the valuation models inappropriate and therefore cause problems to the strategy.
Inversely, volatile and choppy markets with erratic price moves but generally showing ‘normal’ valuation levels create positive environments for Equity Market Neutral strategies.
3 ■AIS: Hedge funds and Managed Futures
A successful Risk Arbitrage strategy relies strongly on fundamental research of the involved companies and the issues surrounding the deal, such as legal and regula- tory (e.g. anti-trust) matters. The deals are often highly complex and the task of the manager is more related to risk management than to stock picking.12 Important elements of the analysis include the following:
■ Analysis of publicly available informationon the companies involved in the transaction. This includes the competitive environment in which they operate, their financial position, assessment of the quality of management and anti- trust concerns.
■ Assessment of the buyer’s motivation for the merger or acquisition as well as the impact of the contemplated transaction on his reputation, competitive position and financial performance. A review of the buyer’s past acquisition history might provide interesting insights.
40
31.12.99 31.01.00 29.02.00 31.03.00 30.04.00 31.05.00 30.06.00 31.07.00 31.08.00 30.09.00 31.10.00 30.11.00 31.12.00
50 60 70 80 90 100 110 120 130
Acquirer Target
FIGURE 3.5■Spread convergence in successful merger deals (illustration) 8409 Chapter 3 p38-110 11/4/02 1:13 PM Page 61
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
■ Evaluation of potential informationregarding business developments at the target company which might undermine the proposed transaction. Many uncompleted mergers fail because the target company’s situation deteriorates unexpectedly.
Detailed analysis of the business and competitive environment as well as the financial situation of the target company is essential for an assessment of this risk.
■ Assessment of the efficiency of any anti-takeover devicesavailable to the target company (poison pills, golden parachutes etc.).
■ Assessment of the strategic rationale of the transaction. The merging
companies should realize valuable strategic opportunities, such as geographic, product or distribution expansion, new technological integration or
applications, significant cost savings or other synergies.
■ Financial analysis(cash flow estimates, ratio analysis etc.) of the post-merger outlooks(pro-forma financial forecasts). This includes an analysis of the amount of funding available for the merger and in what form funding is available (e.g. stock, cash, LBO). Detailed financial analysis provides important insights for assessing the probability that the merger will be completed.
■ Consideration of the background of the merger. The operational and financial history of the companies have to be examined. The manager should know about the merger history of the involved companies, who initiated merger talks and whether there have been discussions about a merger with other companies before. It is also important to examine whether key management interests have been addressed. Some mergers fail because of disagreement over the future roles of senior management (often CEOs).
■ Review of valuation parameters. The valuation analysis should determine whether the price being paid for the target company is excessive relative to the buyer’s business strategy, the market valuation of comparable companies in the particular industry and the target company’s competitive position and financial performance.
■ Calculation of the spread on the deal. The spread is the difference between the price offered for the acquired company and the current market price. Based on the spread, the manager calculates the return expected on closure of the deal.
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■ Examination of merger conditions. The terms of the transaction can contain conditions which may significantly impact the likelihood of the transaction completing and which therefore must be carefully assessed. Such conditions may include walk-away clauses, price provisions related to the acquirer’s stock, financing contingencies, earnings tests, pending completion of due diligence, minimum shares to vote in favour of the merger, revenue or profit hurdles or possible debt covenants.
■ Estimate of the likelihood of regulatory interference with the dealand the likely outcome of such. The constant monitoring of applications for regulatory clearances is vital for Risk Arbitrage strategies. Different regulatory agencies have to be considered (from the perspective of a US merger): Federal Trade Commission (FTC)/Justice Department, SEC (must approve merger proxies), individual states, specific industry (banks: Federal Reserve, utilities: Federal Energy Regulatory Commission, communication: Federal Communications Commission) and foreign regulatory agencies (e.g. EU, specific countries).
All this information is necessary for making an informed assessment of the risk of a proposed transaction failing. A transaction can fail for a wide range of reasons due to anything from failure to achieve the required shareholder approval, to neg- ative earnings news from the target company and a significant drop in the stock price of the acquiring company. Along with the assessment of the probability of a transaction failing, one must estimate the financial impact of such an event. The stock price before the deal announcement can serve as a general guide as to where stock prices might go in case the deal does not go through. However, in many cases applying a discount to the target company’s pre-announcement stock price is appropriate. The failure of a merger is often caused by fundamental issues (e.g.
earning revisions of target company) and the market will probably value the target company lower than before.
Information sources for this last analysis are stock market valuation, trade data sources, past enforcement policies of justice department (DOJ), Federal Trade Commission (FTC) and anti-trust agencies, discussions with management, invest- ment bankers and legal advisors, court hearings and press publications.
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MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
Risk Arbitrage managers differ in the amount of deal risk they are willing to take as well as the level of leverage and diversification employed. Most managers only invest in announced transactions and some even invest only in deals that are sufficiently progressed towards completion. Others enter in positions with higher deal risk (and therefore wider spreads) and a few base their investment decisions on rumours or speculation about possible transactions. Managers also distinguish themselves with respect to sectors and geographical location.
The two basic types of merger offers are a cash tender offer, where a fixed amount of cash is offered for the acquired company’s stock, and a stock swap, where stock of the acquiring company are being offered at a fixed ratio in exchange for the stock of the acquired company. More complex features of a merger transaction are cases in which the exchange ratio is based on the price of the acquiring company’s stock when the deal is closed or those in which the target firm can call off the merger if the acquirer’s stock falls below a certain value. In these situations, the manager has to adjust its hedges constantly and unwind positions if the price falls below the floor value. The chosen merger procedure can affect the balance sheet of the combined company drastically. While cash offers have to be accounted for by the ‘purchase method’ in the USA, in mergers processed through an exchange of stock, the compa- nies can under some circumstances employ the ‘pooling method’.13
E X A M P L E S
The following two examples illustrate the way returns can be achieved for a stock swap transaction and a cash tender offers.14
Stock swap
Assume Bank A and Bank B announce a merger structured as a stock swap in which each holder of one share of Bank B is entitled to receive 0.84 shares of Bank A. The merger is to be completed in 90 days. Bank A and Bank B pay dividends of 39 cents and 37 cents respectively during this period. Assume a manager buys 10,000 shares of Bank B at 281/2 per share for a total cost of $285,000 and sells short 8,400 shares of Bank A at 351/2 8409 Chapter 3 p38-110 11/4/02 1:13 PM Page 64
3 ■AIS: Hedge funds and Managed Futures
per share for a total credit of $298,200. Because of the leverage (2:1), the manager will be required to post 50% of the value of the long position ($142,500) and 50% of the value of the short position ($149,100) with the prime broker, thus resulting in a total cash outlay of $291,600. Assume the manager finances the balance of the long position ($142,500) at an annual- ized rate of 63/4 % for 90 days for a total cost of ($2,371.75). Further assume that the manager receives a short stock rebate of 5.1% annualized on $298,200 for the period of 90 days, which is $3,749.97 and that the manager’s transaction costs equal ($184) or one cent per share. The net profit on this transaction upon completion of the merger is as follows:
Bank A / Bank B spread $ 13,200.00
Transaction costs (184.00)
Bank A dividend (short) (3,276.00) Bank B dividend (long) 3,700.00
Financing costs (2,371.75)
Short stock rebate 3,749.97 –––––––––
Profit $ 14,818.22
$ 14,818.22 365
Annualized return is ––––––––– × ––– = 20.61%
$ 291,600.00 90 Cash tender offer
Assume X Corp. receives a $17.50 cash tender offer from Y Corp. on February 1 and that the tender offer expires on March 5 . Further assume that the price of X Corp. was 17.25 on February 1 and that the manager purchases 500,000 shares at that price. The cash outlay for a manager will be 50% (leverage 2:1) of the purchase price of the stock ($4,312,500). Assume the manager can finance the remaining balance of $4,312,500 for 34 days at a rate of 63/4% per annum for a cost of $27,115.58 and that the manager’s transaction cost is one cent per share ($5,000).
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The net profit therefore is:
Net cash proceeds $ 125,000.00 Financing costs (27,115.58) Transaction costs (5,000.00) ––––––––––
Profit $ 92,884.42
Annualized return is $ 92,884.42 365 days
––––––––– × –––––––– = 23.12%
$ 4,312,500 34 days Sources of return
The inherent return of Risk Arbitrage strategies is the risk premium for taking exposure in deals with uncertain closing. This is referred to as the ‘deal risk pre- mium’. The Merger Arbitrage manager assumes the risk that the deal could fail in which case the manager assumes large losses. The strategy is thus similar to a short option on the close of the deal.
Risk factors
The downside risk of a Risk Arbitrage position is large compared to the expected return if the merger succeeds. The premium paid by the acquirer in a merger deal, which is the difference between the acquired company’s market price right before the merger announcement and the offer made by the acquirer, is usually large compared to the remaining spread between offer price and market price after the announcement of the deal. The risk profile of a typical Risk Arbitrage position is thus comparable to a short position in an option. The manager receives a (more or less predetermined) risk premium for entering the position in return for accept- ing the risk of significant losses if the merger fails.
Risk Arbitrage positions are a ‘bet on the merger completion’. The strategy’s principal risk factor is thus deal risk. Deal risk includes everything that affects the completion of the merger or the timing of it, e.g. the risk of the acquirer getting
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES 8409 Chapter 3 p38-110 11/4/02 1:13 PM Page 66
3 ■AIS: Hedge funds and Managed Futures
out of the deal, the risk of lack of shareholder support, or the risk of (federal or state) regulators not approving the deal. These risks are influenced by a number of different factors:
■ Financial position of the acquirer. Certain market factors (interest rates rise, stock market downturn) can worsen the financial status of the acquirer leaving him unable to finance and complete the transaction.
■ Earnings. A sudden decline in the target’s earnings may make a deal fail.
Different market factors can cause earnings to deteriorate.
■ Size of the premium. The higher the premium (difference between offer price and market price before the merger announcement) paid in the transaction the higher the downside risk.
■ Market sentiment. A general downturn in broad equity markets can increase insecurity about mergers going through.
■ Regulatory concerns. Regulators influence the deal uncertainty spreads as they affect directly the likelihood of deal completion. An example of regulatory disapproval causing a deal to fail is the General Electric/Honeywell merger in June 2001. When the European Commission announced that it was unwilling to approve the merger for anti-trust reasons, the spread widened from 5 to 36% within two days (see Figure 3.6).
■ Consideration. The form of the proposed transaction (stock swap, cash or any combination) can influence the deal probability.
■ Time to completion. A delay in the completion of the deal can significantly reduce the expected return.
Cash deals are not completely market neutral, because the manager cannot hedge market risk with short position in the acquirer’s stock. In case the merger is not completed the position is additionally exposed to the risk of market declines. Other risk factors of the strategy are liquidity risk and deal flow risk. Lack of sufficient market depth and liquidity can become a problem for small cap positions. The returns of Risk Arbitrage managers depend on the number and the ‘quality’ of merger transactions. In times when merger activity is high (as in 1999) Merger
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MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
Arbitrage is very profitable compared to environments where deal flow is declining and deal quality deteriorating (as in early 2001). The returns earned by Risk Arbitrage strategies are not independent of general equity valuation levels. Deal flow and quality are usually higher in equity bull markets. Companies are more likely to initiate mergers in times of rising equity markets, when the economic outlook pro- vides the necessary comfort and high stock prices provide ready currency for mergers. Sharp equity declines can widen spreads and increase deal risk.
Consequently, Risk Arbitrage strategies face market riskin forms of extreme volatil- ity and deteriorating deal flow. The strategy is also exposed to interest rate risk, as significant and unexpected rises in interest rate increase borrowing costs and make it more difficult for the acquirer to finance the deal. Furthermore, higher interest rates might negatively affect the acquired company’s earnings.
As Merger Arbitrage strategies involve short selling of stock, the strategy is exposed to the specific risks of Short Selling (shorting risk) connected to the fact that the short seller has to borrow stock (e.g. short squeezes, risk of dividend increase, execution risk). These risks will be discussed in detail in the section on
0
11.05.01 18.05.01 25.05.01 01.06.01 08.06.01 15.06.01 22.06.01
10 20 30 40 50 60
GE HON Spread
0%
45%
40%
35%
30%
25%
20%
15%
10%
5%
FIGURE 3.6■Price and spread development for the GE–Honeywell deal (rejected by the European Commission on 15 June 2001)
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Short Selling. Operational riskfactors include unfavourable trade executions (bad fills, slippage, clumsy order execution by the broker) and wrong information (this includes fraud riskdue to manipulated financial statements).
Highly volatile markets combined with increasing interest rates create an envi- ronment where Risk Arbitrage strategies are the most vulnerable. Insecurity about earnings, stock prices and future economic outlook usually decrease the number of announced deals dramatically and mergers are more likely to break up. An example for an unfavourable period for Risk Arbitrage strategies was the first half of 2001, when Risk Arbitrage managers suffered significant losses. Generally, peri- ods of falling interest rates and normal to low market volatility are positive for the strategy. It is interesting to note that positive and negative market environments for Risk Arbitrage strategies are somewhat the opposite to those for Convertible Arbitrage strategies. A combination of these two strategies provides good diversifi- cation benefits in a multi-strategy AIS portfolio.