Deal Background and Risks:
Last Spring German pharmaceutical company Fresenius Kabi announced that it was acquiring Akorn (AKRX) for $34/share in an all-cash deal worth $4.75 billion. As is usually the case, the stock inched up toward the acquisition price and closed at $33.09 the day after the deal was announced, leaving a potential profit of $0.91 for arbitrageurs, or in other words a spread of 2.75%. The reason I wrote inched up was because Fresenius had indicated more than two weeks before the deal announced that it was in talks to acquire Akorn and the stock had already moved up to trade at $29.77 after that news broke.
The deal was originally expected to close by the end of 2017 and assuming a closing date of December 31, 2017, the annualized spread on the deal was just under 4%. The small spread indicated that the market did not perceive this to be a high-risk deal. Sure there were the usual suspects of risks including shareholder approval, antitrust review by the FTC, and because it was a cross-border deal, approval from the the Committee on Foreign Investment in the United States (CFIUS). This was still early in the Trump Administration and several cross-border deals were yet to be rejected by the CFIUS. The deal received shareholder approval on July 19, 2017, and the main risk that arbitrageurs were worried about was the FTC review.
The Merger Arbitrage Strategy:
Merger arbitrage is a strategy where investors are betting on a deal closing and (usually) capturing a small profit by buying at a lower price in the market and waiting for the deal to close. For those unfamiliar with the strategy, I have written a short introduction to merger arbitrage here. The strategy has a reputation for generating small returns until an unfortunate event wipes out those profits. The situation with Akorn reminds investors why the strategy also is called risk arbitrage. This podcast by a physician interviewing another physician does a great job of introducing the strategy, its advantages and its risks. Anyone who is currently long Akorn or was recently long the stock for the arbitrage spread on the deal will appreciate the tough questions asked at the end of the podcast.
My research of more than 1,500 deals we track in our database has indicated that during the last eight years more than 95% of the deals closed and they often tend to do so before the expected closing date. You can read this research here, here, here and here. This is in keeping with academic research done over other periods of time. I would love nothing more than to get my hands on deal data from before 2010 to do a deep dive into the closing rate of deals across different market conditions and time periods. Most of the deals I have invested in have closed and in some cases like the acquisitions of Apollo Education, Hutchinson Technologies and Trina Solar, the spreads were juicy enough to generate more than a few pennies of profits. I have had one deal fail on me and I took a bit hit when Walgreens (NASDAQ:WBA) terminated its merger with Rite Aid (RAD). As I mentioned on Twitter, five out of the six arbs I have talked to recently have lost money in Rite Aid. In case you were wondering, the sixth one was not using that strategy at that time. It looks like Akorn is very likely to end up in that other 5% and will be a loss I will take for 2018.
Events Take a Turn for the Worse:
A few things started going wrong for Akorn last year and in recent weeks. An early indication of trouble was in August 2017 when the company reported a significant decline in both second quarter revenue and earnings. Then the Chairman of Akorn resigned on October 31, 2017, after he was arrested in a bribery case related to opioid maker Insys Therapeutics Inc (INSY). In November 2017, Fresenius indicated that the deal was likely to close in 2018 and reiterated in December 2017 that they were looking at an early 2018 close. We updated the potential deal closing date in our Merger Arbitrage Tool to March 31, 2018. The stock dipped in November and December 2017 but made a comeback in January 2018 and the spread at one point narrowed to just 1.3%.
The increase in spread over the last several days was the canary in the coal mine and should have tipped me off to close my position. I have seen this pattern of increasing merger spreads before a deal goes bust and the paper Characteristics of Risk and Return in Risk Arbitrage by Mark Mitchell and Todd Pulvino does a great job of covering this phenomenon. I included a chart from this paper on the Merger Arbitrage Research page of my website and have reproduced it below.
The potential breaking point for Akorn came last week when Fresenius announced that "it is investigating alleged breaches of FDA data integrity by Akorn related to product development." The stock immediately dropped 38.41% and continued lower the following day. The stock is now more than 25% below the pre-deal price of $25.22 and the spread on the deal is 79.23%.
While this may look wildly attractive to some, it reflects the high risk this deal faces and most arbitrageurs are likely to stay away. Figuratively speaking, this is not the same company Fresenius agreed to acquire last year. The situation is likely to play out in one of the following three ways,
1) The deal is consummated and if it does it would be one of the biggest comebacks for a merger situation, one that I have not seen since Hutchinson Technology's wild ride.
2) Fresenius will renegotiate the deal to a lower price like Abbott did with Alere, Bass Pro Shops did with Cabela’s and Walgreens did with Rite Aid. This FDA data integrity issue combined with a business in decline should allow Fresenius to make a strong case for renegotiating the deal.
3) Fresenius backs out of the deal and the stock craters much lower.
I believe this situation is unlike what I experienced with Hutchinson Technology where the stock dropped more than 65% because of an adverse event at the company that was acquiring Hutchinson. As discussed in the Hutchinson article, at one point the spread on the deal was 194%. In that situation, I decided to hold on to the stock and ride out the volatility. With Akorn, holding on to the position is going to take focus away from other more productive activities and I decided to exit the position and take my losses.
Based on where the stock is currently trading at, it looks like the market is assuming scenario 2 is more likely. I do hope that the deal closes and that investors who are currently long benefit from an increase in price. But based on my probabilistic assessment of how things may turn out, I'm going to watch the eventual outcome from the sidelines.