- Bear markets create stress, and merger arbitrage is an example.
- This style has many risks, but also opportunities.
- This article shows the style and example with Black Knight (NYSE:).
Bear markets are tough by definition. Even the bears are struggling to make money (see summer rally).
One reason is that, as the old saying goes, in a crisis, “correlations come together.” All asset placement, diversification, or stock picking tricks are doomed if all goes wrong.
This is one reason why so-called special situations become more interesting in times of crisis. Exceptional situations—investment opportunities based on a specific catalyst that is not directly related to market events or fundamentals—offer returns that are not correlated with market direction. At least in theory. Merger arbitration, which is the subject of this article, falls into the subcategory of special situations.
In practice, such situations exist in the real world and are influenced by financial market conditions. Financial stress concerns are widening merger arbitrage spreads, and rising interest rates are reducing the value of held arbitrage positions.
The 2022 market offers a number of significant merger arbitrage spreads, and this is one of the areas that I found interesting in the current market. Let’s take a look at what merger arbitrage involves, general risks and risks specific to 2022, as well as an example of an interesting deal.
Merger Arbitration Investments
The concept of arbitrage is basically this: a product is available at a given price in one place and at a different price elsewhere, and the arbitrageur profits from the difference between the two prices.
Merger arbitrage involves buying the shares of a company that is about to be acquired while it is still trading below its final acquisition price. To use an obvious example, Elon Musk signed a contract to buy Twitter (NYSE:) for $54.20, Twitter shares are trading at $38.62 so the spread is 40.3% and someone who buys here can earn 40.3. % return on trade closing.
Causes of risk
Like everything in the markets, merger arbitrage trading is not easy. Merger arbitrage spreads have been exceptionally high this year. Here is a select list of some of the highest spreads still available.
Here are some of the reasons why spreads exist outside the Mask category:
Additional antitrust risk
The Federal Trade Commission (FTC) is responsible for reviewing most mergers in the United States and is chaired by Lina Khan, a renowned antitrust expert. In recent years, the European Union has also tightened its controls on mergers. Thus, the regulatory risk is higher than in the past.
Market volatility makes it difficult to finance operations. In other words, if a deal is reached on all stocks, as in the case of Zoom’s attempt to buy Five9 (NASDAQ:) and Zoom’s stock falls sharply, the deal will become less attractive to Five9. Or, if a company seeks to raise funds to finance a deal and the financing terms tighten, the transaction becomes more difficult to complete and some of the synergies expected from the deal are lost.
Interest rate problems
Rising interest rates are also making merger arbitrage less attractive. Arbitrages should be relatively low-risk, with a signed merger agreement and clear deadlines for closing the deal, but the opportunity cost is higher when the risk-free rate rises.
These are explanations for the current market. There are also several other reasons to be wary of merger arbitrage, and one of them should still be considered.
In most cases, the merger will or will not happen. Either you get all the merger fees, or the deal falls through and the acquiree’s stock plummets. This can be frustrating to deal with. It is possible to calculate the implied market probability for a given trade, but it is difficult to guarantee that the probability is correct. If the market thinks there is a 50 percent chance that Twitter will be bought at $54.20, and I think there is a 75 percent chance, and I’m right, but the 25 percent chance is outdated, does it matter that I was right?
There is a whole category of professional investors and savvy individual investors who seek arbitrage trading. The market may seem inefficient at first glance when you look at the large spreads between trades, but chances are that most participants know, for example, that Twitter’s legal case is much stronger than Twitter’s.” there are still logical reasons to believe that the deal will not be at full price.
At the same time, this category of professional investors is focused on operational activities. They only think about the time horizon “until the deal is closed or terminated.” Appropriately, and in the case of Twitter, a requirement: It is unrealistic to think that Twitter shareholders will get their money back anytime soon if the deal falls through, unless there is a sharp market reversal.
However, there are times when focusing on the short term or on the factors that arbitrageurs value most can open up opportunities for individuals. Here’s a non-Twitter example of an interesting merger arbitrage situation right now.
Black Knight – Intercontinental Exchange
Black Knight is a leader in mortgage loan provider software. Intercontinental Exchange (NYSE:) is a leading financial instruments exchange company. ICE signed an agreement to buy Black Knight for $68 in cash plus 0.144 ICE shares per BKI share. BKI traded at $67.31 per share at the September 1 close, compared to a current trade value of $82.69 based on the September 1 ICE close, spread 22.9%. The deal is expected to close in the first half of 2023.
This spread of 22.9% is an obvious attraction. BKI is even trading below the cash value of the deal and is trading just 13.6% higher than before the news of the BKI sale was leaked. Therefore, it may seem that the risk-reward ratio is not extreme, but I will return to this later.
The news was made public as BKI was considering another bid from a private equity group at $73-75 per share (in fact, the news may have been released to encourage ICE to make an offer). This gives us a second reason not to place too much weight on the shortcomings of the deal breaker – it seems that buyer interest in BKI remains, since the company received an offer from the same private equity group also in 2021 (at a higher price). .
The third reason is that if antitrust is the reason this deal doesn’t go through, ICE owes Black Knight $725 million in severance pay. This is more than 3 times Black Knight’s 2021 earnings, so it will give us a good safety cushion to keep the deal from falling apart. And antitrust is the most likely reason for the deal not going through, putting us at risk.
Antitrust risk seems significant – Intercontinental Exchange bought Ellie Mae in 2020 and that’s essentially what they’ve merged with Black Knight. Ellie Mae called Black Knight her main competitor. The Association of Community Housing Lenders asked the Justice Department to “conduct a full antitrust review” of the deal a month after it was announced.
The Intercontinental Exchange claimed that it was a follow-on acquisition and that it had spent a lot of time considering the likelihood of approval and was ready to complete the deal. The market seems to be unconvinced.
Time and market risk
The fact that the deal is not closed for at least six months affects the relative attractiveness of the deal in terms of net return on investment. It also increases the likelihood that something will go wrong – a drop in ICE stock, a local risk to Black Knight’s business, a prolonged recession, whistleblowers, etc. In theory, none of this prevents the deal from closing, but the more uncertainty, the more the probability that the deal will be closed.
The decline is evaluated in the context of the market. Shares have fallen about 13% since news of the BKI sale broke; Since then, BKI has grown by 13%. A reasonable calculation of the downside accounts for this market downturn and a potentially sharper downturn due to the turmoil caused by the collapse of the merger and the slowdown in the mortgage market. It also has a positive effect on the $725 million break fee.
BKI price relative to analogues, indices since the announcement of the transaction
BKI price relative to analogues, indices since the announcement of the transaction.
Merger Arbitrage: A Basket of Risks
I’m interested in BKI because I believe that most arbitrageurs are right in estimating the likelihood of a deal break scenario versus a deal closing scenario and ignore the post-break scenario.
I estimate a drop of about $53.5/share: $59.27 pre-leak price plus a 15% drop, then adding $3.5/share after taxes in severance pay. This gives us a market probability of about 47% chance that the trade will go through and 53% chance that it will break at the current price.
One of the reasons to buy is to think that 47% is too low, and the probability of closing a deal is higher. Another reason is to see a company that has previously rejected two offers at a 15-30% premium to the share price, and whose counterpart (Ellie Mae) has been sold twice in the last three years, and to think that BKI won’t be public for long. markets anyway. Contrary to the scenario on Twitter, I think this is the right stance and a way to get a different perspective than the pros who play arbitrage.
I’ve been on Twitter for a long time – it’s its own drama – and more importantly VMware (NYSE:) which is being acquired by Broadcom (NASDAQ:) and is trading at a wide spread (I had before the deal). As a result, my merger arbitrage is higher than I would normally like. So I’m not inclined to add Black Knight just yet.
However, this is a curious situation, and, as we saw above, there are many such situations. This is an option for more advanced investors who may consider placing cash in a very difficult market.
Note: I found this article helpful, as well as an alternative (more optimistic) option.
Disclosure: I have long TWTR, ZM and VMW.