Merger Arbitrage. Kirchner Thomas

statistical risk models, event risk falls into the unexplained component, the error term. As part of the error term, it is uncorrelated to market risk. It is precisely this property that makes investment strategies based on event risk appealing in the construction of portfolios that seek to reduce exposure to market risk. This topic is discussed in more depth in Chapter 3.

      More specifically, the risk in merger arbitrage is primarily the nonconsummation of the announced merger. Much can go wrong between the announcement of a merger and its closing. For example:

      • Financing for the transaction can dry up.

      • Antitrust authorities can block a transaction.

      • The economic environment can change, making the merger less appealing.

      • Fraud or other misrepresentations can be discovered.

      • A spoiler bidder (a.k.a. white knight) can intervene.

      It is the role of the arbitrageur to weigh these risks against the profit opportunity.

Merger arbitrage generally is used to describe a wide range of investment strategies around mergers, many of which have little to do with actual arbitrage. These investment tactics can be organized into a risk spectrum (see Figure 1.3) from the most speculative activity, which is the most removed from an actual arbitrage, to least risky, which is merger arbitrage in a proper sense.

Figure 1.3 Risk Spectrum of Merger-Related Investments

      At the most risky end of the spectrum is speculation about potential takeover targets. Some investment magazines occasionally publish lists of takeover targets based on financial characteristics, typically priced relative to cash on balance sheet and earnings before interest, taxes, depreciation, and amortization (EBITDA). The idea is that these companies could potentially be bought out based on attractiveness of their accounts for leveraged buyouts. Of course, there is no guarantee that anybody actually will have an interest in acquiring any of the firms on the list. Many more factors must align before a financial buyer might be interested in acquiring a firm.

      Of similar riskiness, albeit occasionally more founded in reality, is the Wall Street rumor mill. There is little doubt that the spreading of such rumors is facilitated by investors who hold the relevant stock. Internet message boards have been a particularly fruitful breeding ground for all sorts of takeover speculation. Sometimes rumors enter analyst reports or newspapers. At that level, rumors are often somewhat more reliable – to the extent that the word reliable can be used in describing a rumor. Several publications have made themselves a name with sometimes-accurate reports of ongoing acquisition discussions. The New York Post as well as the subscription-based service dealReporter both have writers with excellent contacts in the business community and are often first in breaking pending merger negotiations. One possible explanation for their journalistic success is more prosaic: They simply may be used to leak ongoing negotiations if one party believes that such a leak can improve its position in the negotiations. In the apparel industry, Women's Wear Daily has made itself a name with accurate M&A leaks. For example, in August 2005, it reported accurately that J. Jill was to be sold. A few months later, Jill rejected an acquisition proposal from Liz Claiborne and was eventually sold to Talbots.

The high risk of investing in rumored mergers is illustrated by Bloomberg data. After a rumor about a potential merger starts to circulate, the target company's stock jumps initially by 2.9 percent, based on an analysis of 1,875 rumors between 2005 and 2010. However, investors who short such a stock, thereby seeking to profit from its decline, will generate an average return of 1.2 percent in the subsequent month, or an annualized return of 14 percent.5 Clearly, buying a rumored takeover company is not a profitable strategy on average. An example of the perils of investing in rumored mergers is the rumored acquisition of Dresser Rand Group by Siemens AG. On July 17, 2014, the German publication Manager Magazin reported that industrial group Siemens was interested in acquiring turbine compressor maker Dresser-Rand for $6.4 billion, and that investment bank Lazard had been retained as financial adviser for this transaction.6 It was reported that Siemens was even willing to engage in a hostile transaction should that become necessary. The stock spiked to $68 on the back of this report. However, on July 31, Siemens laid out a strategic plan Vision 2020 to its investors that relied on organic growth rather than acquisitions for future expansion. The market reaction to these events can be seen in Figure 1.4. An investor acting on the basis of the press rumor would have suffered a loss of roughly 15 percent by the time of the publication of the strategic plan. Nevertheless, the story was true eventually: On September 21, 2014, Siemens announced an $83 per share acquisition of Dresser-Rand for a total of $7.6 billion. Most speculative investors who bought the rumor probably sold after the publication of the strategic plan and would no longer have been invested at the time of the announcement of the actual merger.

Figure 1.4 Stock Price of Dresser-Rand Group around the Rumor of an Acquisition by Siemens

      A more reliable, although still speculative, merger investment strategy is to follow activist investors who try to get a company to sell itself. Activists file their intentions with the Securities and Exchange Commission (SEC) under Schedule 13D. These filings can be a source of potential merger targets; however, companies that are targets of activists are often in less-than-perfect condition and pose significant investment risk. This is, after all, why activist investors target these firms in the first place. Some commercial services monitor 13D filings and provide additional analysis.

      Companies sometimes announce that they are for sale. These announcements are usually phrased as a “search for strategic alternatives, including a sale” or other transaction. Sometimes these announcements come in response to an attack by activist investors; sometimes a company's board decides on its own to explore the possibility of a sale. Compared to the previously discussed scenarios, investing in a firm whose management is actively pursuing a sale is much safer, but it still is no arbitrage because the company may well be sold for less than it can be purchased for at the time of the announcement. In addition, the outcome of such an investment depends highly on the market environment. In a bull market, it is relatively easy for management to sell the firm at a premium. In contrast, in a bear market, no buyers may materialize and the stock may fall along with the market.

      Potential acquirers sometimes enter into a letter of intent before signing a formal merger agreement. Investing after a letter of intent can be very speculative. Most merger partners enter into a definitive agreement right away. Letters of intent are a sign of adverse selection: Either the buyer or the company is not yet quite ready to sign a definitive agreement. In the case of the acquisition of CCA Industries by Dubilier & Co., a private equity firm managed by the son of a cofounder of Clayton, Dubilier & Rice, a letter of intent led to a busted buyout because the acquiring private equity fund could not arrange the requisite financing. Had the firm found it easy to arrange the financing, it would have entered into a definitive agreement rather than a letter of intent in the first place.

      Hostile bids are of a similar degree of risk as letters of intent. If the target fends off the bidder successfully, its share price may well revert to a lower, prebid level. Even worse, if an arbitrageur has set up a short position in the acquirer (see Chapter 2), a short squeeze could ensue, leading to losses on both the long and short side of the arbitrage.

      The only real merger arbitrage occurs when the arbitrageur enters the position after a definitive agreement has been signed between the target and the acquirer. Arbitrageurs who specialize only in this type of transactions refer to it as announced merger arbitrage to differentiate it clearly from the other, more risky investment styles

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Angela Maier: “Siemens plant Milliardenzukauf in den USA.” Retrieved on 8/1/14 http://www.manager-magazin.de/unternehmen/industrie/siemens-will-us-kompressorenhersteller-dresser-rand-kaufen-a-981221.html.