Wednesday, February 24, 2010

Merger Arbitrage Fundamentals: HPQ and COMS

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”.


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.


Monday, February 8, 2010

How to Read a Merger Agreement Part 1

How to Read a Merger Agreement

The merger agreement (sometimes called the “DMA”, for definitive merger agreement) is an important step in understanding a deal. The merger agreement is the legal tool through which the parties distribute risks between the target’s and bidder’s shareholders in relation to the road that, hopefully, leads to the closing of the merger. The DMA is usually filed with the SEC within three days of a deal’s announcement. Much of the DMA’s language is usually standard, however, one should never take this granted.

Fully understanding the merger agreement will come handy if the merger process becomes tumultuous somewhere down the road: there may be a counter bidder emerging, the transaction may face unexpected regulatory hurdles, or the economy may deteriorate, rendering the strategic rationale for the merger obsolete.

We will explain how to review a typical merger agreement, and the key sections of the document.


This section is, in general, less important for cash deals. It can be important for stock deals, since this is where the collar, if any, is detailed, and it also describes any pricing period.

Closing and Effective Time

For both cash and stock deals you can find information related to closing and the effective time of the transaction. These are, for the most part, not essential, as they tell within how many days a merger closes once all conditions to the merger are satisfied. However, for private equity deals, this section could be important: in private equity deals there usually is a marketing period for the syndication of loans that finance the takeover. The marketing period could be important: it could delay closing of the merger and could have a negative effect on the deal spread (e.g. have a look at Article 1 of the IMS Health/TPG DMA)

Closing Conditions

DMA’s are not binding on the parties unless the closing conditions are satisfied or waived (if allowed). In effect, they define the contingencies under which the parties are free to walk away from the deal. This is very important.

The closing conditions fall largely into four categories: (i) representations and warranties, (ii) material adverse change or material adverse effect (MAC/MAE) conditions, (iii) covenants, (iv) exogenous conditions (such as regulatory approvals). Most of these conditions are cross-references with other clauses and articles of the DMA. So every condition has to be analyzed and checked whether it is cross-referenced with some other clauses in the text.

Reps and warranties

These clauses are usually of less importance. To address the substantial gap between the seller’s and buyer’s information concerning the target company, the seller typically makes a set of contractual representations and warranties. It represents that these facts are true both at the time of the agreement and at closing. However, note that MAC is more than likely to show up in the reps and warranties section. In addition, in pharma/biotech transaction material, drugs could be references in this section, so be careful not to miss this section.


Most large acquisitions include a condition that allows the buyer to avoid closing upon the occurrence of a MAC. Definitions vary among agreements. They are usually subject to carve-outs for excluded categories of events (except to the extent that they have a “disproportionate” effect on the target). The carve-outs are very important. The broader the carve-outs, the more risk the acquirer bears. Carve-outs can range from general economic and political conditions, to market prices and revenue projections of the target.

Sometimes MAC clauses very explicitly define what constitutes a material adverse effect: for pharma companies, this could an upcoming FDA approval for a certain drug, or for an oil exploration company, a possible legislative action related to a specific extraction process such as fracturing.

For Delaware incorporated companies, the courts interpret MAC clauses narrowly, to encompass only unanticipated events or changes that materially and adversely affect the longer term value of the target. So, historically, it has been difficult for acquirers to successfully invoke a MAC/MAE clause.


The satisfaction or waiver of the seller’s covenants is a closing condition. A covenant violation triggers the buyer’s option to terminate the DMA. The covenant clause usually contains the so called “reasonable best efforts” language.

Sections that define reasonable best efforts give important clues to the original intentions of the parties, as to what they expect to do in certain circumstances. In relation to regulatory approvals, one can find the timeframe for regulatory approvals, whether the parties are willing to go to court if the deal is challenged. Reasonable best efforts language might also reveal how far the bidder may went to obtain financing for the deal.

Exogenous conditions

The two most common conditions are related to the financing and regulatory approvals of the deal.

The financing section is cross-referenced with a specific section on financing (apart from the reasonable best efforts language). The financing section is where any committed financing is detailed. Some transactions are funded with cash on hand, some by newly issued equity, and others through a combination of sources, which include bonds and loans. Of course, an investor can obtain a more thorough examination of the funding from a study of any credit agreements or indentures. Careful consideration must be given to the reliability of the lenders.

Exogenous conditions also provide a more detailed a list of regulatory approvals required for the deal to close. This condition is usually cross-referenced. The covenant section could limit the parties’ ability to offer remedies to regulatory authorities. Some merger agreements limit the types and value of the assets that could be offered for divestiture to satisfy antitrust authorities. A lot of times, the regulatory approval process is the main reason for a fairly wide deal spread.


The key pieces in this section are the termination date (sometimes called the “outside date”) and the termination fee. The termination date is when the agreement becomes void. It can have an extended date, which upon the election of the target and/or the acquirer, prolongs the agreement, usually for the sake of receiving regulatory approvals. Termination fees generally range between 3% and 4% of the initial deal value. Transactions can also have reverse termination fees, which are payable by the acquirer, and are historically as high or higher than the basic termination fee. The idea behind a higher reverse termination fee is to prohibit the buyer from walking from the deal.

Specific Performance

An order of specific performance requires a party to perform a specific act (in this case, complete the merger). Here is an example of a specific performance clause, from Silicon Storage Technology’s merger agreement with Microchip Technology, dated February 2.

“Each of the parties hereto acknowledges and agrees that, in the event of any breach of this Agreement, each nonbreaching party would be irreparably and immediately harmed and could not be made whole by monetary damages. It is accordingly agreed that the parties hereto (a) will waive, in any action for specific performance, the defense of adequacy of a remedy at law and (b) shall be entitled, in addition to any other remedy to which they may be entitled at law or in equity, to compel specific performance of this Agreement in any action…”

Governing law

This is usually a standard clause, but could become interesting if the merger process hits a rocky road. One recent example for an interesting case is Apollo’s acquisition of Cedar Fair. New York law is the governing law and venue for litigation. Choosing the laws of New York as governing law is a rare event for Delaware incorporated companies. A new research paper by Cain and Davidoff (”Delaware’s Competitive Reach: An Empirical Analysis of Public Company Merger Agreements“) evaluated the selection of governing law and forum clauses in merger agreements between public firms during the period 2004-2008. They found that, among Delaware-incorporated targets, 91% select Delaware law. So the question arises, which party gains by choosing New York as the governing law and venue of litigation? We will come back to this question in a later posting.


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