Introduction to Merger Arbitrage

Merger arbitrage is a process akin to picking up a few pennies and nickels along the way while panning the river for the big prize, gold. You are basically trying to pick up a few short-term and hopefully low risk dollars in your journey to your long-term investment goals. To explain merger arbitrage (also known as risk arbitrage), I am going to borrow from a blog entry I wrote on January 11, 2007 titled A Merger Arbitrage Opportunity, where I wrote,

“2006 proved to be a banner year for global mergers & acquisitions with $3.79 trillion worth of deals, which even surpassed the deals made during the height of the dot com boom in 2000. As you may have noticed, when a merger or acquisition is announced, the stock of the company getting acquired usually jumps up and closes the day at a price very close to the acquisition price but often a little lower. For example when private equity firm Genstar Capital announced the acquisition of International Aluminum Corp yesterday, the stock jumped up more than 4% to close the day at $52.08. This is almost a dollar less than the acquisition price of $53 per share in cash that Genstar is offering. Here are a few reasons why this occurs.

  1. Unless there is a possibility of a rival bid, the stock of the company getting acquired will stay stagnant and tie up capital until the acquisition is completed.
  2. The acquisition may not go through due to antitrust issues or breach of conditions mentioned in the deal.
  3. The deal may be an all stock or stock plus cash deal and there is a risk that the stock of the acquisitor may drop in value before the acquisition is complete.
  4. If it is a very large deal, there is a risk that the acquisitor may not be able to raise the required capital to complete the deal.

Investors can profit from mergers and acquisition in a variety of ways and one of them is described in detail in this excellent article called Introduction To Risk Arbitrage: Rainy Day Returns? (PDF).

In case you are wondering, risk arbitrage is not just for hedge fund managers and as mentioned in the article above, has been used by both Warren Buffett of Berkshire Hathaway (BRK-A) and his guru Benjamin Graham.”

For the details of an actual merger arbitrage opportunity, I have described a deal I participated in and wrote about on March 2, 2009, which incidentally proved to be near the bottom of the “great recession” bear market.

Merger Arbitrage and the Pfizer – Wyeth Deal:

On Monday January 26, 2009, Pfizer (PFE) made a definitive announcement to acquire Wyeth in a deal estimated at nearly $68 billion or $50.19/share at the time of announcement. Since Dow Jones had already reported on the deal the previous Friday, the stock appreciated from Thursday’s close of $38.83 to $43.74 on Friday, January 23, 2009. Hence I am going to use $38.83 as a pre-deal price.

Pfizer is offering $33 in cash plus 0.985 of a Pfizer share in exchange for each share of Wyeth. With the 0.985 share of Pfizer working out to $17.19 at the time of announcement, the cash component of the deal worked out to $44.7 billion. Pfizer ended 2008 with nearly $24 billion in cash and short-term investments on its balance sheet and has decided to raise $22.5 billion in debt for the deal from a consortium of banks. Since this is a friendly acquisition, the key risk appears to be Pfizer’s ability to raise this debt. The deal is expected to close by the end of the third quarter of 2009 or in the fourth quarter.

Based on the Feb 27, 2009 close of $12.31 for Pfizer, the 0.985 share component works out to $12.12. Combining that with $33 in cash, the deal is worth $45.12 to Wyeth shareholders right now. Wyeth shares closed at $40.82 last Friday, representing a discount of $4.30 or 9.5% to the value of the deal.

Some of the analysis I have come across for this deal, tends to ignore the impact of Wyeth’s dividend on the overall return. Wyeth pays a $0.30 dividend per share each quarter. The first quarter dividend will be paid on March 2nd for shareholders on record Feb 13, 2009 and hence I have not included it while computing the total payment in the table below. The table below looks at actual returns and annualized returns for the arbitrage opportunity for two scenarios. The first scenario assumes the acquisition will close by the end of the third quarter, translating into a 7-month holding period (0.58 years). The second scenario assumes an end of fourth quarter close or a 10-month holding period.

Acquisition Timeline Total Payment Actual Return Annualized Return
Closes End of Q3 $45.72 12% 20.58%
Closes End of Q4 $46.02 12.74% 15.29%
Total Payment = $33 cash + 0.985 of a Pfizer share ($12.12) + Wyeth dividends

In an environment where cash is yielding just 2 to 3%, a 12% actual return appears to be an attractive bet. Please keep in mind that the above returns are not taking into account the probability of success or failure of the deal. If you want to arrive at the estimated annualized returns based on the probability of success or failure of this deal, you can use the formula discussed in the Introduction To Risk Arbitrage article mentioned above,

Expected return = (GC – L(100%-C))/YP

G: Expected gain in dollars in the event of success
L: Expected loss in dollars in the event of failure
 Expected probability of success in percentage
Y: Holding period in years
P: Price of stock at the time of purchase

Assuming the first scenario where the deal closes by the end of Q3, a 70% chance of success that the deal will go through and Wyeth falling $2 to return to the pre-deal announcement price if the deal does not succeed, the expected return works out to,

Expected return = (($4.9 * 0.70) – ($2 * 0.30))/(0.58*$40.82) = 11.95%

Pfizer generated $18.24 in operating cash flow in 2008 and paid out $8.5 billion in dividends. Starting in the second quarter of 2009, Pfizer plans to cut its 32 cent quarterly dividend in half, potentially conserving as much as $3 billion in cash for the company pre-dilution. With Wyeth generating $5.27 billion in operating cash flow in 2008 and the credit markets thawing, I believe the probability of Pfizer raising the capital required to complete this deal is quite high. Even with a 70% probability of success, the expected annualized return of 11.95% is decent given current market conditions.

No Free Lunch:

Merger arbitrage is no free lunch and the strategy comes with its own unique risks. There is a reason it is also know as risk arbitrage.  I would highly recommend reading the article John Paulson On The “Risk” In Risk Arbitrage by the folks at market folly to get an idea of some of the risks associated with this strategy.