DIS and DAT March 2016 - Strategy Session Merger Arbitrage

"No wise pilot, no matter how great his talent and experience, fails to use a checklist."
Charlie Munger

 All right we are going to get a little geeky. We can here the responses now, “Aren’t you always?” In this report, we will explain one of several investment strategies DIS blends together in constructing a client’s portfolio.

In our May 2012 DIS and DAT (seen here), we outlined our Investment Philosophy and broke down the investment portion of one’s portfolio into 3 general categories: Timed Event, Non-specific event and long term value extraction. The timed event category is when a known future event is likely to provide liquidity of the position. We will now take a closer look at one of the strategies in the timed event category. One known event that provides liquidity occurs when two companies merge. Often times the market price of the company being acquired does not go to the full liquidation price immediately.

 A hypothetical example of this strategy may play out like this; ABC corp. is buying XYZ corp. for $100/share in cash. On the day of the announcement, stock price of the company being acquired will usually trade at some discount to the acquisition price. For this example, we will say XYZ corp. is now trading at $95/share. If you purchase XYZ corp. at $95/share and assuming the merger is completed, you will receive $100/share in cash when the deal is closed. This gives you a 5.26% return ($5/$95) for the time period invested, therefore if the liquidation occurs in six months; the annualized return is roughly 10.52%.

Of course this possible return isn’t risk free. That leads us to look at some of the characteristics we review when making this investment as well as some of the risks involved.

Some questions that we review in analyzing the risks involved with an investment in the aforementioned example would be:

• Is it an all cash deal? Since DIS mainly manages tax-deferred accounts, we cannot take short positions in stock deals where you would go long the target and short the acquirer.
• Is there a Definitive Agreement that has been approved by the boards? We do not want to speculate on hostile takeovers or unsolicited bids.
• Are there any large dissenting shareholders or group of shareholders? Large shareholders that do not believe the target is receiving fair value could vote against merger.
• Are there stumbling blocks to Regulatory Approval? Two competing companies with large industry market share may be subject to increase scrutiny from regulators, which could lead to delays or rejection of the deal.
• Is there a termination fee? If so, how much will each party pay? And is it a significant amount to discourage one party from walking away?
• Any financing condition? If so, has the financing to complete merger been secured? Banks may not be willing to extend financing if the deal requires a substantial amount of leverage. 
• Expected time frame for completion?
• Is there a merger deadline date? Can it be extended?
• What’s the downside assuming the deal doesn’t go through? The price the stock traded at prior to announcement may give an idea of where it may trade if the deal falls apart.
• What’s the Expected Return? Annualized Return? Is it worth the risk?

Investment theory states there are 2 basic types of investment risk, systematic and unsystematic risk. Systematic risk is market risk, or inherent macro-economic risks associated with investing. Unsystematic risk is specific risk to an individual security. With the Merger/Arbitrage Strategy, the systematic risk is removed from the investment, as economic factors or market volatility, has little or no effect.

A couple of the more common unsystematic risks relating to this strategy are event risk, and reinvestment risk.  Event risk is the chance the deal falls apart and the investment loses money. Reinvestment risk could be related to the deal is completed and the chance that the next investment has lower returns, or worse, loss of capital. These risks are different from other generic equity investments, where the unsystematic risks focus on business risks such as earnings, cash flows, etc. and the systemic risks still exists.

In conclusion, even though the tool in this strategy is a “stock”, it could react much differently than a broad index of stocks. This is why we believe it is important to focus on diversification of risk drivers in addition to broad asset class diversification of stocks, bonds, and cash.

We appreciate your time and will talk to you again soon,

Reggie McFadden, CFA 

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