Deal Regulation

yedlu, Winter 2024

Merger Arbitrage

Gross Spread

  • Defined as the difference between the offer price and the current stock price of the target after the deal announcement.
    • Example: Offer price = $110, Target price = $100, Gross Spread = $10.
  • Represents the potential profit arbitrageurs can earn by investing in the target stock until the deal closes.

Risks

The gross spread exists because there is risk the transaction might fail. Key risks include:

  • Regulatory Intervention: Antitrust reviews by DOJ/FTC (e.g., AT&T and Time Warner delay).
  • Buyer’s Remorse: Acquirer backing out (e.g., Elon Musk’s Twitter deal).
  • Shareholder Dissent: Target shareholders rejecting the deal.
  • Financial Instability: Target or acquirer facing deteriorating performance.
  • Financing Issues: Acquirer fails to secure funds.
  • Market Conditions: Adverse economic events (e.g., COVID-19 causing deal collapse).

If the deal fails, the target stock price often reverts to pre-announcement levels, causing significant losses for arbitrageurs.

Strategies

  • Cash Offers: Arbitrageurs buy the target’s stock and hold until deal completion.
  • Stock Offers: A more complex strategy where arbitrageurs:
    • Buy Target Shares: To profit from the gross spread.
    • Short Acquirer Shares: Hedge against price fluctuations in the acquirer’s stock, locking in the exchange ratio.

Example (Stock Offer)

  • A offers to merge with T, offering 2 shares of A for each share of T.
    • Acquirer price = $55, Target price = $100.
    • Implied value of T = $110, Gross Spread = $10.
  • Arbitrageur:
    • Buys 1 Target Share at $100.
    • Shorts 2 Acquirer Shares at $55 each.
    • Locks in the $10 gross spread regardless of stock price movements.

Return Analysis

Merger arbitrageurs calculate expected returns based on:

  1. Gross Spread: Value offer – Target stock price.
  2. Net Spread: Gross spread minus costs (e.g., commissions).
  3. Probability of Deal Failure:
    • Estimate based on current price, failure price (pre-announcement price), and expected time to completion.
  4. ROI: Net Spread / Investment Cost.
  5. Annualized Return: Adjust ROI for the deal duration.

Example (Return Analysis)

  • Offer price = $62, Target price = $61.73, Failure price = $51.02, Time to completion = 40 days.
  • Gross Spread = $62 – $61.73 = $0.27.
  • Net Spread (after costs) = $0.25.
  • ROI = $0.25 / $61.73 ≈ 0.405%.
  • Annualized Return = (1 + ROI)^(365/40) – 1 ≈ 3.8%.

If this return exceeds the benchmark (e.g., Treasury bill rate), arbitrageurs invest.

Antitrust Laws

Overview

  • Sherman Act: Prevents monopolies and collusion.
  • Clayton Act: Blocks mergers that reduce competition.
  • FTC Act: Polices unfair business practices.
  • Hart-Scott-Rodino Act: Requires pre-merger notification for deals above thresholds.

Tools

  • HHI Index: Measures market concentration.
    • HHI > 2,500: Highly concentrated.
    • Increase > 200 points likely leads to challenges.

SPACs

Key Points

  • Shell companies raise capital via IPO to acquire private firms (reverse merger).
  • Shorter timeline than traditional IPOs; no “quiet period.”
  • Redemption rates (>70%) often reduce available capital, requiring PIPE funding to close deals.
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