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Merger and acquisitions that include collars tend to increase uncertainty for arbitrageurs and depending on the complexity of the deal, we sometimes classify these deals as “Special Conditions” deals. These are either all stock or cash plus stock kinds of deals where the stock portion of the deal is not a fixed ratio and can vary based on the price of the acquiring company. Every once in a while these kinds of deals offer an attractive opportunity and that is why I am writing another premium post just a day after publishing one on Sunday.
A reader reached out to me last Friday asking for my opinion about United Technologies’ (UTX) acquisition of Rockwell Collins (COL). I noticed that it was a special conditions deal that pays out $93.33 per share in cash and $46.67 in shares of UTX common stock, subject to a 7.5 percent collar centered on UTX’s August 22, 2017 closing share price of $115.69. I did not get a chance to complete my research over the weekend but I pulled up the merger agreement this morning and found the following information about the collar in Appendix A-4 of the merger agreement.
“Exchange Ratio” shall mean (i) if the Parent Stock Price is an amount equal to or greater than $124.37, 0.37525, (ii) if the Parent Stock Price is an amount greater than $107.01 but less than $124.37, an amount equal to the quotient obtained by dividing (A) $46.67 by (B) the Parent Stock Price, and (iii) if the Parent Stock Price is equal to or less than $107.01, 0.43613 (in each case, rounded to five decimal places).”
With United Technologies currently trading at $137.76, the ratio would be 0.37525, which translates to $51.69 for the stock portion of the deal. Adding the $93.33 cash portion gets us $145.02. Rockwell Collins closed Monday’s trading session at $139.60. The profit on the deal would be $5.42 providing a return of 3.88%. A 3.88% return on a cash plus stock deal might not be all that attractive until you consider that United Technologies’ CEO stated last Friday that they expect to close the deal by the end of this month. A 3.88% return in 13 days translates to 109% annualized.
Considering the deal has a stock portion, you would have to short 0.37525 shares of UTX for every COL share you purchase to achieve a near risk-free return. If you tend to hold merger arbitrage positions in a retirement account like an IRA, you could still participate in the deal by buying UTX put options expiring on Oct 5th. This will bring down the total return but not significantly because you only have to buy 1 put for every 266 shares of COL you purchase. You get to keep the upside in case UTX continues to rise in anticipation of the breakup of UTX. The key risk is a large decline in UTX’s stock over the next two weeks, which would result in a higher proportion of UTX stock delivered, leaving you with a few UTX shares not covered by the protective put option.