Merger Education
I. Merger BackgroundII. Types of Stock Mergers a. Cash Mergers b. Stock MergersIII. Risk and ReturnIV. Trading Mergers a. Cash Merger Example b. Stock Merger Example c. Cash and Stock Merger Example
I. Merger BackgroundII. Types of Stock Mergers
I. Merger Background:
A stock merger occurs when a company decides it wants to purchase another company. The two companies will convene and negotiate the terms of the deal, and when an agreement has been reached, they make a public announcement of the deal. However, if the two companies cannot reach an agreement, the acquiring company may announce a hostile bid for the company, which usually comes in the form of a tender offer. After the announcement of the merger, the companies are required to receive regulatory approval by the Federal Trade Commission, Department of Justice, and possibly other regulatory agencies from the industry, state, or government in which the companies do business. The companies also require SEC approval for the proxy document. The proxy contains all the information about the merger so that the shareholder can make an informed decision on whether to vote for or against the merger. After SEC approval is given, the proxy is mailed to all shareholders and a vote on the merger will occur. If the companies have satisfied all the requirements needed to close the merger, the merger will typically close after the vote. However, if the companies are still waiting for regulatory approvals, financing, and/or other requirements, the merger will not close until the companies satisfy all the requirements stated in the proxy.
When the merger is announced, the price of the target company usually will not immediately trade at the price offered by the acquirer. For example, if the acquiring company announced that it would pay $30 in cash for the target company, the target company may not immediately trade at $30. Instead, it may trade around $29 for a while before reaching $30, because there is the risk that the deal may fall apart. This difference between the current price and the merger price is referred by market professionals as the spread. This spread will vary depending on the perceived risk by risk arbitrageurs. If the risk arbitrageur buys the target company’s stock at $28, which was the price when the merger was announced, and holds the stock for 4 months until the merger closes, he will receive $30, making $2 per share, or 21% annualized return. Even though most stock mergers trade below the offered price, occasionally the target company’s share price will trade above the price offered by the acquiring company because risk arbitrageurs are predicting that the current offer could be raised either by another buyer or the original acquirer.
II. Types of Stock Mergers:
A stock merger can come in the form or all cash, all stock, or a combination of cash and stock. If you receive cash from the merger, it becomes a taxable event, whereas a stock merger is not.
a. Cash Mergers:In a cash merger, the acquirer offers to pay cash for all the outstanding shares of the target company. This is a fixed sum of cash that gets divided by the total number of shares outstanding of the target company. For example, if the acquiring company offers $1 billion in cash and the target company has 10 million shares outstanding, each shareholder of the target company would receive $100 ($100 = $1B / 10M) for every share they own when the merger is completed. A tender offer is similar to a cash merger in that the shareholders receive all cash; however, the merger usually closes much quicker than a cash merger. Another difference between a cash merger and a tender offer is that shareholders are required to vote for the approval of the merger, whereas tender offers only give the shareholders the choice to tender their shares. The acquirer can finance the acquisition by using either cash from their balance sheet or borrowed funds through a loan from a bank or other financial institution. When a company uses borrowed funds to finance the acquisition, this is known as a leveraged buyout (LBO). Leverage buyouts are common when the CEO or management of the company attempts to take the company private. Leveraged buyouts are the most risky type of cash merger. b. Stock Mergers:In a stock merger, the acquirer uses their own stock to pay for all the outstanding shares of the target company. Instead of using a fixed sum of cash, the company offers a set number of shares of their company for each share owned of the target company. For example, if the acquiring company is trading at $50 at the time the merger closes and it offers .75 shares of the company for each share of the target company, the shareholders of the target company would receive .75 shares of the acquirer’s stock for every share they owned, which is equal to $37.50 a share ($37.50 = $50.00 * .75). Therefore, the overall value the target company’s shareholders would receive changes with the fluctuations in the acquirer stock price. This is different from a cash merger as the value doesn’t change. Stock mergers ratios can be fixed or variable and can also contain collars. Collars create a minimum and maximum price that the target company can receive.
a. Cash Mergers:In a cash merger, the acquirer offers to pay cash for all the outstanding shares of the target company. This is a fixed sum of cash that gets divided by the total number of shares outstanding of the target company. For example, if the acquiring company offers $1 billion in cash and the target company has 10 million shares outstanding, each shareholder of the target company would receive $100 ($100 = $1B / 10M) for every share they own when the merger is completed. A tender offer is similar to a cash merger in that the shareholders receive all cash; however, the merger usually closes much quicker than a cash merger. Another difference between a cash merger and a tender offer is that shareholders are required to vote for the approval of the merger, whereas tender offers only give the shareholders the choice to tender their shares. The acquirer can finance the acquisition by using either cash from their balance sheet or borrowed funds through a loan from a bank or other financial institution. When a company uses borrowed funds to finance the acquisition, this is known as a leveraged buyout (LBO). Leverage buyouts are common when the CEO or management of the company attempts to take the company private. Leveraged buyouts are the most risky type of cash merger.
b. Stock Mergers:In a stock merger, the acquirer uses their own stock to pay for all the outstanding shares of the target company. Instead of using a fixed sum of cash, the company offers a set number of shares of their company for each share owned of the target company. For example, if the acquiring company is trading at $50 at the time the merger closes and it offers .75 shares of the company for each share of the target company, the shareholders of the target company would receive .75 shares of the acquirer’s stock for every share they owned, which is equal to $37.50 a share ($37.50 = $50.00 * .75). Therefore, the overall value the target company’s shareholders would receive changes with the fluctuations in the acquirer stock price. This is different from a cash merger as the value doesn’t change. Stock mergers ratios can be fixed or variable and can also contain collars. Collars create a minimum and maximum price that the target company can receive.
III. Risk and Return:
Not all mergers trade at the same return, as the return varies depending on perceived risk—the higher the risk, the higher the return. The risk arbitrageur should weigh the risk and return of each deal before trading. This is why this strategy is known as risk arbitrage. When comparing the returns across other pending mergers, the annualized return should be used, as each deal has a different closing date and length. For example, if 2 mergers are trading at a 3% return and have the same risk, and one of them is closing in 3 months and the other is closing in 6 months, it would be better to invest in the merger that is closing in 3 months at a 12% annualized return than the other closing in 6 months at a 6% annualized return. The risk involved in merger investing is that the deal can fall apart or be re-negotiated at a lower price. Almost all mergers are completed, but when a deal does fall apart, the price of the stock could drop significantly. As a risk arbitrageur, it is necessary to estimate the potential risk in each merger. It is difficult to calculate how much the stock’s price would drop if the deal fell apart, however, looking at where the stock traded before the merger was announced is a good starting place. If the company’s financial health is deteriorating, or if other stocks in the same industry are showing weakness, the stock’s price could drop below the pre-merger price. This is why it is important to diversify among many stock mergers instead of investing all your money in just a few. Fundamental analysis can also play a role when investing in mergers. After looking at the fundamentals of the target company, you can estimate what the stock might be worth. This will give you an idea if there is room for another buyer to come in and raise the bid. If the deal falls apart, you may choose to hold the stock afterwards if the stock is undervalued. Here are some examples of what could cause a merger not to be completed as planned:
Regulatory Issues: Are the two companies competing in the same market? When combined, will they have a good percentage of the market share? If both company’s compete in the same market and is considered to be anti-competitive, then the merger may get denied by the regulatory agencies.Friendly or Hostile: Is the merger friendly or hostile? If the merger is hostile, the target company will fight to not allow the deal to be completed.Shareholders: Are shareholders in opposition to the deal because they feel the company is worth more than the price offered? Does the merger make strategic sense? What percentage of the shareholders vote is needed to approve the merger? If there are not enough shareholders to approve the merger, the deal will not be completed.Due Diligence: Did the acquiring company perform due diligence on the target company before making the offer? The acquiring company may later conclude that the target company either is not a good fit, or is not worth what they originally thought, and try to back out of the deal.Financing: Is the acquirer using cash from their balance sheet or using borrowed funds? Is the financing secure? The greater the amount of money borrowed by the acquiring company, the higher the risk.Company’s Health: Did a material adverse effect happen and/or did the company or the industry start deteriorating? This may trigger the acquiring company to try to back out of the deal, as the company may no longer be worth what they offered to originally pay.
If you take the time and effort needed to thoroughly research mergers, then investing in mergers can be a rewarding strategy that yields low risk with consistent returns.
IV. Trading Mergers:
Listed below are some examples of different types of mergers. In these examples, ABC is the acquiring company and XYZ is the target company. Return calculations are not actual results, as they do not reflect commissions, interest, dividends, taxes, or any other costs.
a. Cash Merger Example:Under the terms of the merger agreement, ABC will acquire all of XYZ’s outstanding common stock for $36 per share in cash. The merger is expected to close in 4 months. After the announcement, XYZ is trading at $34 per share and the risk arbitrageur buys 100 shares of XYZ at $34. If the merger is completed as scheduled, the risk arbitrageur will receive $36 per share in cash when the deal closes, and earn a return of 5.8%, or 17.6% annualized. b. Stock Merger Example:Under the terms of the merger agreement, XYZ shareholders will receive a fixed exchange ratio of 0.75 shares of ABC common stock for each share of XYZ they own. The merger is expected to close in 6 months. After the announcement, ABC is trading at $60 per share and XYZ is trading at $42. The risk arbitrageur will buy 133 shares of XYZ at $42 and short 100 shares of ABC at $60. Notice that 100/133 = .75 is the ratio. The number of shares is multiplied so that the smallest share leg is equal to 100 shares. This is the same thing as buying 1 share of XYZ and shorting .75 shares of ABC. To calculate what XYZ stock should trade, just multiply the acquirer's stock price by the merger ratio. For example, XYZ should trade at $45 = $60 * 0.75, but since it is trading at $42, the risk arbitrageur is able to lock in a profit of $3 per share when the deal closes, and earn a return of 7.1%, or 14.2% annualized. When the deal is complete, the risk arbitrageur will receive 100 shares of XYZ for their 133 shares of ABC. This will leave the risk arbitrager with a flat position in both ABC and XYZ once the deal is completed. c. Cash and Stock Merger Example:Under the terms of the merger agreement, shareholders of XYZ will be entitled to receive .62 shares of ABC common stock and $10 in cash for each share of XYZ that they own. The merger is expected to close in 5 months. After the announcement, ABC is trading at $100 per share and XYZ is trading at $68. The risk arbitrageur will buy 161 shares of XYZ at $68 and short 100 shares of ABC at $100. XYZ should be trading at $72 = $100 * .62 + $10, but since it is trading at $68, the risk arbitrageur is able to lock in a profit of $4 per share when the deal closes, and earn a return of 5.8%, or 14.1% annualized. When the deal is complete, the risk arbitrageur will receive 100 shares of XYZ for their 161 shares of ABC. This will leave risk arbitrager with a flat position in both ABC and XYZ once the deal is completed.
a. Cash Merger Example:Under the terms of the merger agreement, ABC will acquire all of XYZ’s outstanding common stock for $36 per share in cash. The merger is expected to close in 4 months. After the announcement, XYZ is trading at $34 per share and the risk arbitrageur buys 100 shares of XYZ at $34. If the merger is completed as scheduled, the risk arbitrageur will receive $36 per share in cash when the deal closes, and earn a return of 5.8%, or 17.6% annualized.
b. Stock Merger Example:Under the terms of the merger agreement, XYZ shareholders will receive a fixed exchange ratio of 0.75 shares of ABC common stock for each share of XYZ they own. The merger is expected to close in 6 months. After the announcement, ABC is trading at $60 per share and XYZ is trading at $42. The risk arbitrageur will buy 133 shares of XYZ at $42 and short 100 shares of ABC at $60. Notice that 100/133 = .75 is the ratio. The number of shares is multiplied so that the smallest share leg is equal to 100 shares. This is the same thing as buying 1 share of XYZ and shorting .75 shares of ABC. To calculate what XYZ stock should trade, just multiply the acquirer's stock price by the merger ratio. For example, XYZ should trade at $45 = $60 * 0.75, but since it is trading at $42, the risk arbitrageur is able to lock in a profit of $3 per share when the deal closes, and earn a return of 7.1%, or 14.2% annualized. When the deal is complete, the risk arbitrageur will receive 100 shares of XYZ for their 133 shares of ABC. This will leave the risk arbitrager with a flat position in both ABC and XYZ once the deal is completed.
c. Cash and Stock Merger Example:Under the terms of the merger agreement, shareholders of XYZ will be entitled to receive .62 shares of ABC common stock and $10 in cash for each share of XYZ that they own. The merger is expected to close in 5 months. After the announcement, ABC is trading at $100 per share and XYZ is trading at $68. The risk arbitrageur will buy 161 shares of XYZ at $68 and short 100 shares of ABC at $100. XYZ should be trading at $72 = $100 * .62 + $10, but since it is trading at $68, the risk arbitrageur is able to lock in a profit of $4 per share when the deal closes, and earn a return of 5.8%, or 14.1% annualized. When the deal is complete, the risk arbitrageur will receive 100 shares of XYZ for their 161 shares of ABC. This will leave risk arbitrager with a flat position in both ABC and XYZ once the deal is completed.