Merger Arbitrage - Kirchner Thomas

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converted into 0.74 shares of B2Gold. For each share of CGA purchased, the arbitrageur must sell short 0.74 shares of B2Gold. By multiplying the exchange ratio with the stock price of B2Gold, it can be seen that per share of CGA an arbitrageur receives C$2.923 (0.74 × 3.95) from the short sale of B2Gold. The spread is hence C$0.063 per share of CGA.

      The return calculation is simplified here in that no dividends need to be taken into account. Neither of the two companies has ever paid any dividends, and there was no reason to believe that this would change prior to the closing of the merger.

      2.5

      where

      The gross return on this arbitrage is 2.2 percent.

      Calculation of the annualized return works as in the example of a cash merger. Only the calculation of compound returns is shown here; simple interest can be calculated analogously. Unlike in the prior examples, the arbitrageur cannot find a direct reference to the closing date in the press release. “The merger will be implemented by way of a Scheme of Arrangement under the Australian Corporations Act 2001” gives a valuable hint. As I will explain later, a scheme of arrangement follows a well-defined timetable. A five-month time frame is a reasonable estimate. If we assume a closing date of February 28, 2013, then there are 162 days from September 19, the day the position was entered.

      Compound interest

      2.6

      The expected annualized return at the time of entering the position is 5.0 percent. The actual closing of this merger occurred on January 18, 2013, so the actual return on this arbitrage was an annualized 6.9 percent over 121 days.

      One of the advantages of stock-for-stock mergers is the simultaneous holding of a long and a short position. Because of the upcoming merger, the two stocks are highly correlated, so that an increase in CGA's stock price is accompanied by an offsetting increase in B2Gold's. If the two stocks were no longer to move in parallel, the spread would change, and the annualized return available to arbitrageurs would either compress or expand.

However, as the fluctuations in the two stocks mostly cancel out due to the short position in B2Gold, the net result for the arbitrageur is a much smoother ride than what an index investor experiences. The evolution of the spread of the CGA/B2Gold merger is shown in Figure 2.5. In the case of a cash transaction, the spread depends on only one variable. In a stock-for-stock merger, it depends on two stock prices. The spread does trend toward zero over time. The spread is not very smooth on an absolute basis. But compared to the gyrations in the index over the same time, the volatility is much lower.

Figure 2.5 Evolution of the CGA/B2Gold Spread

It is clear that short sales from arbitrage activity can lead to significant selling pressure on the stock of a buyer after the announcement of a stock-for-stock merger. Often analysts and journalists attribute the drop of a buyer's stock after a merger announcement to fundamental reasons, such as the prospect for the merged entity. One account of the trading activity following the announcement of the merger of Trane Inc. with Ingersoll-Rand is shown in Exhibit 2.3. Ingersoll-Rand fell over 11 percent following the announcement of the merger. The fundamental reasoning behind this merger appeared solid. Some reports suggested that the combination of the two firms created the number-two air-conditioning company in the United States. The long-term prospects of Ingersoll-Rand clearly were not bad and would not have justified an 11 percent drop. It can be explained only by arbitrage activity. Experienced investment bankers warn company management during merger negotiations of the risk to their stock price and suggest structures with a cash component to a stock-for-stock merger in order to reduce short selling.

Exhibit 2.3 Account of Ingersoll-Rand's Acquisition of Trane for $10.1 Billion, Creating Climate Control Behemoth

      TRENTON, N.J. (AP) – In a deal worth a cool $10 billion, Ingersoll-Rand Co. will acquire Trane Inc. and create one of the world's largest makers of commercial and residential home air conditioners, refrigerators for trucks and stores, and other climate control products.

      But some Ingersoll-Rand shareholders, who had expected the cash-rich company to pour some money into share repurchases, seemed disappointed with the acquisition announced Monday and sold Ingersoll-Rand stock, driving shares down sharply.

Merger arbitrage is attractive to many investors as a portfolio diversifier because of its long/short components. It is assumed that these positions immunize the portfolio against fluctuations in the overall stock market and leave only uncorrelated event risk to the investor, and therefore, the portfolio is market neutral. This argument is revisited in more detail in Chapter 3. Nevertheless, at this point, a short discussion of one of the pitfalls of long/short positions is necessary. A constant percentage spread can lead to dollar paper losses in an extreme bull market, if both the long and the short position increase, but the percentage spread remains constant. Table 2.2 illustrates the problem of a hypothetical increase of CGA and B2Gold when the percentage spread remains constant throughout the increase. The losses discussed here are temporary only and will eventually be recovered once the merger closes.

Table 2.2 Losses Suffered at a Constant Percentage Spread in a Rising Market

      Table 2.2 starts in the first row with the actual spread of 2.20 percent at prices of C$2.86 and C$3.95 for CGA and B2Gold, respectively. It shows the profit and loss (P&L) relative to a position entered at the baseline of C$2.86 and C$3.95. If both CGA and B2Gold rise and the percentage spread remains constant, then the spread expressed in dollars must rise (2.2 percent of $5.72 is more than 2.2 percent of $2.86). The simulated price rise in Table 1.3 shows that a spread of $0.063 will widen to $0.126 per share if CGA were to double in value to $5.72 per share. Although B2Gold's stock appreciates by the same percentage as CGA, the difference in dollar terms increases. At $5.72 per share, the arbitrageur's portfolio would record a loss of $0.063 per CGA share (last column).

      This scenario does not imply inefficiency in the market. If the hypothetical increase in spreads were to occur on the same day as the position was entered, the annualized return would be unchanged, because the percentage spread is the same whether CGA trades at $5.72 or at $2.86.

      It is clear that these losses are only paper losses that are temporary. As long as the merger eventually closes, the arbitrageur will realize a gain of $0.063. Only those who panic and close their position early will suffer a real loss. The arbitrageur is short 0.74 shares of B2Gold for every long position of CGA, and the cash changed hands already when the trade was made. Therefore, the eventual profit is certain as long as the merger closes. In the meantime, however, the account will show a loss.

      Whether or not an arbitrageur wants to hedge against paper losses is a matter of personal preference. Any hedging transactions will entail costs and will reduce the return of the arbitrage. Because the spread eventually will be recovered, it makes little sense to hedge against transitory marked-to-market losses.

      Now what would happen if stock prices were to fall? It can be extrapolated from this discussion that in the case of a fall in stock prices, the dollar spread will tighten, and the arbitrageur will record a gain even though the percentage spread and the annualized return would remain unchanged.

      Sometimes shareholders hold a number of target shares that does not get converted to a round number of buyer shares. For example, a holder of 110 shares of CGA would receive 81.4 shares of B2Gold. However, the

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