There are no hard and fast rules in merger arbitrage that guarantee a riskless profit. But deals where the acquirer is offering cash are generally the easiest opportunities to make a tidy return. Usually, when a cash offer is made, the share price will rise to a level just below the offer price, with the difference between the two levels indicating the market's caution that the deal could fall apart. This is where the merger arbitrageur joins the fray. The best way to illustrate the point is through an example, so let's take a look at a few.
DEAL ONE: Brit Insurance/Apollo Global Management
Granted, this deal hasn't completed yet. The insurance company and sponsor of the England cricket team announced on 10 June that it had rejected a bid of 1,000p a share from the private equity group, sending the shares up 21 per cent to 880p. On 2 July Apollo came back with a revised offer of 1,050p, which was also rebuffed.
Game over, you might think. But we didn't. Our deputy companies editor, John Adams, recommended buying Brit's shares at 905p. Analysts were predicting that if Apollo walked away, no other bidders were interested, so the price might fall to about 800p. But the same analysts also put the value of the net tangible assets of Brit at about 1,100p. What's more, the business had been performing strongly, and such a wide share price discount looked unjustified in the long-term.
Reasoning that this limited the downside, our deputy companies editor argued that the upside was a juicy 16 per cent, based on a deal price of 1,050p, while the probability of the deal happening also looked fairly high. Apollo increased its offer to 1,075p on 28 July, at which point Brit opened its books to the bidder, sending the price to 1,005p.
An arbitrageur could therefore have bought at 905p and sold at 1,005p to make a quick 11 per cent profit in 13 days – an annualised return of 308 per cent – just by shrewdly weighing the upside, the downside and the probability of the deal. They also could have done as John Adams suggested, and sold half the shares at 1,005p, while keeping half in anticipation of the deal completing. And this looks even more likely now, after Apollo announced on 17 September that, in addition to the 1,075p a share that it suggested back in July, the company is prepared to offer up to 25p a share more dependent upon Brit's full-year net tangible assets reaching 1,100p a share. So, with the shares at 1,028p – or 6.5 per cent below that likely offer price of 1,100p – they are still worth buying.
DEAL TWO: Just Retirement/Avalon
This deal, announced in 2009, looked fairly certain to complete as the private equity group's cash offer of 76p a share had the firm backing of 52 per cent of shareholders. Despite this, the price at the time of the announcement was 67.5p, offering 12 per cent upside after dealing costs.
Our companies editor, Simon Thompson, advised investors to buy at this price in his weekly column. Once the price caught up with reality, he recommended selling at 75p. Again, he simply weighed up the upside to the deal, along with the probability of it happening.
DEAL THREE: ICI/Akzo Nobel
Britain's last volume chemical manufacturer was taken over by Akzo in 2007 in a deal that the market didn't seem to believe would happen. The credit crunch was starting to bite, markets were falling and while Akzo was soundly financed, there was a risk that its own shareholders might balk at backing an £8bn acquisition in such uncertain markets.
Mr Bearbull was happy to take that risk, though; advising buying the shares at 638p. He reasoned that Akzo's bosses only need a simple majority of shareholder votes cast to proceed with the deal – and even if they didn't get it, ICI could itself agree to sell its adhesives operations to Henkel (part of the Akzo deal) and return the proceeds to shareholders. The 670p-a-share deal was duly approved, with a 10p dividend along the way, netting a useful profit.
It's not just cash buyouts that give merger arbitrageurs a chance to make a quick buck. Deals that have sweeteners added, such as warrants, or unusual arrangements such as reverse takeovers, can also provide the hungry investor with a swift morsel.
Raven Russia's offer to Raven Mount shareholders back in April last year was one such opportunity. The offer tabled to Raven Mount shareholders consisted of 0.525 units in Raven Russia, comprising one preference share and one warrant per each Raven Mount share. Market makers put a price of 3p on the warrants and 98p for the preference shares, so 101p in total.
An owner of one unit in Raven Russia (comprising one preference share and one warrant) would have received 101p by selling, so a seller of 0.525 units would have received 53p. But Raven Mount's share price had not adjusted for this fact and was trading at 42p. So an arbitrageur could buy the shares at 42p, then when the deal went unconditional and the shares were converted into Raven Russia units, the investor could sell 0.525 units at 53p – and make an 11p profit. This is what our companies editor, Simon Thompson advised at the time. The risk to this deal was that the preference shares price might change in the market, but as the securities paid such a high coupon, and were held predominantly by income-seeking institutional shareholders, this was unlikely to happen.
So now we've looked at the previous examples, which deals at the moment offer an opportunity for the merger arbitrageur?
A classic opportunity, similar to those we have already discussed, is business process outsourcer Tribal Group, which announced on 11 August that it had received a number of initial bid interests. The shares immediately jumped 22 per cent to 83p on the back of the news, but collapsed back to near 58p this week after management said profits would be significantly below expectations. Having fallen so far and considering the long-term prospects for outsourcers as local councils look to heavily cut staff and procure more, we reckon the downside to buying Tribal's shares looks limited in the long run.
But is a deal still likely? Well, as there are a number of interested bidders, they are unlikely to pull out after the profit warning and risk seeing the business snapped up by someone else. Moreover, we can assume the parties are willing to take a long-term view on Tribal, so the profit warning is not likely to be an over-riding factor. If we take broker Investec's previous EPS forecast of 13.2p, and shave off 20 per cent (to account for the substantial profit warning), we get a forecast of 10.6p. A deal-exit earnings multiple of 8 would be undemanding considering other outsourcers' shares trade way above this, so a final take-out price of 85p doesn't seem unreasonable.
This is particularly the case considering there are a number of bidders that could push up the price, and more players also increases the likelihood of a deal going ahead. So, for a 47 per cent upside, the shares look like a buy, especially considering any downside is limited by the group's yield, which is over 7 per cent.
Our second chance to profit from a merger is by buying television shopping specialist Ideal Shopping Direct, which recently announced it had appointed Rothschild to advise on a strategic review of the business, including "a sale of the group alongside other options to create value for shareholders".
So a deal is not yet on the table, but as the company is essentially putting itself up for sale we can assume that one is very likely. At 161p, the shares are up 9 per cent since they made the announcement of a possible sale. So on first inspection this would be our downside risk. But how likely is a deal and what's the upside? Well, the business is certainly in recovery mode after the financial crisis, with sales up 19 per cent at the group's interim results in September, and pre-tax profits of £2.9m, compared with a loss of £1.2m at the same stage last year.
Given these strong results, we reckon that a 200p price tag is fair value for Ideal Shopping – even without a bid premium. Firstly, 200p values the equity value at £67.3m, but the group has strong cash conversion and has a net cash pile of £13.7m. So, taking this cash away, the equity value is £53.6m. Singer Capital Markets forecasts pre-tax profits for the full year of £10m for 2011, with cash profits slightly higher. So a price of 200p would value the company at just over five times forward cash profits, which looks very cheap.
Combine this with the fact that the group could benefit from unutilised tax losses, and has strong asset backing with freehold property on its balance sheet worth £6.7m, a deal price for the business nearer 250p looks reasonable. This would imply an exit multiple of 7 times cash profits using Singer’s forecast – that's hardly demanding.
So the upside looks good, anywhere between 23 per cent and 53 per cent. But is someone likely to snap up the business? We reckon management and shareholders will want to ensure it happens – chief executive Mike Hancox bought £400,000-worth of shares in September 2009. Meanwhile, having acquired horticultural retailer Lead The Good Life late last year for cash and shares, these shareholders will want to push for the highest sale price possible.
|Keep costs down|
|Merger arbitrage typically involves fairly short holding periods, and while the gains can be impressive in annualised terms, they may not be huge in absolute terms. Therefore, you need to keep trading costs to a minimum. Hopefully, you will not pay any dealing charges on exit, because the acquiring company will buy the shares off you at their expense. Even so, you may want to consider alternative methods of playing the arbitrage game – such as contracts for difference (CFDs), spread bets or covered warrants. These can offer leverage, which amplifies any gains but introduces extra risk. There may also be some tax advantages; spread-betting profits are exempt from capital gains tax, for instance, while no stamp duty is incurred on CFDs. Bear in mind that you may not be able to use such instruments for smaller companies' shares, as they are not liquid enough for the providers to lay off their own risk exposure.|