Merger Arbitrage. Kirchner Thomas

the most critical parts of an acquisition, and so Chapter 7 will look at different financing options.

      Mergers are subject to a plethora of legal requirements, and I discuss them under different angles. Readers should keep in mind that this is a financial book and not a legal textbook, so that many aspects are touched on only in a cursory manner. Boards of directors have to follow a number of procedures to ensure that a merger is fair to shareholders. This will be discussed in Chapter 8.

      Unfortunately, the law that is supposed to protect shareholders is often disregarded when managers buy the companies that they are managing as agents of their shareholders. Chapter 9 looks at management incentives for getting mergers done and how the interest of managers are often diametrically opposed to those of shareholders.

      Similar conflicts of interest between managers, acquirers, and shareholders can be found in buyouts by private equity funds, discussed in Chapter 10.

      Minority squeeze-outs present risks of their own to merger arbitrageurs, and therefore are discussed in a chapter of their own, Chapter 11.

      The government gets involved in the merger process on several levels, federal and state. Despite the obvious importance of government regulations, I have decided to relegate its discussion further to the back of the book because I believe that the motivations of the market participants – management, financiers, board members – are more relevant by far to the success of a merger than government regulations, discussed in Chapter 12. As they say: where there is a will, there is a way.

      Next, I step into a minefield by encouraging investors to seek to exercise their rights and get full value for their shares when a company is taken over. Chapter 13 describes methods that shareholders can use to that end. Too often have I seen investors resign when their company gets taken over for a lowball price. Most investors view themselves as stock pickers and will throw in the towel too early. I hope that this chapter will convince investors, maybe even some institutional investors, to fight for full value. Chapter 14 gives some practical tips on investing in merger arbitrage. In particular, readers should retain that cash holdings of event-driven investment strategies are dependent on events and not a deliberate asset allocation decision. As a result, merger arbitrageurs can have highly variable cash positions that are not an indication of the arbitrageur's view of the market.

      The last chapter contains some mathematical material. Stephen Hawking remarked in the introduction to his well-known A Brief History of Time that his publisher advised him that each formula would reduce the potential readership by half. I trust that readers of financial books can handle a few formulae.

      Acknowledgments

      I thank the editorial team at John Wiley & Sons for their support throughout the development of the book, in particular Laura Walsh, who first contacted me with the idea for this book, Emilie Herman, Meg Freeborn, and Bill Falloon as well as the reviewers who made valuable comments.

      Ron Charnock has been very supportive and encouraged me with many helpful tips. Others who have given me ideas, sometimes unwittingly, that are incorporated in the text are Geoffrey Foisie, Randy Baron, Juan Monteverde, Randall Steinmeyer, Eric Andersen, and Marc Weinberg.

      Adam Mersereau recognized the potential behind applying the newsvendor formula to the cash management problem and referred me to Warren Powell, who developed the algorithm in Chapter 14 with Juliana Nascimento.

      Ashish Tripathy worked with me on analyzing probabilities for the closing or failure of mergers.

      Finally, I thank all authors who have given me permission to reprint tables or figures from other studies.

      Part One

      The Arbitrage Process

      Chapter 1

      Introduction to Merger Arbitrage

      Arbitrage is one of the oldest forms of commercial activity. One of the earliest published definitions of the term arbitrage can be found in Wyndham Beaves's seminal Lex Mercatoria,1 first published in 1685, which trained several generations of European merchants until its last edition of 1803. One will be hard pressed to find a finance book today that has been in print for over a century. In the 1734 edition, Beaves writes about arbitrage:

      ARBITRATION (a Construction of the French Word Arbitrage) in Exchanges has been variously defined by the several Authors who have treated of it.

      One says it is a Combination or Conjunction made of many Exchanges, to find Out what Place is the most advantageous to remit or draw on.

      Another describes it, by saying it is only the Foresight of a considerable Advantage which a Merchant shall receive from a Remis or Draught, made on one Place preferably to another.

      A third construes it to be a Truck which two Bankers mutually make of their Bills upon different Parts, at a conditional Price and Course of Exchange.

      According to a fourth, it is the Negociation of a Sum in Exchange, once or oftener repeated, on which a Person does not determine till after having examined by several Rules which Method will turn best to Account.

Lex Mercatoria, 1734, p. 387

      Around that time also appeared in Basel the first book dedicated to arbitrage, J. Wiertz's 1725 oeuvre Traite des Arbitrages de Change,2 which discusses various calculation methods to convert one currency into another. All of these early forms of arbitrage involved currency arbitrage. Patrick Kelly describes a typical nineteenth-century arbitrage in his 1811 book The Universal Cambist, and Commercial Instructor: Being a General Treatise on Exchange, Including the Monies, Coins, Weights and Measures of All Trading Nations and Their Colonies: with an Account of Their Banks and Paper Currencies,3 which took over from Beaves's Lex Mercatoria as the obligatory text book for merchants in the nineteenth century:

      Arbitration of Exchange

      Arbitration of Exchange is a comparison between the course of exchange of several places, in order to ascertain the most advantageous method of drawing or remitting Bills. It is distinguished into simple and compound arbitration: the former comprehends the exchanges of three places only, and the latter of more than three places.

      Simple Arbitration

      Is a comparison between the exchanges of two places with respect to a third – that is to say, it is a method of finding such a rate of exchange between two places as shall be in proportion with the rates quoted between each of them and a third place. The exchange thus determined is called the Arbitrated Price, and also Proportional Exchange.

      If, for example, the course between London and Paris be 24 Francs for £1 sterling, and between Paris and Amsterdam 54d. Flemish for 3 Francs, (that is, 36s. Flemish for 24 Francs,) the arbitrated price between London and Amsterdam through Paris, is evidently 36s. Flemish for £1 sterling: for as 3 Fr.: 54d. Flem. :: 24 Fr.: 36s. Flem.

      Now, when the actual or direct price (as seen by a quotation of otherwise advised) is found to differ from the arbitrated price, advantage may be made by drawing or remitting indirectly; that is, by drawing on one place through another, as on Amsterdam through Paris; […]

      To exemplify this by familiar illustrations, suppose the arbitrated price between London and Amsterdam to be, as before stated, 36s. Flemish for £1 sterling; and suppose the direct course, as given in Lloyd's list, to be 37s. Flemish, then London, by drawing directly on Amsterdam, must give 37s. Flemish for £1 sterling; whereas, by drawing through Paris he will give only 36s. Flemish for £1 sterling; it is, therefore, the interest of London to draw indirectly on Amsterdam through Paris.

      As securities markets began to develop and expand globally during the nineteenth century, arbitrage began to expand beyond simple currency exchanges. This is reflected in how Otto Swoboda expands the definition of arbitrage in his book Börse und Actien, first published in Cologne in the year 1869:4

      Under arbitrage, that is decision, we understand the comparison

1

Wyndham Beawes, “Lex Mercatoria: Or, A Complete Code of Commercial Law; Being a General Guide to All Men in Business.” F. C. and J. Rivington, London, 1754

2

J. Wiertz, “Traité des arbitrages de change: contenant la véritable maniere dont les principales places de l'Europe se servent pour la direction de leurs changes.” Basel, 1725.

3

Patrick Kelly, “The Universal Cambist, and Commercial Instructor: Being a General Treatise on Exchange, Including the Monies, Coins, Weights and Measures of All Trading Nations and Their Colonies: with an Account of Their Banks and Paper Currencies.” Lackington, Allen And Co Finsbury Square, London, 1811.

4

Otto Swoboda, “Börse und Actien,” Verlag Wilh. Hassel, Cologne, 1869. Excerpt translated by the author.