Example 1: All Cash Deal
News & Analysis
Consider two fictitious companies, Winston Railroad and Avenell Transport, whose stock tickers are WRR and AVT respectively. Assume that the shares of Avenell Transport are trading at a price of $24 on Day 0 (D+0) at 08.30 AM. At 09.45AM news filters through that WRR is looking to purchase AVT for $6.75B in an all cash deal. Let us also assume that you happen to have an intuition that the deal has a 70% possibility of being accepted and 30% probability of being rejected.
This means that WRR values the shares of AVT at $45 per share as compared to the current price of $24 per share. As soon as the announcement is made, the share prices are likely to start moving towards $45. Thus it is our intention to hold a position in AVT for as low a cost as possible. However, before we place orders we run a quick analysis of our potential returns to calculate our potential profits.
Here, we have assumed that we purchase the shares of AVT at $35 because of the time lost in our analysis (you can save time by downloading the spreadsheet here, or even better – creating your own). Further, we adjust our net profit by multiplying the probabilities with the potential upside and downside (downside = purchase price – initial share price) which gives us a profit of $318 with an annual return of 22.2% assuming that you closed the trade after approximately 6 months and invested $3,000 in the trade. Feel free to play around with the values in my sheet to better understand the calculations. The cells which need your input are highlighted in gray.
Example 2: Share Offer
Consider both WRR and AVT once again for the purpose of this transaction. Except in this case, WRR offers AVT 0.55 shares for every share of AVT (i.e. for every share you hold of AVT you will receive 0.55 shares of WRR). Assuming that on the day of the announcement WRRs price is $88, it implies that WRR values AVT at $48.40 (0.55 x $88). The key here is that the deal hinges on the price of WRR shares, which are liable to fluctuate every trading day.
Assuming you purchase AVT shares at $35 and the price of WRR shares on the deal day is lower than that on the day of announcement ( $75 vs $88), you will earn a net profit of $535.71. The warning WRR price will indicate at which price of WRR shares you will be in the red. In order to overcome / hedge yourself against this risk, one could short 47.14 shares of WRR and exchange and close them on the final day if not earlier. This trade earns a return of 39% annualized.
Note – For both the tx I have assumed commission fees as $0. You can change this in the spreadsheet for your own calculations
Real World Example
It was reported by Bloomberg on October 08th at 07AM that AMD was in talks to purchase Xilinx for $35B in an all share deal. AMD would therefore offer 1.72 of its own shares per Xilinx share held, implying a per share equity valuation of $149.84 of XLNX. Had one acted quickly and invested $3,000 into XLNX shares at a price of $120, one could achieve a profit of 38% annualized on the deal ($0 commission costs).
It is also interesting to follow the chart of both the companies commencing from the date of the reporting of the potential deal between AMD and Xilinx on October 08th. It can be seen that XLNX stocks jump up to $120.94 within a day
As this is a share offer, as long as the price of AMD hovers nearabouts $80, it is safe to assume that the share price of XLNX is likely to reach the mid to late $140s. Running the numbers (see above image or spreadsheet) will allow to calculate the potential future payoff if one invests in the opportunity. Even today, if we go and buy XLNX for $129 and AMD hovers at $79, a 7% return is there for the taking. You can read more about the deal here.
I would like everyone to take note of the fact that there exist various risks undertaking such trades and that as an individual one is likely to be competing with institutional investors armed with thousand dollar terminals and news sources.
That being said, this is certainly an interesting topic to follow especially since famous investors such as Warren Buffet have also boosted their portfolio returns via arbitrage strategies. In tandem with the right portfolio allocation, this could be a winning strategy for you.
To conclude, I hope this simple primer on merger arbitrage has given you a peek and basic understanding of this practise and I hope this has piqued your interest to explore this further.