Merger arbitrage is an interesting investing strategy. Basically, it involves looking at the merger and takeover activity in the stock market and assessing the chances of a specific merger or takeover being consummated. For example, if you had placed a bet based on the reasoning that Elon Musk would be forced to complete the acquisition of Twitter (TWTR, Financial) when the rest of the market was pessimistic on the deal, you could have recorded a gain when things took a turn in your favor.
Another interesting opportunity that is a lot less controversial is Broadcom's (AVGO, Financial) planned acquisition of VMWare (VMW, Financial). Under the terms of the agreement, announced on May 23, 2022, which has been unanimously approved by the boards of directors of both companies, VMware shareholders will elect to receive either $142.50 in cash or 0.2520 shares of Broadcom common stock for each VMware share. The shareholder election will be subject to proration, resulting in approximately 50% of VMware's shares being exchanged for cash consideration and 50% being exchanged for Broadcom common stock.
Here is how the two stocks have behaved since the announcement (May 20 was the last trading day before the merger announcement). VMWare is up 18% while Broadcom is down about 11%.
Since VMWare shareholders can elect to either take their money as cash or Broadcom shares (subject to proration), I have calculated the arbitrage opportunity using cash as well as shares. The major assumption here is of course the deal will go through. There is no guarantee of that, hence the arbitrage opportunity. The arbitrage is the spread between the current price and the deal price assuming the investor was to buy the VMWare stock now.
Assuming that the deal is paid 100% in cash, the spread is currently 20.88%, and assuming the deal price is 100% Broadcom stock, the spread is 7.49%. More likely it will be 50:50 cash to stock ratio, but it could fall anywhere within the range.
Another assumption is the timing. The companies estimate that deal will close sometime in 2023. The annoucement simply says that, "The transaction, which is expected to be completed in Broadcom's fiscal year 2023, is subject to the receipt of regulatory approvals and other customary closing conditions, including approval by VMWare shareholders." For the purpose of my analysis, I have assumed that the deal will close on March 31, 2023. Therefore I have annualized the upside if the deal closes. However, the closing dates are optimistic, and it may be the third quarter of 2023 when the deal closes.
| Acquirer / Buyer | Broadcom (Cash) | Broadcom (Shares) |
| Target | VMWare | VMWare |
| Acquirer Ticker | AVGO | AVGO |
| Acquire current price ($) | 483.66 | 483.66 |
| Cash or Shares | Cash | Shares |
| Cash / Share of Target | 142.5 | 142.5 |
| Number of shares of Acquirer per Share of Target | 0 | 0.252 |
| Deal price | 142.5 | 121.88232 |
| Target's Ticker | VMW | VMW |
| Target's Current Price | $112.75 | $112.75 |
| Difference if deal successful (Deal price - Current Price) | $29.75 | $9.13 |
| Spread % (Difference / Deal Price) | 20.88% | 7.49% |
| Projected Date of close (estimate) | 3/31/2023 | 3/31/2023 |
| Expected Close time period | 2023 | 2023 |
| Current Upside % (Diff / Target Current Price) | 26.39% | 8.10% |
| Annualized Upside % (Estimated IRR) | 54.72% | 16.80% |
| Break-up fee ($) | 1.5 billion | 1.5 billion |
Another unknown is the regulatory approval of the deal. Broadcom is based in Singapore and VMWare is a U.S. Company. While the two companies are in different businesses, so there shouldn't be any antitrust concerns, it is possible that the U.S. regulators may have some security concerns. EU clearance is another big unknown, and we know the EU has opened an investigation into the merger and may force Broadcom to make concessions.
Overall, I am estimating the takeover has a 75% chance of going through and not being blocked by regulators. Broadcom may have to make concessions to the U.S. or the EU, but that should not affect the buyout price.
Putting it all together, I am assuming that VMWare shareholders will get 50% in cash and 50% is shares. Therefore the upside case is calculated as follows: $29.75 - $9.13 = $20.62 per share. Multiplying this with the probability of 75% that the deal will go through gives us $20.63 x 0.75 = $15.47. Based on the current price of VMWare stock, this works out to an upside case of about 13.5%. This is the probability-adjusted alpha we are looking at.
For the downside case, if the deal does not go through, VMWare stock will likely fall to its pre-deal price of $95.71 (with an estimated 25% probability). This is a probability-adjusted downside case of 4% (($112.75 - $95.71 = $17.04) / 112.75 * 0.25 = 3.77%). This is probablity adjusted delta (or negative alpha).
So to summarize, my estimate of this arbitrage opportunity is an upside of 13.5% vs. a downside of 3.77%, which gives an upside/downside ratio of around 3.58. Meanwhile both Broadcom and VMWare are showing up as undervalued by their GF Value charts, so even if the merger doesn't go through, the stocks could still be good value. Of course, the above calculations have a lot of assumptions, but that is the nature of this game. Merger arbitrage is an excercise in probablistic thinking.
