Sunday, February 21, 2010

Risk Arbitrage - An Investor's Guide: Chapters 1 and 2

Here at Merger Arbitrage Investing, we will cover a number of books related to risk and merger arbitrage. Our first book, "Risk Arbitrage: An Investor's Guide" will be discussed over the next few months, in tandem with other topical posts related to current deals in the market as well as case studies. The goal is to teach the reader, the in's and out's of merger arbitrage and to equip an investor with another tool in his arsenal.

Chapter 1 of the Risk Arbitrage discusses the merger of Staples and Office Depot that ALMOST occurred in the late 90s. This merger did not go through because of anti-trust considerations and many arbitrageurs got burned. It is an interesting case study but the meat of this post will be related to Chapter 2.

Chapter 2 discusses on overview of risk arbitrage. As the author points out, risk arbitrageurs are not speculators that try to predict if XYZ company is going to be taken over. Rather, they profit from the initial merger/take-over announcement and the resulting actions post this announcement.

For this blog - we are solely going to focus on merger arbitrage with a smattering of special situations that we deem appropriate for the readership. Generally speaking, any situation we currently profile would be something that any investor, no matter their size of capital, would be able to participate in. We hope some of these operations turn out to be profitable.

As discussed in a previous post in our first merger arbitrage example, once ABC company makes an announcement acquiring XYZ company, we go about and try to find as much information about the deal as possible. Reg FD has limited some of the disclosure that market participants have been able to gleam from management / IR professionals. That being said, the reason for all this information is to determine the potential risks and rewards of the deal and the outcomes that came spawn from it.

Just as important, we try to estimate the probability that a new suitor may come along, or if the chance the deal gets shut down by the FTC, or the chance the deal simply falls apart. All these probabilities and expected rewards and risks (defined as the dollar value of loss) are rolled together to allow an investor to allocate capital in the best risk/reward fashion - and also to figure out how to hedge these capital allocations.

In doing this, many market participants have legal consultants that they interact with - these people are well versed in anti-trust / corporate law and can be a wise guide to deciphering the archaic structure that is the FTC. Further, given the volatility we saw in merger arbitrage land in 2007/2008/2009, being able to pinpoint what the definition of a MAC is or what reps/warranties need to be fulfilled for a deal to be completed is as important as ever.

Why does the "spread" exist in a merger arbitrage transaction. First, the time value of money. Second, there needs to be an implicit spread to factor in the chance that the deal does indeed fall through.

For example, when rumors circulated that the EU was having issues with Oracle's acquisition of Sun Microsystems (JAVA), the stock fells precipitously for a number of days to the point where an investor could lock in a $0.75-$1.00 dollar spread on a $9.50 takeover price. And the deal was supposed to close in a few months. The reason? The market was pricing in that the deal probably would not go through - that being said, if you had other thoughts, you could of made a pretty penny on this transaction.

Next week, we will start digging into some calculations so investors can calculate their investment returns on merger arbitrage and risk arbitrage situations.


About the Authors

Hunter is the founder of the Distressed Debt Investing Blog and the Distressed Debt Investors Club. He has worked on the buy side for the past 7 years in high yield and distressed debt investing.

Edward has been a professional investor for four years, focusing mainly on the event-driven space. His investment philosophy is value-based, and he spends the majority of his time identifying near-term catalyst based opportunities.


hunter [at] distressed-debt-investing [dot] com