Risk Arbitrage: Abbott Labs and Alza Harvard Business Review Case Study 1. BACKGROUND Risk Arbitrage is essentially just arbitrage with some element of risk. Three main types of risk arbitrage are merger and acquisition arbitrage (also known as just merger arbitrage), liquidation arbitrage, and pairs trading. We will focus on merger arbitrage, as it pertains to this case study. Merger arbitrage is an investment strategy that chooses to capitalize upon arbitrage that presents when a merger or acquisition deal is announced.
Essentially, an arbitrageur is seeking to profit from the movements of the acquirer’s and or target’s stock price from the merger. There are two main types of mergers, a cash merger and a stock merger, which determines how the arbitrage positions the investment. A major inherent risk of risk arbitrage is the risk that the deal will not be completed and that the position will suffer significant loss. There are two principal types of mergers, both of which an arbitrageur can take advantage. First, is a cash merger, in which the acquirer proposes to purchase the target firm for a certain price in cash.
Typically, the price of the target will trade below the proposed price, so the arbitrageur can buy a long position in the target firm; when the firm is acquired, the stock price will increase and the arbitrageur will profit. The second type of merger is a stock for stock merger, which is the merger being studied in this case. In a stock for stock merger, the acquiring firm proposes to trade its own stock for the stock of the target firm. A typical position in this case is a long-short position in which the arbitrageur places a long position in the target firm and a short position in the acquiring firm; this is known as “setting a spread. If the merger is completed, the target stock will be converted into the acquirer’s stock based on the exchange ratio that was determined by the merger agreement. The arbitrageur then delivers the converted target firm stock into his short position to complete the arbitrage. Essentially, the arbitrageur is aiming to capitalize in the difference of the prices of the two firms’ stocks, which will essentially converge somewhere in the middle once the deal is completed. Market Efficiency does not prevent these profits from persisting because the market is already accounting for the risk in a merger.
If there was no risk in the merger, the before and after prices of the securities would be the same before and after the merger, and there would be no profits to be realized. A major inherent risk is the risk that the deal will not be completed. Obstacles for a merger can include either party’s inability to satisfy all of the conditions of the merger, failure to receive antitrust and/or other regulatory clearances, and failure to obtain the shareholders’ approval (though this is sometimes not necessary).
Other obstacles could be lawsuits against the merger, the inability of the acquiring firm to raise enough capital to make the purchase, or a decline in the value of the deal, such as when the acquiring firm’s stock price declines in a stock for stock merger. All of these factors are considered when making a position in a merger deal. 2. PROBLEM DEFINITION Chris Smith, founding partner of Green Circle Capital LP, is trying to decide about his current long position in Alza and short position in Abott Labs with consideration to their pending merger.
Considering that it is already October 27th, 1999 and troubling news has emerged regarding the acquisition of Alza by Abbott Labs, Chris is unsure whether he should close the position and realize losses, hedge his position with options, or increase his position since the spread increased from $4. 20 to $5. 175. His Current position is a long position of 260,000 Alza shares purchases at $48, and a short position of 312,000 Abbott Labs shares that were sold at $43. 50. Details of the position are found on the next page in Figure 1.
Maximum Position Size (Half Position):| $12. 5 million| Date of Investment: | 23-Jun-99| Anticipated Close of Merger:| December 31,1999 | Announced Exchange Ratio:| 1. 2 ABT:1. 0ALZA | Price of Abbott shares shorted: | 43 ? | Number of Abbott Shares Shorted: | 312,000 shares | Basis of Alza Shares Acquired: | 48| Number of Alza Shares Acquired: | 260,000 shares | Collateral Requirements: | | Long Position | 50%| Short Position | 50%| Margin Interest Rate: 6. 2% | 6. 20%| Short Sale Rebate | 5. 60%|
Figure 1: Position of Green Circle Capital LP Regarding Abott Labs and Alza merger Green Circle Capital determined the number of shares for each position based on the announced exchange ratio of the merger and the maximum amount of funds they wanted to invest in a position, which was a half position of $12. 5 million. Chris acquired 260,000 shares at $48/share, which came out to a $12. 48 million allocation. Since the announced exchange rate was 1. 2, Chris also shorted 312,000 shares of Abbott Labs (260,000*1. 2=312,000) at $43. 50.
If the deal did go through, Chris would expect positive returns because the stock price of Alza would increase as a result of the merger (long position would profit) and the stock price of Abbott would decrease as a result of the merger (short position would profit). Another option Chris could take would be to buy Alza put options maturing December 18th at $3. 25 a share for a strike price of $40. 00 (Alza’s current share price is $40. 12). This could serve to hedge his current position, since if the deal fell through, Alza’s share price would drop and could make gains exercising the put option. . VALUATION AND RECOMMENDATION We recommend Green Circle Capital close their long and short positions right away. The fund will take a loss of $254,800 dollars before transaction fees by closing their positions (refer to Figure 2). We also recommend the fund to capitalize on the deal by buying put options at a strike price of $40, giving the assumption the deal will fail and the price of Alza will plummet. Cost of closing the Positions| | | | | Alza| Abbot| Price brought| 48| 37. 75| Price Sold| 40. 12| 43. 5| Difference| -7. 88| 5. 75| Shares| 260000| 312000|
Lose| -2048800| 1794000| Total Lost| | -254800| Figure 2: Loss of Green Circle Capital’s Original Position This recommendation’s core belief lies in the assumption that the merger deal will not go through. The reasons include the circumstances surrounding the FDA’s compliance issues and Abbott’s stock-for-stock exchange ratio. According to the case, FDA filed compliance issues against Abbott’s plant in Illinois and has already suspended production of two drugs that bring significant revenue back to the company. The possible additional suspension of its $1-$1. billion dollar revenue immunoassay business can dig a huge hole in the bottom line of Abbott, driving the price of the stock down further. If the Abbott price drops, the value of the merger is decreased for the Alza shareholders. This will require Abbott to increase its 1. 2 exchange ratio to cover the loss of value, further diluting the value of its own shares. If the drop is large enough, dilution won’t even be feasible. This all results in huge losses for Green Circle Capital, since the risk arbitrage opportunity disappears and they have to take even bigger losses.
We found it alarming that the FDA issues were not disclosed in the merger proxy statement when the risk factors were this significant. Historically, FDA’s involvement in a company for compliance issues has always been an important factor due to the rights FDA has in suspending or shutting down a drug delivery line. We believe this issue is of an uttermost importance and signals a huge risk in the merger. It is highly likely to cause the deal to fall through. Green Circle Capital can still make a profit from this assumption by buying put options at the strike price of $40 (since Alza is trading at $40. 2). This option gives the fund a chance to wait for the price to plummet and buy shares at a cheap discount, then selling them for a profit at $40. The price to buy can be set using Green Circle Capital’s policy on invest $25,000,000 (5% of total fund). Set profit equal to cost in the break even analysis to obtain the buying price: (254,800)+(3. 25*shares)+(price*shares) = 40*shares Shares*price=25,000,000 Solve the system of equations to see the buy price should be anywhere below $36. 39.