So what is merger or risk arbitrage? It is the investment activity to profit from the spread between the agreed prices to buyout the target and the price the target is traded after the deal is announced to the public market.
There are two main kinds of merger and acquisition transaction: cash and stock deals. In the cash deal, the buyer will pay the target by cash. In the stock deal, the buyer will issue its own shares to pay for the target. In addition, the majority of deals are a mix of cash and stocks. For a cash deal, the arbitrageur can buy the target’s share when the potential deal is announced, then exchange for cash at the close of the deal. For a stock deal, normally the arbitrageur would buy the target and short the buyer with an amount equal to the number shares he/she receives in exchange for the target’s shares.
Spread the arbitrageur got from the merger transaction is quite small compared to the premium paid in the deal, thus the investor needs to take care of the downsize very carefully. Paulson said that an experienced arbitrage investors for over 40 years told him, “Risk arbitrage is not about making money, it’s about not losing money.” That is why the importance of risk arbitrage is to manage, control and avoid losses as much as possible. He described the risk in risk arbitrage as anything that affected different important parts of the deals such as the deal completion, the timing of completion and the amount received at its completion. The downside risk of arbitrage investment is very significant in relation to the upside investors would receive. There are many occasions that one has to be right around 95% of the time to make it break even.
There are two big risk umbrellas in risk arbitrage investing, which are macro risks and micro risks. Macro risks include market risk and interest rate risk, whereas micro risks include a lot of things like earnings surprises, financing arrangement, legal, premium, taxes, acquirer, fraud, timing, etc.
Normally the arbitrageur would hedge the market risk by investing in the transaction when the consideration is fixed by locking in the spread of announced buying price and the current market price after the deal is announced. By doing that, the expected return would be earned regardless of any direction of the market, so long as the deal is closed.
So it comes back to the risk of whether the deal can be closed or not. A rapidly falling market might cause the buyers to reevaluate the purchase price. John Paulson noted: “In September 1998, the high yield market almost shut down completely and banks used market-out covenants to rescind financing commitments, causing many leveraged buyouts to break... Generally, in the falling market, cash spreads may widen due to the increased macro uncertainty while spreads in stock deals may contract or stabilize due to the 'cushioning effect' of the gains realized on the short side.”
Not only the falling market can cause problems, so can the rising market. The Internet bubble of 1999 caused the price of the buyers to go up quickly, leading to a rise in the target stock price to the high level that if the deal got broken, a huge loss would be realized.
Beside the market risk, the rising interest rate is worrisome for any arbitrageur as well. Higher interest would make the deal financing difficult; the borrowers might not borrow more debt, and if they can, the price of the money would be high. It might even hurt the bottom line of the target, causing earnings surprises, which make the deal collapse very easily.
The first is earning risk, where there are earning surprises happen before the deal is closed. Buyers often value targets based on multiples of earnings and projected growth. If the target falls short of meeting buyers’ expectations during the time of deal processing, the buyer would try to renegotiate the price or terminate the deal.
Second is the financing risk, where buyers think they can raise money for the particular deal at the time of announcement, but because of many factors varied from rising interest rates or any factors of targets or buyers that make the financing very difficult. Certainly, if there is no financing, the deal cannot be closed. For the premium risk, Paulson wrote that the premium that acquirer pays can be used as a starting point in estimating the downside risk if the deal fails. The greater the premium, the greater the downside risk. The common premium in risk arbitrage can be from 75% up to 150%.
In evaluating the deal, the merger agreement should be examined quite closely to see the type of agreement and the clauses it contains. The agreement-in-principle or letter-of-intent is the weakest form, allowing any party to walk from the transaction at will. The definitive agreements can be better, but it varies from situations to situations. The arbitrageur should do due diligence to see the level of bonding of both parties in the agreement.
In addition, the acquirer should be evaluated carefully. In a cash transaction, the arbitrageur should make sure the acquirer has the ability to pay for the deal. And he/she should look at the previous deals that the acquirer has done before. It is important to see what reputation the acquirer has, whether they are a tough negotiator, or whether 90% or 20% of the deal acquirer announced before closed.
There are many more particular risks inherent in risk arbitrage transactions, including timing of the deal closed, fraud that target created to overstate earnings, regulatory risks etc. So what should an arbitrageur do for risk management? John Paulson has laid out several general points as the guidelines for any arbitrageur. Nobody can eliminate the entire risk, which is why the portfolio of deals should be constructed in a balanced way. To manage portfolio risk, one should focus on the potential downside in the transaction. John Paulson suggested looking for deals whose characteristics imply a high probability of closing, and avoiding low quality deals. Below is the table that John Paulson details to help the arbitrageur know what to avoid and what to focus on.
|Agreements in principle||Definitive agreements|
|Deals subject to financing||Strategic rationale|
|Deals subject to due diligence||Large acquirer|
|Targets with poor earnings trends||No financing condition|
|Targets with negative earnings||No due diligence condition|
|Deals in cyclical industries||Solidly performing target|
|Deals in highly regulated industries||Reasonable valuation|
|Limited regulatory risk|
He concluded that by implementing these criteria, the arbitrageur can receive the maximum benefits of the strategy to have non-correlated, low-volatility return. As Walter Schloss often said: “If you watch the downside, the upside will take care of itself.”