Benefiting from Mergers and Acquisitions

In general, a merger arbitrage is a risk-less profit making strategy. But Green Circle could soon reassess its positions as the risk that the deal will not close (on time) is seriously high.

Two days after the announcement, Green Circle invested in this merger arbitrage. As part of the stock-for-stock deal, the exposure was designed in a way that the long position did not exceed 5% of the allocated quota of the fund capital (5% x 50% x $500M = $12.5M). With such a position, the arbitrageur avoids concentration risk and hedges against stock price declines. The term sheet also provides a pre-defined exchange ratio (1.2) and therefore defines the number of stocks involved: 260k ($12.5M÷$48/share) Abbott shares shorted and 312k (1.2 x 260k) Alza shares bought. At the time of the short sale, the Abbott price was $43.5. Hence, (PAbott x 1.2 - 48) + (43.5 - PAbott) x 1.2 gives the total gross spread at completion. Mathematically, it always yields $4.2. Without any put option, the gross payoff equation is then straightforward: 260k x [(PAlza - 1.2 x PAbott) + 4.2]. If the arbitrageur closes prematurely its positions, he should then expect a gross loss of $255k.

Benefiting from mergers and acquisitions is obviously easier said than done because it depends on whether or not the proposed transaction event is consummated. Although arbitrageurs hedge against market risk, the strategy carries high idiosyncratic risk due to recent issues. First, the divesture of Alza’s prostate cancer treatment Viadur will delay the time necessary to close the merger. As the magnitude of the spread is partly dictated by the time value of money, the sale operation will lower the return. Secondly, Abbott is embroiled in a dispute with the Food and Drug Administration that causes discontent among Alza’s shareholders. The value of the target firm could suffer from it and ultimately widen the arbitrage spread. Even more so, the collaboration on integration issues is damaged and could jeopardise the transaction. Finally, other term sheet issues (e.g. change of the arbitrage ratio, acquirer’s price fluctuation or material adverse change clause) intensify the perceived risk. As a result, the probability of failure grows. The arbitrageur would face a double price risk. If the transaction is called off, the target firm’s stocks will fall sharply and yield a gross loss even higher than  $255k (it is highly probable that PAlza < 4.2 +1.2 x PAbott). Ex post, a good strategy would have been to buy put options  so that Green Circle could close the deal and generate a profit of $1,203k (cf. $3.25 for the underlying) minus $255k. Today, I would still advise buying put options and hold the current position. The fund would enhance its weighted profit as it would be hedged in both cases.

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