- With merger arbitrage, the biggest risk is always that the deal may not go through.
- The market is currently giving the AT&T – Time Warner deal a 40% chance of success.
- We’ll share some merger arbitrage insights from Warren Buffett.
This and other merger and acquisition deals offer the opportunity to make a buck on merger arbitrage. We’ll explain how merger arbitrage is done, what can be gained from it, and what the risks are.
Merger Arbitrage Mechanics
Merger arbitrage involves making a profit in one of three scenarios: on the certainty that a company will be acquired, or that two companies will merge, or on the probability that the deal could be called off.
The most common form of merger arbitrage is when company A and B announce that their boards have agreed on an acquisition and set a price. As acquisition deals take some time to close because regulators and shareholders have to approve the deal and finances have to be available, there is always a gap between the set acquisition price and the current stock price. Making profit on this price gap is called merger arbitrage.
But there are other types of merger arbitrages. In a stock merger, a hedge fund manager often shorts the acquiring company and buys the target company. As there is always uncertainty involved in deals, the target company trades at a discount to the agreed merger price, this gap is the hedge fund’s profit. As the deal evolves, the acquiring company’s stock price should in theory decline further to reflect the full cost of what the company is paying for the acquisition. When the deal closes, the hedge fund receives shares of the acquirer and covers their short position, hopefully at a lower price.
In a cash deal, investors can seize the merger opportunity by going long the target company. When the deal closes, the difference between their entry price and deal price is their profit.
The risks involve the deal falling through for financial reasons, where the acquiring company isn’t able to round up the necessary finances for the acquisition. Due diligence outcomes can influence a change in the agreed price, and regulatory objections can postpone the deal or even prohibit it.
An example of a regulatory blocked merger involves AT&T and T-Mobile (NASDAQ: TMUS). The regulators feared that the second and fourth-largest wireless carriers in America becoming one company would create monopolistic issues.
The AT&T – Time Warner Deal
All of the above will be much clearer by analyzing the current AT&T and Time Warner merger.
On Saturday, October 22, 2016, the two companies announced their merger. It’s a definitive agreement under which AT&T will acquire Time Warner in a stock-and-cash transaction valued at $107.50 per share. Time Warner shareholders will receive $53.75 per share in cash and $53.75 per share in AT&T stock where the stock portion will be subject to a collar such that Time Warner shareholders will receive 1.437 AT&T shares if AT&T’s average stock price is below $37.411 at closing and 1.3 AT&T shares if AT&T’s average stock price is above $41.349 at closing.
Given that the current AT&T price is $36.70, Time Warner shareholders will already get less money than initially announced as $53.75 in cash and 1.437 shares of AT&T at $36.7 adds up to $106.48. If AT&T’s stock price declines further, Time Warner shareholders might get even less.
Figure 1: AT&T’s stock price last 30 days and since acquisition rumors. Source: Yahoo Finance.
On the other hand, risks of a lower payment and regulatory objections keep Time Warner’s stock price at a much lower level than the acquisition price.
Figure 2: Time Warner’s stock price. Source: Yahoo Finance.
At current prices, and if the deal closes as the companies expect before the end of 2017, investors going long Time Warner are looking at a 22.1% return. The risks come from the fact that AT&T’s stock price could decline further, albeit the 5.32% dividend yield and a PE ratio of 15.92 indicate a small possibility for long term future price declines. The biggest risk is that the deal doesn’t go through and Time Warner’s stock price returns to $78 where it was before acquisition rumors started.
So, there is an opportunity for a 22.1% positive return and an 11% decline. With the current S&P 500 earnings yield of 4% as a required market return rate, the above returns imply that the market gives a 40% chance that the deal will go through and a 60% chance that it won’t. If you think the chances are different, you can make the trade on the side you see more probable. But before jumping in and investing, there is more to know about arbitrage.
Arbitrage Insights From Warren Buffett
Warren Buffett, who is considered a long-term investor, sometimes does arbitrage in order to put his cash to the best use. In his 1988 letter to shareholders, in four questions he simply explains what you need to know about merger arbitrage:
- How likely is it that the promised event will indeed occur?
- How long will your money be tied up?
- What chance is there that something still better will transpire – a competing takeover bid, for example? and
- What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?
It all boils down to correctly assessing your required returns and the risks you are willing to take. If you have a lot of cash, a merger arbitrage with a 22.1% yearly return sounds a lot better than just buying the market where the earnings yield is only 4% and there’s a chance of a 20, 30, or even 40% fall in a bear market.
The good news is that if you don’t like the odds of the AT&T – Time Warner deal, there will be plenty of other mergers in the future that you can take part in and where if the deal falls through you would be happy holding the stock for its underlying business or until another merger comes along.