Merger Arbitrage & Shareholder Wealth
Effects of M&A Transactions
Chapter 12 Part 1
Distribution of Takeover Premiums
1993 ~ 2000 (U.S.)
Number of
transactions
285
298
217
210
130
129
111
71
69
37
-10
0
10
20
30
40
50
60
70
80
28
90
28
18
12
7
100
110
120
More
[%]
Source: Securities Data Company
Target Shareholder Wealth Effects
• Target takeover premiums average 30% +
– 3 day announcement window – Target shares gain 16%
– With longer window Target shares gain 24%
– Why is announcement effect less than takeover premium?
• This is real money
– average annual stock return for the typical NYSE, Amex and Nasdaq listed firms
was 12%!
– Given a Target’s median equity value of $230 million
– The Target share gain of 16% translates into $37 million for Target shareholders,
who are the clear winners!
• Variations
– Target shareholders also gain more in cash deals than in stock deals, even
controlling for deal size
– Target shareholders gain much less in MOEs (Merger of Equals). Why?
Target Shareholder Wealth Effects in
Cancelled Deals
• Target stock prices react strongly to deal cancellation
announcements
• Target stock price immediately drops (on average), but
remains above its pre-takeover bid announcement
price level.
• If initial bidder does not make another bid and no
other bidder materializes, then over next 6 months
Target stock price continues to fall toward its pretakeover bid announcement price.
• Interpretation: once the market concludes that no
subsequent takeover bid is likely, the Target stock price
falls to its pre-bid level
Target Stock Returns Near Announcements
Fig. 2. Cumulative average abnormal returns to target firms’ stocks from trading day –126 to +253 relative to the first bid in
the period 1975 – 91. Market model parameters are used to calculate abnormal returns. The full sample of 1,815 offers for
NYSE- and AMEX-listed target firms is broken into 1401 successful and 414 unsuccessful offers.
Buyer Shareholder Wealth Effects
• Not as positive as for target
– Three day merger announcement return is -.7% for successful
Bidder shares
– Longer window return is –3.8% for Bidder shares
– Neither return is statistically significant, but it is still disturbing that
Acquirers do not seem to benefit from the merger
– (Maybe it’s just a statistical artifact)
• Acquiring shareholders appear to subsidize mergers, while
Target shareholders capture more than the entire gains for
the transaction!
• But Acquirer wealth effects are not the same across M&A
deals
Stock versus Cash Financed M&A
• Average Announcement Effects for Bidder Stocks Vary with the
Merger Currency Choice
– Cash deals have insignificantly positive Bidder announcement
returns of +.4%
– Stock deals have significantly negative Bidder announcement
returns of -1.5%
– So Bidder shareholder wealth effect is negative only in stock
mergers
– Yet Target shareholders gain more in cash deals! Why?
• What is special about stock financed acquisitions?
Stock versus Cash Financed M&A
• Stock financed deals represent a combo: an acquisition + a stock offer
by the Buyer
• Studies of seasoned equity offerings (vs. IPO) find average
announcement returns of -3.0%
• So why don’t stock acquisitions have a -3.0% announcement return?
• Backing out the announcement return from the deal announcement
effect (previous slide) would leave a positive 1.5% acquisition
announcement effect (difference between expected 3% loss and
reported 1.5% loss )
• So revisiting the cash/share difference -• if the stock offer effect is taken out, Buyer shareholders gain more
wealth in stock deals than cash deals ( which have 0.4% announcement
effect)!
• But Target shareholders gain more wealth in cash deals ( +1.5% )
• Why? Premiums rise with hostility & less favorable tax treatment
Risk Arbitrage Basics
• After an M&A deal announcement, arbitrageurs are
primary buyers of Target stock.
– Risk arbitrageurs buy Target shares within minutes of
an M&A announcement, pushing up a Target’s stock
price, moving it toward a Bidder’s offer price.
– (In bad old days, arbs would be tipped as to M&A
announcement, so they could “warehouse”
– Yet, a Target’s stock price is almost always below a
Bidder’s offer price. Why?
– A risk arbitrageur’s motivation is short-term profits
from buying Target stock at a price typically below a
bidder’s offer price (“deal spread”), and then holding
it until deal completion or possibly selling it sooner.
Risk arbitrage 2
• Deal Break Insurance
– Target shareholders often prefer to sell immediately and capture
most of the takeover premium, rather than wait until deal
completion to capture the entire takeover premium. Why?
– Arbitrageurs accept deal break risk by buying Target stock,
thereby supplying deal break insurance to risk averse Target
shareholders.
• How does it change dynamic?
• Arbs do not want to hold stock for long given their large risk
exposure.
• Arbs have high costs of capital, so they need to liquidate their
positions quickly.
• Arbs also prefer to be paid in cash to reduce their costs of closing
their positions.
Deal Spread on Compaq-HP Merger
Deal spread is
difference
between sale
price and offer
price
Risk Arbitrage Basics: Cash Deals
• Risk arbitrage is profitable when: (1) a positive deal spread and (2) deal
is completed.
• Deal spread = Bidder’s offer – Target stock’s market price
• Arbitrageurs bear deal-break risk: After a deal cancellation, Target shares
will drop with the reduction in probability of an expected takeover
premium.
• If the price falls below an arb’s purchase price, then they take large
losses.
• Risk Arbitrageur’s Decision Rule:
–Buy Target stock if deal spread exceeds the sum of the arbitrage costs:
(1) Transaction costs of buying Target stock and later selling it or tendering it.
(2) Cost of hedging a Target stock’s market risk and idiosyncratic risk
(3) Risk premium for bearing deal break risk (expected loss on deal cancellation).
Risk Arbitrage Basics: Cash Deals
• Arbs calculate an expected return from the deal spread and their estimate of the
probability of a deal break (cancellation).
– Arb’s Expected Rate of Return =
Target’s Expected Purchase Price (w. Deal) x Probability of Deal Completion
+
Target Stock’s Expected Price (w. Deal Break) x Probability of Deal Break
–
Target Stock’s Current Price
/
Target Stock’s Current Price
Math
phobes -Don’t
worry
about this
• Key Economic Variables:
(1) Probabilities of a deal break and a deal completion
(2) Expected Target purchase price with deal completion
(3) Expected Target share price with a deal break
• Arb’s Risk Exposure: Deal break risk, market risk, industry risk, firm specific risk.
They can all cause the post-deal break Target stock’s price to fall!
• Arbs Decision Rule: expand or contract Target stockholdings by comparing their
expected rate of return to Treasury bill interest rate + deal risk premium.
Hedging Market Risk in Cash Deals
• After a deal break, Target shares will
– (1) drop due to a reduction in probability of an expected takeover premium
and
– (2) could drop further if overall stock market has fallen.
• Risk arbs try to limit their loses by hedging a Target stock’s market risk
& idiosyncratic risk
– Arbs can hedge away the market risk in a Target stock by buying “at-the-money” put
options on a stock market index.
– A put option gives a buyer a right, but not an obligation, to sell an underlying risky asset
(stock index) at the option strike price. An at-the-money option is where the strike
price equals the underlying risky asset’s current market value.
– By exercising the option to sell the stock index when it falls, an arb is paid the
difference between the strike price (set equal to stock index’s earlier higher value), and
stock index’s lower current value.
• In a deal break, a put option on a market index protects the arb against
a loss in Target stock value due to a general market downturn or
meltdown.
– What other losses are still there? from loss of expected takeover premium or
from industry risk or firm specific risk
Risk Arbitrage in Stock Deal (Fixed Exchange Rate):
Effects on Target & Buyer Stock Prices
• Target stock price rises immediately after an M&A announcement
and Bidder’s stock price tends to fall
• Target stock price tracks Buyer stock price (high correlation) if:
– It is a fixed exchange rate stock financed deal
– The deal is likely to succeed
– Any collar or walk away clause is far away from being triggered
• Buyer stock price falls on M&A announcement if:
– It is a fixed exchange rate stock financed deal
– The deal is likely to succeed
– Deal size relative to Buyer’s equity capitalization is large
Share prices of JP Morgan & Chase
200
180
Stock Price ($)
160
140
120
CMB
JPM
100
80
60
40
20
0
15-Jul-00
4-Aug-00
24-Aug-00
13-Sep-00
3-Oct-00
23-Oct-00
Ratio of share pices of JP Morgan & Chase
0.5
0.45
0.4
CMB/ JPM
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
15-Jul-00
4-Aug-00
24-Aug-00
13-Sep-00
3-Oct-00
23-Oct-00
M&A Arbitrage: Hedging in Fixed Exchange Rate
Stock Deals
• Within minutes of an M&A deal announcement, arbs act:
– Buy Target stock, pushing up its price
– Short sell Bidder stock, putting downward pressure on its
price.
– Short sale of B stock hedges some of the risk of holding
Target stock (why?)
• Short selling a stock – What does it mean?
– You borrow stock from a shareholder and immediately sell at
current market price.
– You also commit to return the stock at a future date by
buying the stock in the market at its future unknown price
A poem about short selling . . .
He who sells what isn’t his’n
Must buy it back or goes to prison.
Daniel Drew (1797-1879)
Legal and Economic Bounds on the Search for
Information
• Information is the principal raw material in the
arbitrage business
• It can be useful for purchasing stock in
takeover targets prior to merger
announcement (which can be insider trading)
or merger arbitrage--purchase of
acquirer/target stock after deal
announcement.
• A legal boundary as much as economic.
"The
most valuable
valuable commodity
commodity II know
know of
of isis
The most
information,
wouldn't
you agree?"
information.
Wouldn’t
you agree?
How Law Shapes the Information
Market
• Positive Stimulus e.g. Mandatory
disclosure
– when must you disclose to the public you are
doing a merger?
• Negative Stimulus e.g. Antifraud liability
– Can you trade (without disclosing) ahead of the
market on merger knowledge?
Mandatory Disclosure
• Disclosure to protect investors; triggered by:
– Issuance of securities (Securities Act of 1933);
– Solicitation of Proxies (Securities Exchange Act of
1934- Section 14(a))
– Making a Tender Offer (Section 14(d))
– Going Private (Rule 13e-3)
– Periodic Reporting (Annual-10K, Quarterly-10Q; 8K)
• So, at what point in the acquisitions process will
each trigger require disclosure?
Mandatory disclosure
• Disclosure required by the Securities Act of 1933 when securities
are issued.
– Applies to acquisitions in which stock is used as currency.
– disclosure does not occur until issuance is to occur which will be after
public announcement of the deal.
• Section 14(a) of the 1934 Act requires extensive disclosure when
proxies are solicited.
– Applies to deals requiring a shareholder vote
– mergers on the target side and some mergers on the acquirer side, but
not tender offers.
– not be required until after the deal has been negotiated by the boards
and publicly announced
Mandatory disclosure
• The Williams Act amendments to the Securities Exchange Act
– adds disclosure if offer asking target shareholders to sell as opposed to
vote
– E.g. the bidder’s financing
• via Section 13(d) disclosure required even before a transaction is
announced
– “early warning” section requires disclosure when a person’s ownership
exceeds 5% even if no pending tender offer and applies to groups
– Tender offer regulation includes some substantive regulation
– e.g. requiring best price and
– requiring an offer be open for 20 business days
– goes beyond the usual disclosure focus of the federal securities laws
Periodic Disclosures
• 10‐K and 10‐Q disclosures required under the federal
disclosure laws
– Calendar is the trip wire
– if the filing date happens to occur in the midst of
negotiations, there can be tough questions about whether
information about the deal needs to be disclosed,
– particularly under the broad Regulation S‐K, the common
disclosure base for the various SEC disclosure
requirements
– Shortly after the Basic case the SEC issued a release giving
planners more room to keep pending merger talks under
wraps
State disclosure & Stock exchange
rules
• Whatever disclosure is required by state law
will occur after the deal has been negotiated
by the board and announced when the board
is asking for some shareholder action
• Stock exchange listing requirements
sometimes require disclosure even where
federal and state law does not, as, for
example, in the Basic case below.
Negative Disclosure Obligations- Antifraud
• Rule 10b-5– Can’t lie or speak half-truths
– “unlawful…(b) to make any untrue statement of a material fact
or to omit to state a material fact necessary to make the
statements made…not misleading; (c) to engage in…a fraud or
deceit”
• Dilemma for the planners of a merger– Basic v. Levinson, 485 U.S.
224 (1988):
– Takeover target in extended talks with acquirer received calls
from the press and inquiry from NYSE
– Company’s response: “Management is unaware of any present
or pending company development that would result in the
abnormal heavy trading activity [of] the last few days.”
• = Liability to all who sold for too little in the run up to merger
announcement
Management’s Choices in a Basic setting
•
Tell the whole story
–
And then what happens?
• Dissemble (i.e., lie)
•
No comment!
–
FN 17 No comment is functional equivalent of
silence;
–
“silence absent a duty to disclose is not misleading
under Rule 10b-5”
–
And then what happens?
Another option . . . Keep it secret
• Prevent press inquiry or stock exchange call from occurring
• structure transaction to minimize possibility that information will
get out
• This regularly practiced by takeover lawyers and clients
• Negotiations kept within a small group of participants on need to
know basis for as long as possible
• When group in the know starts to broaden, the pace to completion
begins to accelerate
• common that deals are often hurried to be completed over the
weekend when markets are closed so as to be done by the time
that markets reopen
• E.g. timeline in the HCA case in next chapter