In my prior post, “Allied Capital Goes from Value Trap to Deep Value,” I made the point that the Ares/Allied acquisition created a potentially interesting merger arbitrage opportunity. As astutely pointed out by commenter BeauZeau at Seeking Alpha, the merger arbitrage opportunity is not quite as large as I portrayed.
In a classic merger arbitrage, the investor ought to short the acquiror (ARCC) and buy the target (ALD). That is because, assuming that the deal closes, the target and acquiror shares are now representative of the same asset. Consequently, any price discrepancy between the two stocks represents a fundamental disconnect with underlying value*. In the case of ARCC and ALD, I posited that the proposed exchange rate of .325 ARCC shares for each ALD share creates an opportunity based on current closing prices.
*Those familiar with the concept of arbitrage will see my description of merger arbitrage as a flawed definition of arbitrage. Officially, merger arbitrage is a risk arbitrage and is not the same as a traditional riskless arbitrage opportunity. I intend to write a follow up post for those who have less experience with this concept later this week.
At Ares’ closing price of $10.46/share, ALD shareholders would be entitled to approximately $3.40/share in value. This represents a 7.9% premium versus ALD’s closing price of $3.15. In a classic merger arbitrage, however, shorting ARCC would require the investor to pay upwards of two quarters worth of dividends (the ARCC/ALD merger is expected to close by Q1 2010). ARCC currently pays a 13.4% annual dividend yield. Two dividends would equate to roughly 6.7% in yield. As such, the true spread between ALD and ARCC is closer to 1% than the 7.9% that is initially seen when only comparing stock prices.
Merger arbitrage does contain some risk. The deal may not close in time which could result in an arbitrageur missing more of ARCC’s dividends. The deal may not close at all which could have completely unpredictable results on stock movements, thus destroying the pair trade (short ARCC/long ALD) opportunity. As such, the minute 1% spread is a good sign that the market is pricing a near definite probability of this transaction closing and believes just 1% in return over the next 6 months is adequate compensation for the risk.
In this sense, a classic merger arbitrage of ALD and ARCC seems much less worthwhile to us retail investors who don’t have massive balance sheets to throw at small percentage gains. Despite this, I believe the initial thesis of my prior post on the opportunity to purchase Allied Capital stock holds true. Prior to this acquisition, Allied Capital’s auditors were issuing going concern warnings. With the balance sheet and liquidity provided by Ares, Allied Capital’s undervalued portfolio definitely looks much more attractive. That being said, on a risk adjusted basis, it would seem much more prudent to outright purchase ARCC at this juncture as you would be “guaranteed” dividends over the next few quarters and you won’t hav_[thecuriousinvestor.com] to worry about the risk of the transaction not being confirmed.
Full disclosure: Author has no positions in the stocks mentioned in this post.