Merger Arbitrage. Kirchner Thomas

risk spectrum in Figure 1.3.

      The remainder of the book addresses transactions in which a definitive agreement has been reached.

Merger arbitrage resembles in many respects the management of credit risk. Both are concerned with the management of a large asymmetry in payoffs between successful transactions and those that incur losses. A typical stock investor is faced with an almost symmetric payoff distribution (see Figure 1.5). The stock price is almost as likely to go up as it is to go down. The likelihood of a small gain is roughly the same as the likelihood of a loss of equal size. Larger changes in value are also almost equally likely. The downside is unlimited, or limited only by a complete loss of the investment. The upside, however, is unlimited. Every now and then, an investor gets lucky and owns the next Microsoft or Berkshire Hathaway. A small upward drift in stock prices means that in the long run, stocks trend up.

Figure 1.5 Payoff Distribution for Stock Investors

The situation is different for merger arbitrage and credit managers (see Figure 1.6). The upside in a merger is limited to the payment received when the merger closes. Likewise, the most credit managers will receive on a loan or bond is the interest (or the credit spread if they manage a hedged or leveraged portfolio). The downside is unlimited: If a merger collapses or a loan goes into default, a complete loss of capital is possible in a worst-case scenario. The only reason why investors are willing to take risks with such an asymmetric payoff distribution is because the probability of a large loss is very small and the probability of a small gain is very large. The skill in merger arbitrage, as in credit management, is to eliminate investments that have a high probability of generating losses.

Figure 1.6 Asymmetric Payoff Distribution

Another field in finance has payoff distributions very similar to those of merger arbitrage and credit: option selling. An option seller expects to make only a small return in the form of the option premium but can suffer a significant loss when the option is in the money. Option strategies are often depicted in payoff diagrams, such as that of a short (written) put option in Figure 1.7. In 1873, Henri Lefèvre, the personal secretary of James de Rothschild, pioneered the use of these diagrams for option payoffs. If at expiration the stock price rises above the strike price, the option seller will earn only the premium. However, if the stock price falls below the strike price, the option seller will suffer a significant loss. Merger arbitrage and credit resemble this payoff pattern. Figure 1.8 shows the payoff diagram for a simple merger arbitrage, where a buyer proposes to acquire a company for cash consideration. If the transaction passes, the arbitrageur will receive only the spread between the price at which she acquired the target's stock and the price at which the firm is merged. However, if the merger collapses, the stock price probably will drop, and the arbitrageur will incur a loss that is much larger than the potential gain if the merger is closed.

Figure 1.7 Lefèvre Diagram of the Put Option Characteristics of Merger Arbitrage

Figure 1.8 Lefèvre Payoff Diagram of Cash Mergers

      From an arbitrageur's point of view, the most important characteristic of a merger is the form of payment received. Therefore, in merger typology arbitrageurs use payment method as the principal classifier. Other merger professionals, such as tax advisers or lawyers, often use other criteria to categorize mergers. For example, tax advisers distinguish between taxable and tax-exempt mergers, whereas legal counsel may distinguish mergers by its antitrust effect. There are three principal categories of mergers and one rare category:

      1. Cash mergers. The shareholders of the target firm receive a cash consideration for their shares.

      2. Stock-for-stock mergers. The shares of the target firm are exchanged for shares in the acquirer.

      3. Mixed stock and cash mergers. The target company's shareholders receive a mix of cash and a share exchange.

      4. Other consideration. In rare instances, shareholders of the target firm receive debt securities, spun-off divisions of the target, or contingent value rights. The next chapter will show how each of these types of mergers can be arbitraged.

Chapter 2

      The Mechanics of Merger Arbitrage

      This chapter discusses the first three types of merger consideration and how arbitrageurs will set up an arbitrage trade and profit from it:

      • Cash mergers

      • Stock-for-stock mergers

      • Mixed stock and cash mergers

      Cash Mergers

      The simplest form of merger is a cash merger. It is a transaction in which a buyer proposes to acquire the shares of a target firm for a cash payment.

We will look at a practical example to illustrate the analysis. An announcement for this type of merger is shown in Exhibit 2.1, which is the press release announcing the purchase of Autonomy Corporation, a U.K. – based infrastructure software firm, by Hewlett-Packard Co. It is typical of announcement of cash mergers.

      The terminology used in mergers is quite straightforward: A buyer, HP in this case, proposes to acquire a target, Autonomy here, for a consideration of £25.50 per share. The difference between the consideration and the current stock price is called the spread. When the stock price is less than the merger consideration, the spread will be positive. Sometimes the stock price will rise above the merger consideration, and the spread can become negative. This happens occasionally when there is speculation that another buyer may enter the scene and pay a higher price.

      In a cash merger, the buyer of the company will cash out the existing shareholders through a cash payment, in this case £25.50 per share. An arbitrageur will profit by acquiring the shares below the merger consideration and holding it until the closing, or alternatively selling earlier.

      Arbitrageurs come across press releases as part of their daily routine search for newly announced mergers. This one was released on August 18, 2011, at 4:10 pm Eastern Standard Time, which was 9:10 pm British Summer Time, when markets both in Europe and the United States were closed. For regulatory reasons, companies announce significant events like mergers after the end of regular market hours or in the morning prior to the opening. This is meant to prevent abuse by investors with slightly better access to news. With the growing importance of after-hours trading and the availability of 24-hour trading of U.S. stocks through foreign exchanges, this restraint has already become somewhat pointless but is still considered best practice.

Exhibit 2.1 Press Release Announcing Acquisition of Autonomy by HP (Extract)

      PALO ALTO, Calif., and CAMBRIDGE, England, Aug. 18, 2011 – HP (NYSE: HPQ)