Wednesday, February 24, 2010
One of the most important aspects of a merger arbitrage transaction is the regulatory process. How a deal is deemed from an antitrust standpoint is critical, as failure to receive regulatory approval can derail an agreement. On 3Com, the company agreed to be acquired by Hewlett-Packard on November 11, 2009 for $2.7 billion ($7.90/share). 3Com is a familiar name to the arb community, as it was involved in a deal that was terminated because of regulatory issues.
For background, Bain Capital agreed to acquire 3Com on September 28, 2007 for $2.2 billion ($5.30/share). As a part of the transaction, Huawei Technologies (a Chinese firm) would acquire about 17% of 3Com and become a commercial and strategic partner. Shortly after the merger announcement, all the talk was about the scrutiny that US regulators would use to evaluate the deal. 3Com sells telecommunications systems to US government agencies, and the Chinese government had recently made publicized attacks on US government networks. The thought was that a party who is critical of US networks would have say in the strategic direction taken. (As a side note, Huawei’s president is Ren Zhengfei, a former officer in the People’s Liberation Army.) In early October of 2007, Bain and Huawei filed for a review by the Committee on Foreign Investment in the United States (CFIUS). Then came the influx of letters and resolutions from Congressman who sought to block the deal on national security concerns. In late February of 2008, the acquirers withdrew their CFIUS filing, and the stock, already at $3.73/share immediately dropped to $2.87/share. The shareholder vote was subsequently postponed twice, to further address CFIUS concerns, and two days before the vote was to be held, Bain terminated the agreement out of CFIUS fears. This left 3Com at $1.98/share, a far cry from the $5.30/share deal price.
With that bit of history, the first thought in arbs’ minds when the Hewlett-Packard deal was announced was “China”. Obviously, this transaction does not have the same risk as one with Bain and Huawei, since there is no national security concern. It does still, however, hinge on approval from China’s Ministry of Commerce. China initiated its review on December 29, 2009, and initiated a Phase II review period on January 27, 2010. The initial Phase II review lasts up to 90 days, with a possible extension of up to an additional 60 days. Your annualized return is diminished if you think a deal will close on a certain date, but regulatory issues prolong (or worse, prevent) its completion. Arb names only move on events like this if they were not priced in, and indeed, a Phase II review was largely factored into 3Com (closed at $7.55/share before the Phase II was announced).
So, with no national security concern, what is holding up China from approving the merger? We don’t know, exactly, since China is notoriously one of the least transparent regulatory bodies in the world. Some believe that China might block the deal to retaliate against the US for CFIUS’ past with Huawei’s attempt to take a 3Com stake. In January, the fear was that a block could follow Google’s threat to leave China. At the current $7.63/share, we are provided a 3.5% return (20% annualized to a late-April close) if the merger is successful. Excluding the China factor, this deal would have about half that return. However, arbs have priced in a discount due to this risk. From a pure antitrust perspective, approval should be granted, since the deal simply transfers ownership from one US owner to another. What will ultimately happen? This highlights the “risk” in “risk arbitrage”.