to explore the possibility of a sale. Compared to the previously discussed scenarios, investing in a firm whose management is actively pursuing a sale is much safer, but it still is no arbitrage because the company may well be sold for less than it can be purchased for at the time of the announcement. In addition, the outcome of such an investment depends highly on the market environment. In a bull market, it is relatively easy for management to sell the firm at a premium. In contrast, in a bear market, no buyers may materialize and the stock may fall along with the market.
Potential acquirers sometimes enter into a letter of intent before signing a formal merger agreement. Investing after a letter of intent can be very speculative. Most merger partners enter into a definitive agreement right away. Letters of intent are a sign of adverse selection: Either the buyer or the company is not yet quite ready to sign a definitive agreement. In the case of the acquisition of CCA Industries by Dubilier & Co., a private equity firm managed by the son of a cofounder of Clayton, Dubilier & Rice, a letter of intent led to a busted buyout because the acquiring private equity fund could not arrange the requisite financing. Had the firm found it easy to arrange the financing, it would have entered into a definitive agreement rather than a letter of intent in the first place.
Hostile bids are of a similar degree of risk as letters of intent. If the target fends off the bidder successfully, its share price may well revert to a lower, prebid level. Even worse, if an arbitrageur has set up a short position in the acquirer (see Chapter 2), a short squeeze could ensue, leading to losses on both the long and short side of the arbitrage.
The only real merger arbitrage occurs when the arbitrageur enters the position after a definitive agreement has been signed between the target and the acquirer. Arbitrageurs who specialize only in this type of transactions refer to it as announced merger arbitrage to differentiate it clearly from the other, more risky investment styles shown in the risk spectrum in Figure 1.3.
The remainder of the book addresses transactions in which a definitive agreement has been reached.
Merger arbitrage resembles in many respects the management of credit risk. Both are concerned with the management of a large asymmetry in payoffs between successful transactions and those that incur losses. A typical stock investor is faced with an almost symmetric payoff distribution (see Figure 1.5). The stock price is almost as likely to go up as it is to go down. The likelihood of a small gain is roughly the same as the likelihood of a loss of equal size. Larger changes in value are also almost equally likely. The downside is unlimited, or limited only by a complete loss of the investment. The upside, however, is unlimited. Every now and then, an investor gets lucky and owns the next Microsoft or Berkshire Hathaway. A small upward drift in stock prices means that in the long run, stocks trend up.
Figure 1.5 Payoff Distribution for Stock Investors
The situation is different for merger arbitrage and credit managers (see Figure 1.6). The upside in a merger is limited to the payment received when the merger closes. Likewise, the most credit managers will receive on a loan or bond is the interest (or the credit spread if they manage a hedged or leveraged portfolio). The downside is unlimited: If a merger collapses or a loan goes into default, a complete loss of capital is possible in a worst-case scenario. The only reason why investors are willing to take risks with such an asymmetric payoff distribution is because the probability of a large loss is very small and the probability of a small gain is very large. The skill in merger arbitrage, as in credit management, is to eliminate investments that have a high probability of generating losses.
Figure 1.6 Asymmetric Payoff Distribution
Another field in finance has payoff distributions very similar to those of merger arbitrage and credit: option selling. An option seller expects to make only a small return in the form of the option premium but can suffer a significant loss when the option is in the money. Option strategies are often depicted in payoff diagrams, such as that of a short (written) put option in Figure 1.7. In 1873, Henri Lefèvre, the personal secretary of James de Rothschild, pioneered the use of these diagrams for option payoffs. If at expiration the stock price rises above the strike price, the option seller will earn only the premium. However, if the stock price falls below the strike price, the option seller will suffer a significant loss. Merger arbitrage and credit resemble this payoff pattern. Figure 1.8 shows the payoff diagram for a simple merger arbitrage, where a buyer proposes to acquire a company for cash consideration. If the transaction passes, the arbitrageur will receive only the spread between the price at which she acquired the target's stock and the price at which the firm is merged. However, if the merger collapses, the stock price probably will drop, and the arbitrageur will incur a loss that is much larger than the potential gain if the merger is closed.
Figure 1.7 Lefèvre Diagram of the Put Option Characteristics of Merger Arbitrage
Figure 1.8 Lefèvre Payoff Diagram of Cash Mergers
From an arbitrageur's point of view, the most important characteristic of a merger is the form of payment received. Therefore, in merger typology arbitrageurs use payment method as the principal classifier. Other merger professionals, such as tax advisers or lawyers, often use other criteria to categorize mergers. For example, tax advisers distinguish between taxable and tax-exempt mergers, whereas legal counsel may distinguish mergers by its antitrust effect. There are three principal categories of mergers and one rare category:
1. Cash mergers. The shareholders of the target firm receive a cash consideration for their shares.
2. Stock-for-stock mergers. The shares of the target firm are exchanged for shares in the acquirer.
3. Mixed stock and cash mergers. The target company's shareholders receive a mix of cash and a share exchange.
4. Other consideration. In rare instances, shareholders of the target firm receive debt securities, spun-off divisions of the target, or contingent value rights. The next chapter will show how each of these types of mergers can be arbitraged.
Chapter 2
The Mechanics of Merger Arbitrage
This chapter discusses the first three types of merger consideration and how arbitrageurs will set up an arbitrage trade and profit from it:
• Cash mergers
• Stock-for-stock mergers
• Mixed stock and cash mergers
Cash Mergers
