Risk Arbitrage (outline)

Patrick Fruzzetti, Christopher Lentz, Lewis Silberman, Kimberly Williams

Risk Arbitrage – Defined

 Seeking to profit by acquiring securities which

are discounted from the value to be paid or
them in a proposed merger or acquisition due
to the uncertainty of transaction timing and
completion
 Brencourt Advisors LLC  Shorewater Advisors LLC
 EAC (Soros) Management LP  Taconic Capital Advisors LP
 Eton Park Capital  Westchester Capital
Management, L.P. Management, Inc.
 Glazer Capital, LLC  York Capital
 Gruss Asset Management LP  Harvest Hedge Fund
 Haycyon Asset Management  Quattro Global Capital, LLC
LLC
 Paulson & Co Inc
Risk and Return Profiles

 Risk
 Legal/Regulatory
 Merger Agreement Details
 Timing
 Return
 Trading Spread
 Net Spread
Risk Arbitrage Strategy

 Why is it an interesting strategy?

 US companies are flush with cash, $1.8 T, that will
drive more M&A
 “Characteristics of Risk and Return in Risk
Arbitrage” by Mitchell & Pulvino
▪ Risk arbitrage positively correlated with market returns
in severely depreciating markets
▪ Uncorrelated with market returns in flat and
appreciating markets
Risk Arbitrage Performance

 2010 Index Returns through September:

 4.0% Hennessee Group Merger Arbitrage Index
 5.51% Barclay Merger Arbitrage Index
 4.63% HedgeFund.net HFN Merger/Risk Arbitrage
Index
 2010 Single Fund Example
 2.51% The Merger Fund

http://www.economist.com/node/17103806?story_id=17103806&CFID=146332686&CFTOKEN=14944332
http://hennesseegroup.com/indices/returns/year/2010.html
http://www.barclayhedge.com/research/indices/ghs/Merger_Arbitrage_Index.html
http://www.hedgefund.net/hfn_public/marketing_index_new.aspx?template=realtime.html
http://www.mergerfund.com/pdfs/TMF_performance_quarterly.pdf
Cash takeover – basic strategy

 How to do it: Buy The Target

 Capture the spread between the market price and
announced tender price
 Asymmetric risk is not priced into the market
 Recent trend shows increased likelyhood of
consummation
▪ In 2010 year to date, there is a significant increase in the proportion of announced
deals that close (or are expected to close) in less than 45 or in less than 60 days.
▪ 29% of deals to close within 60 days, as compared with the 13% average between
2002-2010.
▪ 16% of deals to close within 45 days, as compared with the 4% average between
2002-2010.

Source: Barclays Third Quarter 2010 Risk Arbitrage Review

Cash deal - example

 3PAR
 Cash deal - example
 3PAR
 Cash deal - example
 3PAR
 Cash deal - example
 3PAR
 Cash deal - example
 3PAR
Stock deals – basic strategy

 How to do it: In a stock-for-stock transaction,

short a number of acquirer shares equal to
the exchange ratio and purchase target
shares
 Same premise as cash arbitrage, but completed
via stock
 More moving parts, since outcome is dependent
on market prices of both stocks, non cash
endpoint to trade
Stock deals – basic strategy

 Why Holders Should Sell

 Realize majority (>95%) of deal premium
 Not worth risk of arb spread
 Merger Arb is not core competency
 95% of deals close, but not worth the risk

 In general, Holders overestimate the chances of an

another bidder/overbid

 Harman Example
 Deal Announced April 2007 – Stock trades up from ~$100 to $122.
 Deal Cancelled September 21, 2007 – Stock plummets to $80. Slow
leak from 122 to 112 in preceeding 4 months
Stock deals – basic strategy

 HAR
Stock deal - example

 Optionality enters into merger arbitrage

trades in various forms.
 Fixed-value collars
 Price Caps
 Walkaway provisions accompanied by price floors
 Cancelled Deals
 Huntsman/Hexion
 Penn National Gaming/Fortress
 3PAR – Dell payment
Our edge – PATRICK/LEWIS
 Focused trade selection
 Run a portfolio for alpha
▪ Don’t “own every deal”
 Hedging
 Take advantage collapsed volatility in out-of-the-money options in
“riskier” deals
 Investment staff with varied financial backgrounds
 Diverse sector and product experience
 Outsource legal advisory
 Cost-effective but critical deal “check”
 Prime brokerage relationships
 Lowers financing (leverage) and borrowing costs
Proposed Portfolio – Overview
PATRICK/LEWIS
 How many deals on at once?
 Initially, five
 Mix of cash and stock for stock or blends
 Position sizing?
 Initially, equally-weighted
 Transaction costs
 Wait three days (approx.) to initiate position
▪ Risk arbitrage desks likely to set spreads at cheap rates
 Hedging
 Evaluate cost of protection
 Leverage
 2x in order to enhance returns
Proposed Portfolio – Q/CTL

 Qwest Communications and CenturyLink

 Gross spread = $0.30 (4.72% premium)
 Current Price = $6.43
 Payment Type – Stock
 Friendly bid
 Tender offer expires 6/30/2011
 Strategy: Long 1 Q share and short 0.1664
CTL shares
Proposed Portfolio – Q/CTL
Proposed Portfolio – ADCT/TEL

 ADC Telecom and Tyco Electronics

 Gross spread = $0.04 (0.31% premium)
 Current Price = $12.71
 Payment Type – Cash
 Friendly bid
 Tender offer expires 11/15/2010
 Strategy: Long ADCT shares
Proposed Portfolio – ADCT/TEL
Proposed Portfolio – PSYS/UHS

 Psychiatric Solutions and Universal Health

 Gross spread = $0.08 (0.24% premium)
 Current Price = $33.67
 Payment Type – Cash
 Friendly bid
 Tender offer expires 12/31/2010
 Strategy: Long PSYS shares
Proposed Portfolio – PSYS/UHS
Proposed Portfolio – GYMB/Bain

 Gymboree Corp. and Bain Capital

 Gross spread = $0.54 (0.83% premium)
 Current Price = $64.86
 Payment Type – Cash
 Friendly bid
 Tender offer expires 12/31/2010
 Strategy: Long GYMB shares
Proposed Portfolio – GYMB/Bain
Proposed Portfolio – KG/PFE

 King Pharmaceuticals and Pfizer

 Gross spread = $0.08 (0.56% premium)
 Current Price = $14.17
 Payment Type – Cash
 Friendly bid
 Tender offer expires 6/30/2011
 Strategy: Long KG shares
Proposed Portfolio – KG/PFE
Proposed Portfolio – GENZ/SAN

 Genzyme Corp. and Sanofi-Aventis SA

 Deal Price - $69 (20x original 2011E = $3.45)
 GENZ stating bid too low. Revised 2011E =
$4.30-$4.60 (or ~$89 at 20x multiple)
 Current Price = $71.96
 Payment Type – Cash
 Hostile bid
 Tender offer expires 6/30/2011
 Strategy: Long GENZ shares
Proposed Portfolio – GENZ/SAN
Proposed Portfolio

 Insert excel file here

Questions?