Merger Arbitrage - Kirchner Thomas

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been unanimously approved by the boards of directors of both companies, Sunoco shareholders can elect to receive, for each Sunoco common share they own, either $50.00 in cash, 1.0490 ETP common units, or a combination of $25.00 in cash and 0.5245 ETP common units. The aggregate cash paid and common units issued will be capped so that the cash and common units will each represent 50 percent of the aggregate consideration. The cash elections and common unit elections will be subject to proration to satisfy this cap. Upon closing, Sunoco shareholders are expected to own approximately 20 percent of ETP common units. In addition, $965 million of Sunoco's existing notes will remain outstanding.

      Mixed transactions with election rights can be difficult to calculate because they require some guesswork. Arbitrageurs are used to making assumptions, as we have seen in the estimation of closing dates and now again when dealing with cash/stock proration ratios. Shareholders can choose to receive either cash or stock. Arbitrageurs and some shareholders will pick the option that is worth the most. In this transaction, if the value of Energy Transfer Partners shares to be received is above $50.00 at the time of the merger, profit-maximizing shareholders will want to receive shares. If the value of these shares is less than $50, shareholders will prefer $50 in cash instead of the less valuable shares. In either case, no shareholder will accept a blend of shares and stock. The buyer would either have to pay all stock or all cash, which is not what it intended to do. For this reason, these transactions have a proration provision, so that the buyer of the firm can make the blended cash/stock payment of 50 percent stock and 50 percent cash. However, not all shareholders will seek to be paid in cash when the shares are below $50. Some shareholders fail to make a selection and will be allocated the less valuable consideration by default. Many long-term shareholders will select shares even when the cash payment is more valuable because they intend to continue to hold the shares. Strategic investors or managers will hold on to their shares. Some asset allocators may find it easier to roll their shares into the buyer's stock than reinvest themselves. Finally, the most important group selecting stock rather than cash are long-term holders who have significant appreciation in their holdings of target stock. They would be faced with an immediate tax bill if they realized a gain in the merger. By selecting stock, they can defer realization of a taxable gain into the future. Because all of these investors have a preference for stock even if the cash component is worth more at the time of the merger, slightly more cash will be paid to shareholders who select cash than if proration were applied at the stated ratio.

      In the case of Sunoco, 73.92 percent of shareholders elected to receive cash, 4.25 percent elected all stock, 2.61 percent requested to receive the 50/50 proration, and the remaining 19.22 percent did not make a selection. Shareholders who did not make a selection also received the 50/50 mix. Out of luck were shareholders who elected to receive all cash: Due to proration, they received $26.47 in cash and 0.49373 shares of Energy Transfer Partners. This shows that aiming for one of the extremes – all cash or all stock – can be a risky undertaking. An arbitrageur who hoped for an all-cash allocation would have ended up with almost half of the position exposed to the market – not quite an arbitrage. Most of the time, it is optimal to target the prorated allocation. With some experience and a study of the shareholder base, it is possible to make a rough estimate of the final proration.

      Arbitrageurs must use experience and guesswork to determine the ratio that is most likely to apply. In the next discussion, it is assumed for simplicity that the ratio of cash/stock that the arbitrageur will receive is that of the stated proration factor.

      To calculate the gross return,

      2.10

      where

      This gross return can be annualized by analogy with the previous examples.

      Mergers with Collars

      The CGA/B2Gold merger discussed above had a fixed exchange ratio of 0.74. This exposes both CGA and B2Gold to a certain market risk: If the value of B2Gold's stock increases significantly, then the 0.74 shares that CGA shareholders will receive for each share will also increase in value. In this case, the value of the transaction will be much higher than $4 billion. While CGA shareholders will be happy with this outcome, the investors in B2Gold will wonder whether they could have acquired CGA by issuing fewer shares and suffering less dilution. Conversely, if B2Gold's stock falls, then CGA's shareholders will receive less valuable shares for each B2Gold share. They would have been better off with a higher exchange ratio.

      For this reason, many merger agreements include provisions to fix the value of stock received by the target company's shareholders at a set dollar amount or at a fixed exchange ratio. The exchange ratio is adjusted as a function of the share price of the acquirer. Two reference prices are determined.

      Two types of collars are common:

      1. Fixed-value collars. Target shareholders will receive a set dollar value's worth of shares of the acquirer as long as the acquirer's share price is within a certain collar. This collar is buyer-friendly. The exchange ratio can change within the collar range. This type of collar is so common that the term fixed value is often dropped. References to a generic “collar” relate to fixed-value collars.

      2. Fixed-share collars. A set number of shares is given to the target shareholders as long as the acquirer's share price is within a certain range. If the acquirer's share price rises above the maximum, the exchange ratio declines. This collar is seller-friendly. The exchange ratio is fixed within the collar range.

The November 2012 acquisition of investment bank KBW, Inc., by Stifel Financial Corp. contained a fixed-value collar, shown in the press release in Exhibit 2.6.

Exhibit 2.6 Acquisition of KBW, Inc. by Stifel Financial Corp

      Stifel Financial Corp. (NYSE: SF) and KBW, Inc. (NYSE: KBW) today announced that they have entered into a definitive merger agreement to create the premier middle-market investment bank with a specialized focus on the financial services industry.

      Under the terms of the agreement, which was unanimously approved by the boards of directors of both companies, KBW shareholders will receive $17.50 per share, comprised of $10.00 per share in cash and $7.50 per share in Stifel common stock. Additionally, holders of certain restricted KBW shares, that will continue to vest post closing, will receive $17.50 in Stifel common stock. The stock component of the consideration is fixed at $7.50 per share, subject to a collar, provided that the volume weighted average closing price of Stifel common stock for the ten days prior to closing is between $29.00 and $35.00 per share. If the volume weighted average price rises above $35.00 per share, the exchange ratio will be fixed at 0.2143 shares of Stifel common stock for each share of KBW, and if it falls below $29.00 per share, the exchange ratio will be fixed at 0.2586 shares of Stifel common stock for each share of KBW.

      The transaction is valued in excess of $575 million, which includes the outstanding shares and restricted stock awards of KBW. Approximately $250 million in excess capital on KBW's balance sheet is expected to be immediately available to Stifel upon closing.

      In this acquisition, KBW shareholders will receive a package worth $17.50 as long as the share price of Stifel is between $29 and $35. In this case, they will receive $10 in cash and $7.50 worth of Stifel stock. For example, if the price of Stifel is $31, they will receive $10 plus 0.2419 shares of Stifel. The ratio of 0.2419 is calculated by dividing $7.50 by $31. If the price of Stifel stock falls below $29, then the ratio will be fixed at 0.2586, so if Stifel stock is worth only $25, then the value received by KBW shareholders will be only $16.47 ($10 cash, plus Stifel stock worth $25 × 0.2586). Below the lower collar boundary, KBW shareholders will participate in any depreciation of Stifel shares, as they would if the ratio had been fixed, and will receive less value than $17.50. Similarly, for a share price above the upper boundary of the collar, the value received will exceed $17.50. For example, for a price of Stifel shares of $40, KBW shareholders will receive a package worth $18.57 ($10 cash, plus Stifel stock worth $40 × 0.2143). Certainty as to the value exists only within the collar.

Readers are fortunate that the press release in Exhibit

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