Merger Arbitrage. Kirchner Thomas

conditions. Regulatory approvals include approval by the Australian Foreign Investment Review Board, and ASX and TSX approvals in respect of the issue of new B2Gold shares under the Scheme and as consideration for the cancellation of the CGA options.

      A Scheme Booklet setting out the terms of the Scheme, Independent Expert's Report and the reasons for the CGA Directors' recommendations is expected to be circulated to all CGA shareholders. A meeting of CGA shareholders to consider the Scheme is expected to be held later in the year and the Scheme is expected to be implemented shortly thereafter. The Scheme is conditional upon approval by 75 % of the number of votes cast, and 50 % of the number of CGA shareholders present and voting, at the meeting of CGA shareholders.

      In addition to the approval by CGA shareholders, the Scheme is conditional upon B2Gold shareholders approving the issuance of B2Gold shares that will be issued in connection with the Scheme and the cancellation of the CGA options by a simple majority of the B2Gold shares that are voted at a shareholder meeting to be held in reasonable proximity to the CGA shareholder vote.

      The Merger Agreement also contains customary and reciprocal deal protection mechanisms, including no shop and no talk provisions, matching and notification rights in the event of a competing proposal and a mutual reimbursement fee payable by B2Gold or CGA in specified circumstances.

      In this case, B2Gold is the buyer, CGA the target, and the per share consideration is no longer a fixed cash amount but a fixed number of B2Gold shares. Shareholders of CGA will receive 0.74 shares of B2Gold for each share of CGA that they hold. The number 0.74 is referred to as the exchange ratio or conversion factor.

      The dollar amount of C$3.18 mentioned in the press release refers to the value of the merger on the day before the announcement. This amount is calculated simply by multiplying the closing price of B2Gold's stock of C$4.30 on September 18, the last trading day before the announcement, by the conversion factor of 0.74. It is not the value that shareholders will receive at the closing of the merger. The value will vary with the stock price of B2Gold. This distinction is important, because unlike in the case of a cash merger, arbitrageurs face an uncertain dollar value at the time of closing that will vary with B2Gold's stock price. Therefore, they cannot just buy the stock of the target CGA and wait for the merger to close.

      The naive approach would be to purchase CGA stock and wait for the merger to consummate. The investor would receive 0.74 shares of B2Gold that it would then need to sell at the prevailing market price, which could be higher or lower. There is no arbitrage in such a transaction. Recall that one of the elements of the definition of arbitrage was that a purchase and sale occur simultaneously. Holding a stock and waiting to sell it for a higher price is speculation, not arbitrage.

      Instead, arbitrageurs must lock in the value of the transaction through a short sale. For readers new to short sales, a brief explanation is given here. Additional aspects of short sales are discussed in Chapter 14.

      Short Sales

      Most investors will only buy stocks and sell stocks that they bought previously and hold in their portfolio at the time of the sale. Selling short differs from a normal sale mainly through the timing of the purchase. A short sale is done before the stock is acquired. If a stock declines in value, a short seller will make a profit; if a stock increases in value, the short seller will suffer a loss.

      An important component in short selling is the delivery of the stock to the buyer. The buyer is unaware that the stock has been sold short and rightfully expects delivery. In order to make delivery of the stock, the short seller must borrow it from someone who owns it. Most brokerages and clearing firms offer their customers the ability to borrow stock. Online discount brokerages generally have fully automated systems to locate stocks that can be borrowed for their customers. If the stock cannot be borrowed, it cannot be sold short, and the brokerage will inform the customer. In return for lending out the stock, the lender demands a fee, which the arbitrageur must factor into the calculation. This will be discussed later.

      The process of closing the short sale – that is, buying back the shares that have been shorted – is a buy-to-cover transaction.

      Sometimes the lender of a stock requests its return, for example, if the stock is to be sold. In that case, the customer must either buy to cover or the broker will do a buy-in, meaning that the broker places the buy-to-cover order. If an investor is served with a notice of an upcoming buy-in, it is always better to buy the stock oneself and maintain control over the order than to let the broker execute a buy-in.

      Selling short is sometimes portrayed as illegal, dishonest, or un-American. However, in financial markets, arbitrage would not be possible without short selling. Arbitrage involves the simultaneous sale of an asset identical to the one acquired; in many instances, this is possible only through short sales. If there were no arbitrage in financial markets, many products would not be priced correctly, and investors might overpay.

      The chief executives of some companies have launched a crusade against naked short selling, which is an illegal activity in which the short seller does not borrow the stock that is sold short. However, regulations to prevent naked short sales are in place already.

      One complication in the merger is that even though CGA Mining is an Australian company, it is dually listed in Canada and Australia. An arbitrageur must decide which of the two shares to purchase. A brief glance at the trading volume of the shares on the two exchanges shows that the vast majority of the trading volume occurs in the Canadian market. Another advantage of investing in the Canadian shares is that arbitrageurs do not have to deal with the unfavorable time zone during which the Australian market is open for trading. Executing both sides of the arbitrage simultaneously can be difficult for companies whose shares are listed on different continents and where opening hours overlap only briefly, if at all.

The stock prices of B2Gold and CGA are shown in Figure 2.4. It can be seen that CGA jumped on September 19, the day of the announcement, from a close of C$2.65 the prior day to an open of C$2.84, rose as high as C$2.95 during the day and closed at C$2.71. B2Gold had closed at C$4.30 before the announcement and fell to a closing price of C$3.79. Articles in the press often attribute such a drop of an acquirer's stock price to skepticism about the merger in the investor community. However, it will be seen that the drop is often the byproduct of arbitrage activity.

Figure 2.4 Stock Prices of B2Gold and CGA

      For simplicity, it will be assumed that an arbitrageur enters the position on September 19 at the closing price. The arbitrageur will execute two transactions:

      1. Pay C$2.86 per share to buy 1,000 shares of CGA. This is the volume-weighted average price (VWAP) for the day, a realistic level at which investors could have bought CGA.

      2. Sell short 740 shares of B2Gold at C$3.95 per share, which is the VWAP for this stock for September 19.

It helps to examine the cash flows and stock holdings after these two trades. They can be found in Table 2.1. There is an expense of C$2,860 to acquire the shares of CGA, and proceeds from the short sale amount to C$2,923.

Table 2.1 Cash Flows in CGA/B2Gold Merger

      It can be seen that this transaction leaves the arbitrageur with a net cash inflow of C$63. At the closing of the merger, the 1,000 shares of CGA will be converted into 740 shares of B2Gold. The arbitrageur is then long 740 shares and at the same time short 740. The long position can then be used to deliver shares to the counterparty from which the short position was borrowed. Once the delivery has been completed the arbitrageur no longer has a position in stock, long, or short, but is left with a profit of C$63.

      The example of 1,000 shares is useful for illustrative purposes. Rather than looking at the purchase of 1,000 shares, transactions should be calculated on a per-share basis. Each share of