable option strategy to surface.
The proposed takeover of GeoResources by Halcon Resources (HK) is an opportunity for an option play. GEOI shares closed at $37.80 per share on Friday June 22nd, well below their value based on acquisition terms. Upon acquisition, GEOI shareholders will receive $20 in cash, and 1.932 in HK shares. Based on the $ 10.75 closing price for KMI shares the stock portion of payment is worth $20.77. Adding the cash and stock gives a $40.77 deal value per GEOI share. Investors can try to capture the deal spread by buying GEOI shares while simultaneously purchasing an GEOI January 2013 put with a $30.00 strike price for $1.05 and selling a GEOI January 2013 call with a $40.00 strike price for $1.60. Investors would risk a $8.35 maximum loss for a gain of $2.75, a 32.9% 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 have deal spreads that are too narrow to compensate investors for option premiums. These other deals might be tradable given the right circumstances, but not through simple option plays like the one listed here.
Please read the article disclaimer.
* 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.
Disclosure: I am long VQ.
