BACKGROUND
Risk Arbitrage is the practice of arbitrage that involves certain levels of risk. It encompasses three main forms: merger and acquisition arbitrage (also known as merger arbitrage), liquidation arbitrage, and pairs trading. This case study focuses specifically on merger arbitrage, which exploits arbitrage opportunities that arise when a merger or acquisition agreement becomes public.
An arbitrageur aims to profit from changes in stock prices during a merger of the acquiring company and/or target company. The type of merger, whether cash or stock, determines the investment strategy used by the arbitrageur. However, there is a considerable risk involved in risk arbitrage as substantial losses may occur if the merger deal does not materialize. There are two primary types of mergers that an arbitrageur can exploit. The first type is a cash merger, where the acquiring company offers a predetermined amount of cash to purchase the target company.
Usually, the price of the target is less than the proposed price, allowing the arbitrageur to purchase a long position in the target company. When the acquisition happens, the stock price of the target company rises, leading to profits for the arbitrageur. This scenario pertains to a stock-for-stock merger, where the acquiring firm gives its own stock as compensation for the shares of the target firm.
One strategy commonly used in this situation involves establishing a long-short position. This means the arbitrageur takes a long position in the target firm and a short position in the acquiring firm, often referred to as “setting a spread.” If the merger is successful, the target stock is converted into the acquirer’s stock based on an exchange ratio specified in the merger agreement. The arbitrageur then delivers the converted target firm stock to close their short position and complete the arbitrage. The main goal of the arbitrageur is to take advantage of the price difference between both firms’ stocks, which will gradually converge once the deal is finalized. Despite market efficiency, these profits can still persist because they are already taken into consideration when assessing potential risks associated with mergers.
The merger poses a risk as the securities’ prices would remain unchanged without any profit if there were no risk involved. One major risk is the potential failure of completing the merger. Possible obstacles that could impede a merger include either party’s inability to meet all conditions, not obtaining antitrust and/or other regulatory clearances, and failing to secure shareholders’ approval (though this approval is sometimes unnecessary).
When considering a merger, it is crucial to be aware of the different challenges that may arise. These challenges include legal disputes, difficulties in obtaining sufficient funds for the acquiring company to finalize the purchase, and the potential for a decrease in the value of the deal. Specifically, if a stock-for-stock merger occurs and the stock price of the acquiring firm drops, it can negatively impact the overall value. All these factors play a role in deciding whether or not to proceed with a merger.
PROBLEM DEFINITION
Chris Smith, who is a founding partner of Green Circle Capital LP, is facing a decision regarding his current investment strategy involving Alza and Abbott Labs. This decision is influenced by the pending merger between the two companies. Given that it is already October 27th, 1999, and concerning news has surfaced regarding Abbott Labs’ acquisition of Alza, Chris is uncertain about the best course of action. He must choose between closing his positions and accepting losses, protecting his positions with options, or increasing his positions as the spread between the two stocks has widened from $4.20 to $5.175. Currently, Chris holds a long position on 260,000 Alza shares which he acquired at a price of $48 per share, and a short position on 312,000 Abbott Labs shares which he sold at a price of $43.50 per share.
If the deal were to proceed, Chris anticipates favorable returns. This is because the merger would raise the stock price of Alza (yielding profit for a long position) and lower the stock price of Abbott (yielding profit for a short position). Alternatively, Chris could purchase Alza put options with a maturity date of December 18th, priced at $3.25 per share with a strike price of $40.00. (Alza’s current share price is $40.12.) This approach would act as a safeguard for Chris’s current position, as the failure of the deal would cause a drop in Alza’s share price, creating gains upon exercising the put option.
VALUATION AND RECOMMENDATION
We advise Green Circle Capital to immediately close both their long and short positions, resulting in a loss of $254,800 dollars (refer to Figure 2). Additionally, we suggest that the fund seizes the opportunity and purchases put options at a strike price of $40, anticipating the failure of the deal and a subsequent decrease in the price of Alza.
This recommendation is based on the assumption that there are certain factors that will prevent the merger deal from proceeding. These factors include compliance issues with Abbott’s Illinois plant, which have been identified by the FDA, and the stock-for-stock exchange ratio.
The FDA has taken action against Abbott’s plant in Illinois, resulting in the suspension of production for two drugs that generate a significant portion of the company’s revenue. If the FDA also suspends Abbott’s immunoassay business, valued at $1-$1. billion dollars, it could significantly impact Abbott’s financial performance and lead to further decline in its stock price.
This decrease in value would negatively affect the merger’s value for Alza shareholders. Therefore, specific measures need to be implemented to address this situation.
Abbott intends to increase its 1.2 exchange ratio in order to counter the decrease in value, consequently reducing the value of its shares. In the event of a substantial decline, dilution becomes unfeasible. Consequently, Green Circle Capital incurs notable losses as the risk arbitrage opportunity disappears and they bear even greater losses.
We are concerned about the merger proxy statement’s failure to address important FDA issues. Throughout history, the FDA has played a crucial role in enforcing companies’ compliance and has the power to suspend or cease drug delivery operations. This omission is significant and poses a major threat to the merger’s success. The likelihood of this issue causing the deal to fail is high. However, there is an opportunity for Green Circle Capital to benefit from this situation by purchasing put options with a strike price of $40, taking into account Alza’s current trading value of $40.2.
By selecting this option, the fund can wait for a significant decrease in price and purchase shares at a discounted rate. These shares can then be resold for a profit of $40 per share. The purchase price is determined by Green Circle Capital’s policy of investing $25,000,000, which represents 5% of the total fund. To calculate the purchase price, we utilize break-even analysis where profit equals cost based on the equation: (254,800) + (3.25 * shares) + (price * shares) = 40 * shares. Additionally, solving the system of equations indicated by Shares * price = 25,000,000 reveals that the purchase price should not surpass $36.39.
