G.

Andrew Karolyi*
John Shannon

Where’s the Risk in Risk Arbitrage?

Abstract

This study measures the returns to investing in 37 Canadian acquisition targets with over
$50 million in capitalization during 1997. On average, risk arbitrage returns yield an
average of 4.78% in excess of the TSE index over an average duration of 57 days per
deal, or 33.9% excess return on an annualized basis. We find that these risk arbitrage
excess returns cannot be explained by factors related to the deal, such as its likelihood of
success, the time to close, payment method or industry sector of the target company.

First Draft: May 4, 1998

Current Version: November 17 1998
Comments Welcome

*
Fisher College of Business, Ohio State University, and Nesbitt Burns, Inc., respectively. This research
was prepared as an independent study (Business 699) by John Shannon, MBA 1998 at the Rischard Ivey
School of Business, University of Western Ontario, under the supervision of Professor Andrew Karolyi.
The views expressed in this study are solely those of the authors and do not necessarily represent opinions
of Nesbitt Burns, Inc. We are grateful to comments of Craig Dunbar, Steve Foerster, Bruce Langstaff
(Bunting Warburg) and especially Paul Halpern. All remaining errors are our own. Address correspondence
to: G. Andrew Karolyi, Fisher College of Business, Ohio State University, Columbus, Ohio 43210-1144,
U.S.A. Phone: (614) 292-0229, Fax: (614) 292-2418, E-mail karolyi@cob.ohio-state.edu.
 Where’s the Risk in Risk Arbitrage?

The resurgence in Canadian merger and acquisition activity in the last few years

has rekindled interest in the profitability of risk arbitrage as a strategy for Canada’s

institutional investment community.1 In general, risk arbitrage is an investment strategy

that purchases the shares of a company immediately after the announcement of a merger

or acquisition in order to lock in the fixed spread between the offer price and the post-

announcement market price for the target firm. While mergers require approval of the

target firm'’ management and are typically friendly, tender offers do not require such

approval and may be hostile in nature. The announcement of a merger or tender offer

normally leads to an increase in the price of the stock of the target and often of the

acquiring firm because of the potential value-increasing synergies.2 Between the

announcement and close of a deal, the stock tends to trade somewhere between the pre-

announcement price and the offer price and, if the deal is successful, the arbitrageur

benefits by locking in the fixed spread. The key success factor for the arbitrageur is her

ability to determine whether or not the merger or tender offer will be successful. If the

proposal fails, the stock would be expected to decline toward pre-announcement levels,

so the downside risk is significant. Since shareholders generally govern the outcome of

1
Crosbie and Company (Toronto Globe & Mail, March 16, 1998) report that in the first quarter of 1998,
279 deals worth $42 billion were announced, a 75 percent increase from the first quarter of 1997.
2
Seminal studies of this phenomenon include M. Bradley, A. Desai and E. H. Kim, 1983 “The rationale
behind interfirm tender offers: information or synergy,” Journal of Financial Economics, pp. 183-206, and
P. Dodd and R. Ruback, 1977, “Tender offers and stockholder returns: an empirical analysis,” Journal of
Financial Economics, pp. 351-374. A useful summary is found in G. Wyser-pratte, 1982, Risk Arbitrage II,
(new York University’s Salomon Brothers Center, New York), and F. Weston, K. Chung and J. Siu, 1998,
Takeovers, Restructuring and Corporate Governance (Prentice Hall, New York). A recent contribution by
F. Cornelli and D. Li, “Risk Arbitrage in Takeovers” (University of Michigan working paper, 1998) models
the informational asymmetry between management and arbitrageurs in the takeover process.

1
the tender offer or merger proposal, rejection is most often due to an inadequate bid or an

expectation of potentially superior bids.

This study examines the profit potential of risk arbitrage in Canadian mergers and

acquisitions (M&A). Our sample comprises 37 deals valued at over $50 million that took

place during 1997. We measure the returns and risks associated with this type of

investment strategy relative to intrinsic value of the target companies for such deals, but

also relative to the specific features of different deals. The risk and return of risk arbitrage

as a strategy is particularly interesting in the Canadian setting because of the unique

industrial structure of the market, the extent of cross-border dealing and the smaller size

of the deals. It is well-known that resource stocks represent a disproportionately large

component of the capitalization of the Canadian market. But, it is also worth noting that,

according to Crosbie and Company, the two hottest sectors for Canadian M&A is utilities

and oil and gas, the latter comprising 14 of 37 deals in our study. Second, of the 279

deals in the first quarter of 1998, 118 or 40 percent are cross-border deals (77 represent

Canadian takeovers of foreign firms, another 41 foreign acquisitions of Canadian

targets).3 Finally, while a $1 billion deal will often top the list of largest deals in any

quarter in Canada, similar lists in the U.S. will top $5 to $10 billion.4 This size difference

could limit the liquidity of the risk arbitrage market in Canada.

We find that the average return to the risk arbitrage strategy yields 4.78 percent in

excess of the TSE 300 stock index. With the average duration of these risk arbitrage

strategies lasting 57 days, this figure translates into an annualized excess return of 33.9

percent. We find that the resulting abnormal returns are insensitive to various attributes of

3
See Globe & Mail, March 16, 1998, ibid.

2
the deal, such as the average number of days to close the deal (or fail), the market

capitalization or industry sector of the target company, or the means of payment for the

transaction. Though we caution readers of the limited scope of our findings (i.e. Canada,

1997, deals over $50 million), we offer them as a puzzle and ask why the profit potential

of risk arbitrage has been underestimated to date in Canada.

Some Background

Several researchers, including Dodd and Ruback (1977) and Bradley, Desai and

Kim (1983) provide empirical evidence that corporate acquisitions by tender offers

provide significant and positive abnormal returns to the shareholders of both the target

and bidding firm.5 Bradley et al. Look specifically at unsuccessful offers and they show

that target firms in those cases experience no wealth change unless target shareholders

reject one bid and accept another made by a rival firm. In those cases, the unsuccessful

bidder realized a significant wealth loss following rejection. Most of the share price

reactions occur on the day of the announcement by the rival firm. For the target, if the

initial bid is rejected because it is too low and if no subsequent bid materializes, a greater

positive abnormal return is achieved. This initial gain, however, tends to dissipate over

the next two years. Several studies have extended the findings by Dodd and Ruback and

Bradley et al. to predict tender offer success from information available to the potential

bidding firm before the conveyance of the tender offer.6

4
Fidelity’s Merger Fund manages about $300 million in assets for risk arbitrage. See Barron’s “Mutual
Funds – World’s Safest Stock Fund,” September 18, 1995).
5
See Bradley et al. (1983, ibid.) and Dodd and Ruback (1977, ibid.).
6
See R. Walkling, “Predicting tender offer success: A logistic analysis,” Journal of Financial and
Quantitative Analysis, pp. 461-478, W. Samuelson and L. Rosenthal, 1986, “Price movements as
indicators of tender offer success” Journal of Finance, pp. 481-499, and K. Brown and M. Raymond, 1986,
”Risk arbitrage and the predication of successful corporate takeovers,” Financial Management, pp. 54-66.

3
 The most closely related article to our study is Dukes, Frohlich and Ma (1992)

which examined 761 tender offers in the U.S. between 1971 and 1985.7 They determined

that 82 percent of the transactions were profitable yielding average abnormal returns of

24.6 percent over 52.4 days on average (annualized yield of 171 percent). They also

found that the abnormal return increases inversely with the level of success probability,

which is measured by the largest price spread relative to some pre-announcement

benchmark relative to the tender premium based on the offer price.

Data and Methodology

Using Crosbie and Company’s database, we identified all announced takeover

bids for Canadian publicly—traded targets in 1997 where the market capitalization of the

target company was over $50 million. We limited our sample only to those deals that

were both announced in and completed/failed in 1997. Further, following Dukes et al.

91992), we eliminated from our sample any transactions with a higher degree of

complexity in locking in a spread on the announcement date, such as the existence of a

"boot" in a tender offer. A “boot” involves some security exchanges at an undetermined

stock ratio and which would require the arbitrageur to make a valuation estimate on the

bidder'’ stock.

We assumed that the best price that the arbitraguer could acquire the stock at was

the closing price on the day of the announcement or the closing price on the day after

announcement , if the announcement was made after the market close. The end price

7
W. Dukes, C. Frohlich and C. Ma, 1992, “Risk arbitrage in tender offers,” Journal of Portfolio
Management, Summer, pp. 47-55.

4
received by the arbitrageur is the offer price or the price at the end of the trading day that

the companny announces publicly that the takeover bid has failed.

If the tender offer is successful, the spread is computed as,

SPREADi = (Pioffer – Piannounce)/ Piannounce x 365/daysi,

where Pioffer is the tender offer price for the ith offer, Piannounce is the announcement date

price for the ith offer, and daysi is the duration of the deal in days. If the tender offer fails,

the return is computed as,

SPREADi = (Piclose – Piannounce)/ Piannounce x 365/daysi,

where Piclose is the actual market closing price on the expiration date of the failed offer.

The latter return is computed assuming that the arbitrageur sells the shares back to the

market when the offer is not accepted. We also compute adjusted spreads by subtracting

the TSE return (without dividends reinvested) matched over the same deal duration

period. The adjusted spreads are annualized in the same way.

Table 1 shows that the average transaction represented about $572 million in

capitalization with a typical duration of 57.3 days. The largest contingent of risk arbitrage

candidates originated in the oil and gas sector with 14 deals. The oil and gas transactions

were typically shorter in duration (44 days) and on average smaller in size ($410 million).

Deals in relatively more closely-regulated industries such as financial services, paper and

forest products and communications and media take relatively longer to complete than

average. Though not reported in Table 1, all but three deals (91 percent) were successful

by year end. This is very close to the 89 percent success rate for tender offers in the larger

Dukes et al. (1992) U.S. sample.

5
Risk Arbitrage Spreads

Returns for the risk arbitrage deals are summarized in Table 1 and Figure 1. We

present the mean raw and adjusted spreads and betas. The spreads are annualized using

the formulas in the previous section. The betas are computed from daily returns during

the pre-announcement year and up to the ten days before the announcement date itself.

Note that the duration of each offer – and consequently the holding period for the risk

arbitrage strategy – varies, so that comparisons across deals are not straightforward.

Nevertheless, the annualized equivalent returns provide some guidelines. The average

risk arbitrage spread was 7.81 percent. On an annualized basis, with an average duration

of 57.3 days, the spread translates into 52.25 percent. To put these results into context, we

observed the largest return (20.2 percent or 115.4 percent annualized) for the Polymer

takeover of Dominion Textile in December 1997 where the tender price of $12.10 per

share ultimately closed at $14.55 after 64 days. This consumer products deal was not

unusual for companies in that sector, as the other three deals generated the highest

average spread of 13.04 percent (64.11 percent annualized). Financial services and oil

and gas risk arbitrage deals followed closely averaging about 9 and 7 percent (more than

43 percent annualized), respectively.8

Over the year, the TSE 300 index return 13.47 percent. As a result, the 52.25

percent overall annualized risk arbitrage spread would have easily cleared the market

benchmark, particularly if we consider that the average pre-announcement period betas

for the target stocks was 0.517. To address this benchmark issue more formally, we also

computed the adjusted spreads in Table 1. These measure the spreads on the target firms

8
Cambridge’s takeover of Markborough in June 1997 was the sole real estate deal and it generated a 23.37
percent spread over a 42 day period (203% annualized).

6
from announcement date to close/failure date in excess of the TSE 300 return (without

dividends reinvested) over the same horizon. On average, the adjusted spread was 4.79

percent which translates into an annualized 33.9 percent.

Figure 1 shows that the distribution of raw and adjusted spreads for M&A

transactions is significantly positively skewed. In fact, only five of the 37 deals yielded

zero or negative raw spreads and none declined by more than 6 percent. By contrast,

eleven deals yielded more than 10 percent. For the adjusted spreads, the distribution

shifts closer to zero, but the number of large positive outcomes (eight deals exceeding 10

percent) exceeds the large negative outcomes (-8.55 percent is lowest adjusted spread for

the Ranger Oil takeover of Elan Energy).

Where’s the Risk?

We use several types of comparisons to assess the risk involved in the business of

risk arbitrage. First, the annualized return from a conservative buy-and-hold strategy was

evaluated by benchmarking the risk arbitrage spreads with the return on the TSE 300

index. These results were presented in Table 1 and Figure 1. This naïve benchmark

captures relative performance, but, of course, ignores the risk exposures from investing in

these target companies.

A second method used to compare risk and return of different investments is to

compute the risk-adjusted excess return. This is usually done by first estimating the

systematic risk, or beta, of the investment and then subtracting the corresponding

portfolio of the market (TSE 300 index) return. A positive excess return would suggest

that there is profit beyond the compensation justified by the underlying risk. As Dukes et

7
al. (1992) point out, the concept of adjusting for systematic risk is less relevant in the

case of M&A deals because the target firms usually experience significant reorganization

or restructuring in response to tender offers. As a result, the risk structure of the firm may

change dramatically around the time of the tender offer. While the estimate of risk using

conventional statistical procedures may be biased, the magnitude of the changes may still

provide clues on relative risk. For each deal, we computed the pre-announcement period

beta for the target firm using daily returns in the year before announcement and an “in

play” beta using the daily returns from 10 days following the announcement to the close

of the deal. We excluded the 10 days before and after the announcement date in order to

minimize the influence of the unusually large returns during the announcement period.

Table 1 shows that the pre-announcement betas of the targets averaged 0.517, much

lower than expected for the risky nature of the deals in which the companies are

involved.9 In unreported results, the “in play” betas were even lower with an average of

0.393. Some of the most dramatic declines occur for those sectors that experience the

highest risk arbitrage spreads, including consumer products and paper and forest

products. Only for one sector, financial services with its four deals, did the in-play beta

increase relative to its pre-announcement beta, and this is driven primarily by an outlier

in the Investors Group takeover of Quorum Growth in May 1997. This comparison is

problematic not only because of measurement problems, but also because during the “in-

play” period - especially for all-cash offers – the movement of the market is unlikely to

have any impact on the price of the target firm. The betas are more likely to reflect non-

9
The average betas of these companies are likely low because of the “intervaling” effect in betas due to
non-trading factors.

8
market specific influences, such as new bidders, changes in the bid price or an increase in

the probability that the new bid will be successful.10

Though we must acknowledge problems inherent in these risk measures, risk

arbitrageurs surprisingly appear to benefit not only from spreads that outperform a buy-

and-hold, but also from changing risks associated with these strategies. To capture both

effects together, Figure 2 shows the cumulative abnormal returns to the risk arbitrage

strategy in event time from 50 days prior to the announcement date until the deal closed

of failed.11 The cumulative pre-announcement returns – which the arbitrageur would not

accrue – represent about 5 percent up to the announcement date. The most significant

single-day jump of 4 percent occurs on the announcement date and by Day 50 following

the announcement the abnormal return cumulates to a total of 17 percent. The risk

arbitrageur takes advantage of the cumulative returns from the close of the announcement

date only and would have achieved on a risk-adjusted basis 5.95% over 50 days, or 43.4

percent annualized.

The third method used to incorporate the risks of the risk arbitrage strategy

focuses on deal-specific elements. The deal element consists of factors such as the

expected time to close, necessary regulatory approvals, strategic fit of the two entities,

conditions of the agreement, payment mechanisms (cash versus stock or mixed offers),

and the financial health of the bidder and target. These factors are distinct from value-

specific elements which relate to the intrinsic valuation of the target, such as other recent

10
I thank Paul Halpern and Bruce Langstaff for clarifying this point.
11
We compute the raw daily returns for each target stock and subtract the TSE 300 index return adjusted by
the company’s pre-announcement beta. These abnormal returns are averaged across all 37 target companies
in event time (with the announcement date equal to Day 0) and cumulated from Day –50 to Day +50 or the
close/fail date, whichever comes first.

9
comparable transactions, potential competing bidders, the company’s ultimate worth

relative to the current bid price.12 To evaluate these deal-specific factors, we perform

multivariate regression analysis of the raw and adjusted spreads against a series of

variables which relate to deal-specific factors. These factors include the number of days

to close, the pre-announcement betas, the pre-announcement (2-week and 12-month

prior) stock price run-up and an oil and gas sector dummy variable. Days to close is a

potential proxy for the likelihood of success (Dukes et al., 1992) as it may signal the

impact of subsequent offers from competing bidders, which we do not double count in

our sample.13 We also include value-relevant risk attributes of the target as control

variables, including the capitalization of the target, and price-to-sales and price-to-book

ratios based on the share price two weeks prior to the announcement.

Table 2 presents the summary statistics from the regression analysis presented

separately for the raw and adjusted non-annualized spreads. In the first regression using

raw spreads, we find that the market capitalization variable is marginally significant with

a positive coefficient of 0.051. That spreads are positively related to size runs counter to

our priors from the size effect literature which suggests that the smaller, less liquid deals

would be riskier and should command a higher risk premium. Another variable that is

significantly negatively related to raw spreads is the 2-week pre-announcement run up.

That is, the profits that risk arbitrage yield are smaller if there is a larger run-up

immediately before the announcement. Schwert (1996)14 suggests that the relationship

12
Wyser-Pratte (1982, ibid., Chapter 1) defines this dichotomy of deal and value elements.
13
For example, London Insurance Group was acquired by Great-West Life Company at $34 after 140 days,
but only after Royal Bank initiated with the first bid at $28. We thank Paul Halpern and Bruce Langstaff
for clarifying this important point.
14
W. Schwert (1996) “Markup pricing in mergers and acquisitions,” Journal of Financial Economics, pp.
153-192, shows that the pre-bid runup and the post-announcement increase in the target’s stock price – his
reference to ‘markup’ – are generally uncorrelated.

10
between the run-up and the “mark-up” (what we call risk arbitrage spreads) may be a

reflection of the total control premium paid by the acquirer. To the extent that a large run-

up reflects either trading by insiders or toehold acquisitions by potential bidders, he

predicts that the mark-up does not have to be as large to achieve control, so that the mark-

up and run-up would be substitutable. While he finds little evidence of correlation

between markups and run-ups, our evidence is consistent with his prediction.

Interestingly, while we would expect the duration of the deal to best represent the indirect

proxy for the risk of deal failure (based on previous studies), the coefficient is positive,

but not significant statistically. Overall, the intercept coefficient is significantly positive

indicating the robustness of the risk arbitrage spreads to these deal-specific attributes.

The coefficient of determination (or R2) for the regression is 30.9 percent, or 7.96 percent

adjusted for the number of variables in the regression.

The second regression repeats the analysis for the adjusted spreads (non-

annualized). In this case, none of the deal-specific variables are statistically significant,

including the market capitalization and the pre-announcement run-up, though the signs of

the coefficients are similar. The days to close variable has a larger coefficient than with

the raw spreads, but it is still insignificant. The intercept coefficient for the adjusted

spreads regression is lower, as expected, but it is also still significant. The R2 drops

dramatically to 13.5 percent or –1.5 percent adjusting for the number of variables in the

regression, which indicates that the explanatory power of these deal-specific factors is

poor.

11
Implications

The evidence from this study has several interesting implications. It is possible for

average investors in Canada to participate in risk arbitrage, long considered the domain of

more informed, skilled traders. We have demonstrated that such investors would have

earned significantly higher than normal profits in the process of risk arbitrage. Most

merger and acquisition studies show that shareholders do not necessarily lose the

incremental wealth accumulated between announcement of the acquisition and the

resolution date, even if the tender offer fails. This is the key factor in the significant

spreads in risk arbitrage and the findings of this study support this argument. Not only do

risk arbitrage investors earn higher returns than for a conservative buy-and-hold strategy,

but also the magnitude of their excess returns are insensitive to a number of deal-specific

attributes, such as the number of days to close, payment method, size of the deal and the

pre-announcement share price run-up.

It remains to be seen if these risk-return patterns in the M&A market in Canada in

1997 are an anomaly or an exception that proves the rule. One indisputable fact is that the

opportunities to evaluate such a strategy will continue as the M&A market of the 1990s

continues to blossom in Canada.

12
TABLE 1

Returns for Risk Arbitrage in Canada by Industry Sector

Industry Sector Number of Average Market Average Average Average Averaage Betas
Deals Duration of Capitalization Spread Annualized Adjusted Annualized
Deal (days) ($ millions) Spread Spread Adjusted
Spread

Communications & Media 1 78.0 923.0 8.53% 39.91% -4.06% -19.01% 0.464
Consumer Products 4 82.3 510.0 13.04% 64.11% 5.32% 26.35% 0.376
Financial Services 4 82.0 1807.0 9.28% 35.35% 4.37% 7.79% 0.649
Industrial Products 5 42.2 127.6 3.23% 31.52% 1.38% 33.29% 0.807
Merchandising 2 37.0 108.5 3.32% 35.84% 4.61% 78.59% 0.297
Oil & Gas 14 43.9 410.0 6.19% 47.26% 6.36% 37.19% 0.496
Paper & Forest 4 85.8 1256.5 6.46% 36.24% 4.61% 27.29% 0.616
Real Estate 1 42.0 375.0 23.37% 203.1% 14.71% 127.8% 0.179
Transportation 2 50.5 99.5 9.75% 61.19% 2.02% 3.15% 0.361

Total All Transactions 37 57.3 571.6 7.81% 52.25% 4.79% 33.93% 0.517

Note: Betas are computed from daily returns during the 250 days prior to the announcement period which runs 10 days on either side
of the announcement date. Adjusted spread is computed as the excess return of the target company relative to the TSE 300 index.

13
TABLE 2

Regression Analysis of Returns for Risk Arbitrage in Canada

Regression Variable Spreads Adjusted Spreads

Intercept 0.1754 0.0447

(2.59)** (1.86)*
Market Capitalization (logarithm) 0.0507 0.0334
(1.66)* (0.80)
Beta -0.0388 0.0214
(-1.23) (0.49)
Price to Sales Ratio (x 10-3) 0.5564 0.5216
(0.14) (0.09)
Price to Book Ratio -0.0014 -0.0021
(-0.44) (-0.48)
Oil &Gas Dummy 0.0284 0.0357
(0.83) (0.77)
Days to Close (x 10-3) 0.0688 0.1922
(0.12) (0.25)
Cash Offer Dummy -0.0162 0.0076
(-0.50) (0.17)
Pre-Announcement Run-Up (2 week) -0.1879 -0.1396
(-2.13)** (-1.16)
Pre-Announcement Run-Up (1 year) 0.0178 0.0307
(0.61) (0.76)

R2 (adjusted) 0.309 (0.079) 0.135 (-0.015)

F-statistic 1.346 0.470

Note: Oil & Gas Dummy equals one for all deals in the oil & gas sector; otherwise, zero.
Cash Offer dummy equals one for all cash or mixed cash/stock offers; otherwise, zero.
Betas are computed using 1 year of daily returns prior to the acquisition announcement
period which runs 10 days before and after the announcement date. R2 is the coefficient
of determination and F-statistic tests the null hypothesis that all the regression variables
are insignificant. ** denotes significance at the 5% level, *, at the 10% level.

14
FIGURE 1

Frequency Distribution of Risk Arbitrage Spreads and Adjusted Spreads

14

12

10

0
<-5% -5% to 0% 0% to 5% 5% to 10% 10% to 15% 15% to 20% >20%

Spreads Abnormal Returns

16
FIGURE 2

Cumulative Abnormal Returns to Risk Arbitrage Strategy

20%

15%
Cumulative Abnormal Returns (%)

10%

5%

0%
-50 -40 -30 -20 -10 0 10 20 30 40 50

-5%
Days Relative to Acquisition Announcement Date

17