Merger Arbitrage & Shareholder Wealth Effects of M&A Transactions

1. Chapter 12 Part 1 Merger Arbitrage & Shareholder Wealth Effects of M&A Transactions

2. Distribution of Takeover Premiums1993 ~ 2000 (U.S.) Number of transactions Source: Securities Data Company

3. Target Shareholder Wealth Effects • Target takeover premiums average 30% + • 3 day announcement window – Target shares gain 16% • With longer window Target shares gain 24% • Why is announcement effect less than takeover premium? • This is real money • average annual stock return for the typical NYSE, Amex and Nasdaq listed firms was 12%! • Given a Target’s median equity value of $230 million • The Target share gain of 16% translates into $37 million for Target shareholders, who are the clear winners! • Variations • Target shareholders also gain more in cash deals than in stock deals, even controlling for deal size • Target shareholders gain much less in MOEs (Merger of Equals). Why?

4. Target Shareholder Wealth Effects in Cancelled Deals • Target stock prices react strongly to deal cancellation announcements • Target stock price immediately drops (on average), but remains above its pre-takeover bid announcement price level. • If initial bidder does not make another bid and no other bidder materializes, then over next 6 months Target stock price continues to fall toward its pre-takeover bid announcement price. • Interpretation: once the market concludes that no subsequent takeover bid is likely, the Target stock price falls to its pre-bid level

5. Target Stock Returns Near Announcements Fig. 2. Cumulative average abnormal returns to target firms’ stocks from trading day –126 to +253 relative to the first bid in the period 1975 – 91. Market model parameters are used to calculate abnormal returns. The full sample of 1,815 offers for NYSE- and AMEX-listed target firms is broken into 1401 successful and 414 unsuccessful offers.

6. Buyer Shareholder Wealth Effects • Not as positive as for target • Three day merger announcement return is -.7% for successful Bidder shares • Longer window return is –3.8% for Bidder shares • Neither return is statistically significant, but it is still disturbing that Acquirers do not seem to benefit from the merger • (Maybe it’s just a statistical artifact) • Acquiring shareholders appear to subsidize mergers, while Target shareholders capture more than the entire gains for the transaction! • But Acquirer wealth effects are not the same across M&A deals

7. Stock versus Cash Financed M&A • Average Announcement Effects for Bidder Stocks Vary with the Merger Currency Choice • Cash deals have insignificantly positive Bidder announcement returns of +.4% • Stock deals have significantly negative Bidder announcement returns of -1.5% • So Bidder shareholder wealth effect is negative only in stock mergers • Yet Target shareholders gain more in cash deals! Why? • What is special about stock financed acquisitions?

8. Stock versus Cash Financed M&A • Stock financed deals represent a combo: an acquisition + a stock offer by the Buyer • Studies of seasoned equity offerings (vs. IPO) find average announcement returns of -3.0% • So why don’t stock acquisitions have a -3.0% announcement return? • Backing out the announcement return from the deal announcement effect (previous slide) would leave a positive 1.5% acquisition announcement effect (difference between expected 3% loss and reported 1.5% loss ) • So revisiting the cash/share difference -- • if the stock offer effect is taken out, Buyer shareholders gain more wealth in stock deals than cash deals ( which have 0.4% announcement effect)! • But Target shareholders gain more wealth in cash deals ( +1.5% ) • Why? Premiums rise with hostility & less favorable tax treatment

9. Risk Arbitrage Basics • After an M&A deal announcement, arbitrageurs are primary buyers of Target stock. • Risk arbitrageurs buy Target shares within minutes of an M&A announcement, pushing up a Target’s stock price, moving it toward a Bidder’s offer price. • (In bad old days, arbs would be tipped as to M&A announcement, so they could “warehouse” • Yet, a Target’s stock price is almost always below a Bidder’s offer price. Why? • A risk arbitrageur’s motivation is short-term profits from buying Target stock at a price typically below a bidder’s offer price (“deal spread”), and then holding it until deal completion or possibly selling it sooner.

10. Risk arbitrage 2 • Deal Break Insurance • Target shareholders often prefer to sell immediately and capture most of the takeover premium, rather than wait until deal completion to capture the entire takeover premium. Why? • Arbitrageurs accept deal break risk by buying Target stock, thereby supplying deal break insurance to risk averse Target shareholders. • How does it change dynamic? • Arbs do not want to hold stock for long given their large risk exposure. • Arbs have high costs of capital, so they need to liquidate their positions quickly. • Arbs also prefer to be paid in cash to reduce their costs of closing their positions.

11. Deal Spread on Compaq-HP Merger Deal spread is difference between sale price and offer price

12. Risk Arbitrage Basics: Cash Deals • Risk arbitrage is profitable when: (1) a positive deal spread and (2) deal is completed. • Deal spread = Bidder’s offer – Target stock’s market price • Arbitrageurs bear deal-break risk: After a deal cancellation, Target shares will drop with the reduction in probability of an expected takeover premium. • If the price falls below an arb’s purchase price, then they take large losses. • Risk Arbitrageur’s Decision Rule: • Buy Target stock if deal spread exceeds the sum of the arbitrage costs: • Transaction costs of buying Target stock and later selling it or tendering it. • Cost of hedging a Target stock’s market risk and idiosyncratic risk • Risk premium for bearing deal break risk (expected loss on deal cancellation).

13. Risk Arbitrage Basics: Cash Deals • Arbs calculate an expected return from the deal spread and their estimate of the probability of a deal break (cancellation). • Arb’s Expected Rate of Return = Target’s Expected Purchase Price (w. Deal) x Probability of Deal Completion + Target Stock’s Expected Price (w. Deal Break) x Probability of Deal Break – Target Stock’s Current Price / Target Stock’s Current Price • Key Economic Variables: (1) Probabilities of a deal break and a deal completion (2) Expected Target purchase price with deal completion (3) Expected Target share price with a deal break • Arb’s Risk Exposure: Deal break risk, market risk, industry risk, firm specific risk. They can all cause the post-deal break Target stock’s price to fall! • Arbs Decision Rule: expand or contract Target stockholdings by comparing their expected rate of return to Treasury bill interest rate + deal risk premium. Math phobes -- Don’t worry about this

14. Hedging Market Risk in Cash Deals After a deal break, Target shares will (1) drop due to a reduction in probability of an expected takeover premium and (2) could drop further if overall stock market has fallen. Risk arbs try to limit their loses by hedging a Target stock’s market risk & idiosyncratic risk Arbs can hedge away the market risk in a Target stock by buying “at-the-money” put options on a stock market index. A put option gives a buyer a right, but not an obligation, to sell an underlying risky asset (stock index) at the option strike price. An at-the-money option is where the strike price equals the underlying risky asset’s current market value. By exercising the option to sell the stock index when it falls, an arb is paid the difference between the strike price (set equal to stock index’s earlier higher value), and stock index’s lower current value. In a deal break, a put option on a market index protects the arb against a loss in Target stock value due to a general market downturn or meltdown. What other losses are still there? from loss of expected takeover premium or from industry risk or firm specific risk

15. Risk Arbitrage in Stock Deal (Fixed Exchange Rate): Effects on Target & Buyer Stock Prices • Target stock price rises immediately after an M&A announcement and Bidder’s stock price tends to fall • Target stock price tracks Buyer stock price (high correlation) if: • It is a fixed exchange rate stock financed deal • The deal is likely to succeed • Any collar or walk away clause is far away from being triggered • Buyer stock price falls on M&A announcement if: • It is a fixed exchange rate stock financed deal • The deal is likely to succeed • Deal size relative to Buyer’s equity capitalization is large

18. M&A Arbitrage: Hedging in Fixed Exchange Rate Stock Deals • Within minutes of an M&A deal announcement, arbs act: • Buy Target stock, pushing up its price • Short sell Bidder stock, putting downward pressure on its price. • Short sale of B stock hedges some of the risk of holding Target stock (why?) • Short selling a stock – What does it mean? • You borrow stock from a shareholder and immediately sell at current market price. • You also commit to return the stock at a future date by buying the stock in the market at its future unknown price

19. A poem about short selling . . . He who sells what isn’t his’n Must buy it back or goes to prison. Daniel Drew (1797-1879)

20. Legal and Economic Bounds on the Search for Information • Information is the principal raw material in the arbitrage business • It can be useful for purchasing stock in takeover targets prior to merger announcement (which can be insider trading) or merger arbitrage--purchase of acquirer/target stock after deal announcement. • A legal boundary as much as economic.

21. The most valuable commodity I know of is information.  Wouldn’t you agree? "The most valuable commodity I know of is information, wouldn't you agree?"

22. How Law Shapes the Information Market • Positive Stimulus e.g. Mandatory disclosure • when must you disclose to the public you are doing a merger? • Negative Stimulus e.g. Antifraud liability • Can you trade (without disclosing) ahead of the market on merger knowledge?

23. Mandatory Disclosure • Disclosure to protect investors; triggered by: • Issuance of securities (Securities Act of 1933); • Solicitation of Proxies (Securities Exchange Act of 1934- Section 14(a)) • Making a Tender Offer (Section 14(d)) • Going Private (Rule 13e-3) • Periodic Reporting (Annual-10K, Quarterly-10Q; 8K) • So, at what point in the acquisitions process will each trigger require disclosure?

24. Mandatory disclosure • Disclosure required by the Securities Act of 1933 when securities are issued. • Applies to acquisitions in which stock is used as currency. • disclosure does not occur until issuance is to occur which will be after public announcement of the deal. • Section 14(a) of the 1934 Act requires extensive disclosure when proxies are solicited. • Applies to deals requiring a shareholder vote • mergers on the target side and some mergers on the acquirer side, but not tender offers. • not be required until after the deal has been negotiated by the boards and publicly announced

25. Mandatory disclosure • The Williams Act amendments to the Securities Exchange Act • adds disclosure if offer asking target shareholders to sell as opposed to vote • E.g. the bidder’s financing • via Section 13(d) disclosure required even before a transaction is announced • “early warning” section requires disclosure when a person’s ownership exceeds 5% even if no pending tender offer and applies to groups • Tender offer regulation includes some substantive regulation • e.g. requiring best price and • requiring an offer be open for 20 business days • goes beyond the usual disclosure focus of the federal securities laws

26. Periodic Disclosures • 10‐K and 10‐Q disclosures required under the federal disclosure laws • Calendar is the trip wire • if the filing date happens to occur in the midst of negotiations, there can be tough questions about whether information about the deal needs to be disclosed, • particularly under the broad Regulation S‐K, the common disclosure base for the various SEC disclosure requirements • Shortly after the Basic case the SEC issued a release giving planners more room to keep pending merger talks under wraps

27. State disclosure & Stock exchange rules • Whatever disclosure is required by state law will occur after the deal has been negotiated by the board and announced when the board is asking for some shareholder action • Stock exchange listing requirements sometimes require disclosure even where federal and state law does not, as, for example, in the Basic case below.

28. Negative Disclosure Obligations- Antifraud • Rule 10b-5– Can’t lie or speak half-truths • “unlawful…(b) to make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made…not misleading; (c) to engage in…a fraud or deceit” • Dilemma for the planners of a merger– Basic v. Levinson, 485 U.S. 224 (1988): • Takeover target in extended talks with acquirer received calls from the press and inquiry from NYSE • Company’s response: “Management is unaware of any present or pending company development that would result in the abnormal heavy trading activity [of] the last few days.” • = Liability to all who sold for too little in the run up to merger announcement

29. Management’s Choices in a Basic setting • Tell the whole story • And then what happens? • Dissemble (i.e., lie) • No comment! • FN 17 No comment is functional equivalent of silence; • “silence absent a duty to disclose is not misleading under Rule 10b-5” • And then what happens?

30. Another option . . . Keep it secret • Prevent press inquiry or stock exchange call from occurring • structure transaction to minimize possibility that information will get out • This regularly practiced by takeover lawyers and clients • Negotiations kept within a small group of participants on need to know basis for as long as possible • When group in the know starts to broaden, the pace to completion begins to accelerate • common that deals are often hurried to be completed over the weekend when markets are closed so as to be done by the time that markets reopen • E.g. timeline in the HCA case in next chapter