Merger Arbitrage: Avoid It Like the Plague

by Will Ashworth | December 19, 2012 6:30 am

Merger Arbitrage: Avoid It Like the Plague

If you’re not familiar with the concept of M&A arbitrage, here’s the quick version: Someone buys the stock of a company that’s in the process of being acquired because they anticipate higher offers. In other words, the investor is willing to bet money on another suitor entering the fray and driving up the price.

It’s a surprisingly popular gamble, but a dangerous one considering the risk you expose yourself to far outweighs the upside. In fact, if you look at a few recent examples, you’ll see that it makes more sense to just avoid M&A arbitrage at all costs.

After all, you don’t want to get burnt.

Clearwire/Sprint

Clearwire (NASDAQ:CLWR[1]) stock surged 71% on Oct. 11 on the news that Japanese mobile carrier Softbank would pay $20 billion for a 70% stake[2] in Sprint (NYSE:S[3]), which held its own 50.45% interest in CLWR. Investors (rightly) speculated that Sprint would then buy the remaining interest in Clearwire to bring its spectrum under one roof, which it ultimately offered to do Dec. 13 at $2.90 per share.

So, at the end of that fateful October day, Clearwire’s shares stood at $2.22. Those who owned its stock prior to Oct. 11 had a decision to make: Hold ‘em or fold ‘em. If you had bought Clearwire’s shares in July — when they were below $1 — it would have been awfully difficult not to cut and run despite the anticipated bid. But if you owned shares that were deeply in the red, opinions like those of Mount Kellett Capital Management — which said shares were worth $6.30 — might have led you to postpone selling so you could hope and pray for such a bid.

Unfortunately, that highly inflated bid never came. Sprint’s sweetened offer of $2.97 per share Dec. 17 — only 7 cents better than the one pitched Dec. 13 — was the best investors could hope for.

The worst fate was reserved for those who bought Clearwire stock Dec. 14 at prices as high as $3.40 per share, betting that an offer superior to $2.90/share would appear. Those speculators are now sitting on 15% losses.

Who was making those bets? And why? It was obvious to most observers that Sprint wasn’t going to open the vault to buy the remaining shares. For two years, Clearwire’s board entertained various strategic alternatives; Softbank was the best hope for both companies. Traders likely were pushing rumors of higher bids to drive demand for Clearwire’s shares, allowing them to profitably exit their positions beyond the original bid of $2.90 while John Q. Public was left holding the bag.

The fat cats win again.

Schiff/Reckitt Benckiser

Another recent example of M&A arbitrage is Schiff Nutrition International (NYSE:SHF[4]), the Utah-based vitamin and supplement company that was successfully acquired by Britain’s Reckitt Benckiser (PINK:RBGPY[5]) for $1.4 billion.

The adventure originally began back on Oct. 30. when Bayer (PINK:BAYRY[6]) offered to buy Schiff for $1.1 billion or $34 per share — a 47% premium over its Oct. 26 closing price. Two weeks later, Reckitt offered $42 per share, and the bidding war was on.

Or was it?

Investors expecting Bayer to counter bought shares for as much as 6% higher than Reckitt Benckiser’s very generous offer. Two trading days after Reckitt’s offer, Bayer dropped out of the competition; the bidding war was over before it began.

If you’re going to play the M&A arbitrage game, you’d better be operating on more than a hunch, because the pros will take your action every day of the week.

Do the Math

MarketWatch contributor Andy Hicks, a buy-side equity trader in San Francisco, discussed using merger arbitrage to generate excess returns[7] on your portfolio’s cash. Hicks reckons that if you select cash-only deals that represent less than 25% of the acquirer’s market cap and will close within six months, you might be able to squeeze out an additional 31 basis points of yield over a six-month Treasury bill. Hicks uses three M&A opportunities:

  1. National Oilwell Varco (NYSE:NOV[8]) and Robbins & Myers (NYSE:RBN[9])
  2. IBM (NYSE:IBM[10]) and Kenexa (NYSE:KNXA[11])
  3. Wellpoint (NYSE:WLP[12]) and Amerigroup (NYSE:AGP[13])

He ends up assigning 30% of an imaginary $25,000 in the first deal, 50% in the second, and 20% in the third and final deal. All told, you’d generate $54.50 in income over the six-month arbitrage compared with $16.25 for the T-bill.

That sounds great … except the fact that deals don’t always take place.

In the three examples above, only the IBM deal has been completed, and National-Oilwell Varco’s purchase of Robbins & Myers has been delayed into 2013 because of additional information requested by Canada’s Competition Bureau and the U.S. Department of Justice’s ongoing review. In this instance, the six months is entirely necessary.

What happens if the deal falls through?

One can never know for sure, but Robbins & Myers traded for $46.80 the day before the announcement. It’s entirely possible that the stampede to exit would send its shares back to where they came from. How fast you’re able to exit determines how bad your losses will be. In Hicks’ example, you’d have bought at $59.65 per share, a 35-cent spread between your price and the buyout price. If it goes all the way back to $46.80, you’ve lost $1,600 instead of the projected gain of $17.50 (after commissions).

Ouch.

Bottom Line

The moral of the story in all three of these examples is that merger arbitrage is best played only by the professionals. If you’re parking money for six months, the last thing you should be doing is betting on the takeover spread.

If you want to blow $1,600, go spend it at JCPenney (NYSE:JCP[14]). At least then somebody might get a job out of it.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

Endnotes:
  1. CLWR: http://studio-5.financialcontent.com/investplace/quote?Symbol=CLWR
  2. would pay $20 billion for a 70% stake: http://investorplace.com/2012/10/so-what-do-we-do-with-sprint-now/
  3. S: http://studio-5.financialcontent.com/investplace/quote?Symbol=S
  4. SHF: http://studio-5.financialcontent.com/investplace/quote?Symbol=SHF
  5. RBGPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=RBGPY
  6. BAYRY: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAYRY
  7. using merger arbitrage to generate excess returns: http://www.marketwatch.com/story/increasing-cash-yield-with-merger-arbitrage-2012-09-20
  8. NOV: http://studio-5.financialcontent.com/investplace/quote?Symbol=NOV
  9. RBN: http://studio-5.financialcontent.com/investplace/quote?Symbol=RBN
  10. IBM: http://studio-5.financialcontent.com/investplace/quote?Symbol=IBM
  11. KNXA: http://studio-5.financialcontent.com/investplace/quote?Symbol=KNXA
  12. WLP: http://studio-5.financialcontent.com/investplace/quote?Symbol=WLP
  13. AGP: http://studio-5.financialcontent.com/investplace/quote?Symbol=AGP
  14. JCP: http://studio-5.financialcontent.com/investplace/quote?Symbol=JCP

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