Merger Arbitrage. Kirchner Thomas

plc (LSE: AU. or AU.L) today announced the terms of a recommended transaction under which HP (through an indirect wholly-owned subsidiary, HP SPV) will acquire all of the outstanding shares of Autonomy for £25.50 ($42.11) per share in cash (the “Offer”). The transaction was unanimously approved by the boards of directors of both HP and Autonomy. The Autonomy board of directors also has unanimously recommended its shareholders accept the Offer.

      Based on the closing stock price of Autonomy on August 17, 2011, the consideration represents a one-day premium to Autonomy shareholders of approximately 64 percent and a premium of approximately 58 percent to Autonomy's prior one-month average closing price. The transaction will be implemented by way of a takeover offer extended to all shareholders of Autonomy. A document containing the full details of the Offer will be dispatched as soon as practicable after the date of this release. The acquisition of Autonomy is expected to be completed by the end of calendar 2011.

      […]

The first observation an arbitrageur will make is that the stock of Autonomy jumped immediately upon the announcement of the merger. As can be seen in Figure 2.1, Autonomy closed at £14.29 on August 18, the last day before the announcement of the merger. It opened at £25.27 on August 19, quickly peaked at £25.29, and moved down for the rest of the day to close at £24.52. Some unfortunate investors bought shares at the opening price, and because there must be a seller for every buyer, some lucky sellers parted with their investment at the high price for the day. An investor who wanted to enter into an arbitrage on this merger had a realistic chance of acquiring shares at the day's average price of £24.92. Volume that day was brisk: While it had averaged just under 1 million shares per day (precisely 0.97) over the prior month, it reached 48.6 million on August 19 and averaged 3.7 million per day over the next month. Therefore, the assumption that an arbitrageur could have obtained that day's average price is reasonable.

Figure 2.1 Stock Price of Autonomy before and after the Merger Announcement

A chart like that shown in Figure 2.1 is typical of stocks undergoing mergers. The buyout proposal is generally made at a premium to the stocks' most recent trading price. This leads to a jump in the target's stock price immediately following the proposal. As time passes by and the date of the closing approaches, the spread becomes narrower. This means that the stock price moves closer to the merger price. An idealized chart is shown in Figure 2.2, whereas Autonomy's actual chart is more typical of the behavior of most such stocks. Figure 2.1 also shows the FTSE index, the stock index considered a reference for the London market. Its axis has been scaled (right-hand side) to match the percentage change in Autonomy's stock price. If Autonomy and the FTSE have the same percentage change, then their respective lines will move by the same magnitude in the graphic. It can be seen that prior to the merger announcement, Autonomy's moves on a daily basis match those of the FTSE very closely. After the announcement on August 19, Autonomy and the index no longer move in tandem. This is a good visual illustration at the micro level of the low correlation that merger arbitrage has with the overall stock market. Fluctuations in the index do not impact Autonomy once it becomes the target of an acquisition.

Figure 2.2 Idealized Chart of Stock in a Cash Merger

      In some instances, the buyout proposal is made at a discount to the most recent trading price. This rarely happens and is limited to small companies where the buyer is in a position to force the sale. It often leads to litigation and a subsequent increase in the consideration. A transaction at a discount to the last trading price is called a takeunder.

      Insider Trading

      Investors looking at the large jump in Autonomy's stock on August 19 will be tempted to calculate the profits they could have made with a little advance knowledge of the upcoming merger. Insider trading is a crime, not a form of arbitrage.

      As readers of the financial press know, every merger cycle is characterized by insiders taking advantage of advance knowledge of mergers. Law enforcement has been successful in prosecuting even the most elaborate insider trading rings. One recent case involved New York bankers who bought options over the Internet through an online brokerage account established in Austria in the name of an elderly woman living in Croatia. Despite the complexity of the scheme, the perpetrators were caught and imprisoned.

      Penalties for insider trading are up to 10 years in prison, in addition to monetary penalties, rescission of profits, and potential civil liability in shareholder lawsuits.

      Not all that may look like insider trading really is insider trading

      It has become a popular sport among academic economists to create models in order to demonstrate malfeasance in one area of finance or another. A particularly fruitful target appears to be insider trading around merger announcements. One study shows that short-term hedge funds increase their holdings of merger targets in the quarter prior to the announcement of a transaction and conclude from this finding that insider trading must be rampant. However, merger announcements do not occur randomly and do not happen in a vacuum. Astute observers can predict potential targets when a firm announces that it is reviewing strategic alternatives or has hired an investment bank. CEOs may talk on quarterly earnings calls about their desire to acquire firms, or be acquired. While these methods are far from perfect, they will be good enough to make variables in a quantitative model statistically significant. Similarly, potential acquirers frequently announce their intent to make acquisitions either explicitly or indirectly – for example, by taking out large lines of credit. Again, experienced observers will read the signals from these announcements and may often enough interpret them correctly. Studies that ignore such signals and consider only merger announcements miss relevant variables and yield meaningless results.7

      The problem is certainly not insider trading; it is the misguided attempt to draw overly specific conclusions from naïve linear regression models based on a limited set of data, in particular when much relevant information is not easily quantifiable. It is an old wisdom among statisticians not to fall into the trap of “data availability.” Merger investing clearly has the potential for insider trading; however, considering that insider trading investigations over the last two decades have occurred outside the arbitrage community and concerned mostly individual investors, it is hard to see how there can be a problem.

      An arbitrageur who buys the stock on August 19 for £24.92 will receive £25.50 when the transaction closes. The gross profit for the capital gain on this arbitrage is £0.58 on £24.92, or 2.33 percent:

      2.1

      where

      This return will be achieved by the closing of the merger. A key component in investments is not just the return achieved but also the time needed. A more useful measure of return that makes comparisons easier is the annualized return achieved. The relevant time frame starts with the date on which the arbitrageur enters the position and ends with the date of the closing. The press release stated that the “acquisition of Autonomy is expected to be completed by the end of calendar 2011.” Therefore, the last day of the year, December 31, is used as a conservative estimate for the closing of the transaction. Pedantic arbitrageurs would choose December 30 instead because December 31 was a Saturday in 2011. As there is a large degree of uncertainty about when the transaction will actually close and the choice of the closing date is no more than an educated guess the difference between