Arbitrage process – I

I have been reading a book on risk arbitrage and came across the following steps in a typical deal (merger, spin-off, recap etc)

Deal announcement – This generally involves a press release or filing of an offer with BSE/ NSE with the requisite details. An investor has to be on a constant lookut for such announcements.

Gather and analyse information – After the investor comes to know about the deal, the next step involves gathering and analysing information.
The following are the various types of information which needs to be considered

Financial information: This involves reading all the filings with the stock exchange, Financial details of the companies involved such as the annual report, quarterly reports and analyst reports.

Legal information: gather and analyse any legal information which may impact the deal. For ex: check if there is an legal dispute in which the target or the acquiring company is involved, which may impact the success of the deal
Any tax and accounting implication should also be studied

Interpret and estimate – This stage involves the interpreting the information from step 2 and coming up with values for the following three variables

Returns estimate – The formulae used for the returns would as follows: Final target company price-Current price / Current price. In addition if the deal involves a stock for stock merger, then the investor should add the dividends to be received. If however the deal involves a mix of cash and stock, then the total return can be calculated as follows

(% of cash* amount of cash+% of stock * amount of stock)- Current price / Current price

If the transaction involves shorting the accquiring company stock and using borrowed money, then the return should be reduced by the dividends which needs to paid for the shorted stock and also by the interest cost of the borrowed capital.

Risk estimate – The risk in the transaction is the downside risk of the target company + Upside risk of the accquiring company

Downside risk = Current price – estimate of target company price if the deal fails

If the deal fails, and the investor has shorted the accquiring company stock to hedge, then he may incur an upsideside risk too

Upside risk = estimate of the accquiring company price if deal breaks – current price

The estimate of the prices for the target and accquiring company is done based on several factors such the pre-deal price, price of other companies in the industry etc.

Probability – This is the probaility of the deal coming through. The investor may assume there is an 80% probaility of the deal coming through. His estimate of returns my be 15% and estimate of risk may be 30%.

Based on these numbers the risk adjusted return is = .8*.15+.2*-.3 = 6%. This could be the absolute returns. If the investor expects the deal to complete in one month, then the annualized return is 72%.

It is important to consider the time it will take for the transaction or deal to happen and use that to estimate the annualized returns. The longer the time for the successful closure, the lower the annualized returns.

Estimation of probability is a very subjective exercise. An an investor one has to analyse the various subjective elements of a deal and estimate the likelyhood of the deal being successful.

The earlier one invests in a deal, the more the uncertainity and hence higher the spread. In the event that there are multiple scenarios possible for a deal such as possiblity of a white knight appearing, then the risk/return of each scenario needs to wieghted with the probability of that scenario to arrive at the estimated returns for a deal.

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