One of the great events in an investor’s life is that day you one of your portfolio companies agrees to sell itself at a hefty premium. Rarely does recognition of a good call come at all once, and you will be forgiven for the initial euphoria (and maybe a bit of gloating). However, as sweet as this time is, you eventually have to face the decision of whether you should hold the position or sell.
On one hand, you can lock in your gains immediately and re-deploy that capital elsewhere. But on the other hand, the stock hasn’t traded up exactly to the deal price, and if you hold on you’ll earn another couple points – risk free, right? Not quite.
There are significant risks associated with holding out. I’ve detailed situations on this site where holdouts found themselves in the unenviable position of seeing their gains disappear as the deal falls through. However, this is not even the riskiest behaviour; some investors, seeing the spread between the announced deal price and actual stock price, will initiate a new position in the company as part of a “merger arbitrage” strategy. Unfortunately, many investors don’t properly hedge against the downside (the costs of doing so usually exceed the slim potential gains) and are thus taking on huge downside risk with disproportionately small upside potential.
Consider the case of Pep Boys (PBY), which agreed to sell itself to The Gores Group in late January. Shareholders who suffered through the second half of 2011 were richly rewarded, with a one-day gain of 23.6% to $14.93. The deal was announced at $15, and in the coming weeks, shares of PBY traded as high as $15.46, as investors speculated that the deal price would rise, likely as a result of the emergence of another bidder.
Unfortunately, before the deal was completed, PBY issued weak 1Q 2012 results and The Gores Group asked for time to consider the implications:
On April 26, 2012, Parent notified Pep Boys that, based on the serious deterioration in the Pep Boys business, Parent believes the Proxy Statement is no longer accurate and that the meeting should be delayed 30 days to allow Parent to determine the cause and extent of the significant downturn. Among other things, Parent believes that: (i) in light of this downturn, the projections provided to the board are no longer accurate, and (ii) Pep Boys may have experienced a material adverse effect or may have violated covenants contained in the Merger Agreement. If Parent concludes that a material adverse affect or material breach of covenant has occurred and is successful in asserting these positions in a court of law, Parent would be relieved from its obligation to consummate the Merger. Parent has informed us that, notwithstanding our mailing of this proxy statement, it is reserving all of its legal rights, and that Parent intends to continue its review of Pep Boys to determine the root causes of this downturn and to determine its course of action with respect to the Merger.The decline was as dramatic as the initial increase, with shares declining below the price at which the company was trading before the deal was announced:
The deal was not officially called off until the end of May. Throughout May, several commentators touted the spread that had been created as an investment opportunity. Indeed, as of the close of May 29, the projected profit for merger arbitrageurs of a $15 deal amounted to a 35.5% return (393% annualized).
But then after close of markets on May 29, the company announced the deal had been scuttled and that Gores would pay PBY $50 million to walk away. Shares collapsed an additional 12.5% after hours to $9.70.
I hope the foregoing has illustrated the risks inherent in holding out for greater gains and the even greater risks of initiating a new position while chasing these announced deals. It is telling that merger arbitrage goes by another name: risk arbitrage; the reason being that, unlike in riskless arbitrage, the investor retains a significant amount of risk.
As they say,
Pigs get fat, hogs get slaughtered.Sell when you can.
What experiences have you had with merger arbitrage?
Author Disclosure: None