Extensions of the Merger Arbitrage Risk Model

St phane Daul e RiskMetrics Group stephane.daul@riskmetrics.com

A traditional VaR approach is not suitable to assess the risk of merger arbitrage hedge funds. We recently proposed a simple two- or three-state model that captures the risk characteristics of the deals in which merger arbitrage funds invest. Here, we rene the model, and demonstrate that it captures merger and acquisition risk characteristics using over 4000 historical deals. We then measure the risk of a realistic sample portfolio. The risk measures that we obtain are consistent with those of actual hedge funds. Finally, we present a statistical model for the probability of success and show that we beat the market in an out-of-sample study, suggesting that there is a potential alpha for merger arbitrage hedge funds.

Introduction

The merger arbitrage strategy consists of capturing the spread between the market and bid prices that occurs when a merger or acquisition is announced. There are two main types of mergers: cash mergers and stock mergers. In a cash merger, the acquirer offers to exchange cash for the target companys equity. In a stock merger, the acquirer offers its common stock to the target in lieu of cash. Let us consider a cash merger in more detail. Company A decides to acquire Company B, for example for a vertical synergy (B is a supplier of A). Company A announces that they offer a given price for each share of B. The price of stock B will immediately jump to (almost) that level. However, the transaction typically will not be effective for a number of months, as it is subject to regulator clearance, shareholder approval, and other matters. During the interim, the stock price of B actually trades at a discount with respect to the offer price, since their is a risk that the deal fails. Usually, the discount decreases as the effective date approaches and vanishes at the effective date. In a stock merger, company A offers to exchange a xed number of its shares for each share of B. The stock price of B trades at a discount with respect to the share price of A (rescaled by the exchange ratio) as long as the deal is not closed. With a cash merger, the arbitrageur simply buys the target companys stock. As mentioned above, the targets stock sells at a discount to the payment promised, and prots can be made by buying the

Electronic copy available at: http://ssrn.com/abstract=1548411

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Extensions of the Merger Arbitrage Risk Model

Figure 1 Cash deals. Share price of target (thick line) and bid offer (dotted line)
LabOne Inc.
46 13 12.5 44 12 11.5 Share Price 11 10.5 10 9.5 9 8.5 34 31May05 31Jun05 31Jul05 31Aug05 30Sep05 31Oct05 Date 8 9Jun05 31Jun05 31Jul05 Date 31Aug05 30Sep05

InfoUSA Inc.

42 Share Price

40

38

36

targets stock and holding it until merger consummation. At that time, the arbitrageur sells the targets common stock to the acquiring rm for the offer price. For example, on 8 August 2005, Quest Diagnostic announced that it was offering $43.90 in cash for each publicly held share of LabOne Inc. The left panel of Figure 1 shows the LabOne share price. It can be seen that the shares closed at $42.82 on 23 August 2005. This represents a 2.5% discount with respect to the bid price. The deal closed successfully on 1 November 2005 (just over two months after the announcement), generating an annualized return of 10.9% for the arbitrageur. In a stock merger, the arbitrageur sells short the acquiring rms stock in addition to buying the targets stock. The primary source of prot is the difference between the price obtained from the short sale of the acquirers stock and the price paid for the targets stock. For example, on 20 December 2005, Seagate Technology announced that it would acquire Maxtor Corp. The terms of the acquisition included a xed share exchange ratio of 0.37 share of Seagate Technology for every Maxtor share. Figure 2 shows the movement of both the acquirer share price and the target share price. On December 21, Maxtor shares closed at $6.90 and Seagate at $20.21 yielding a $0.58 merger spread. The deal was completed successfully on 22 May 2006. More complicated deal structures involving preferred stock, warrants, or collars are common. From the arbitrageurs perspective, the important feature of all these deal structures is that returns depend on

Electronic copy available at: http://ssrn.com/abstract=1548411

Introduction

53

Figure 2 Equity deal. Share prices of Maxtor (thick line) and Seagate Technology (dotted line) Seagate Technology share prices are rescaled by the exchange ratio.
11 10 9 8 7 6 5 4 3 31Oct05

Share Price

31Dec05

28Feb06 Date

30Apr06 31May06

mergers being successfully completed. Thus the primary risk borne by the arbitrageur is that of deal failure. For example, on 13 June 2005, Vin Gupta & Co LLC announced that it was offering $11.75 in cash for each share of infoUSA Inc. In the right panel of Figure 1, we see that after the announcement, the share price of infoUSA jumped to that level. The offer was withdrawn, however, on 24 August 2005, and the share price fell to a similar pre-announcement level. A recent survey of 21 merger arbitrageurs (Moore, Lai, and Oppenheimer 2006) found that they invest mainly in announced transactions with a minimum size of $100 million and use leverage to some extent. They gain relevant information using outside consultants and get involved in deals within a couple of days after the transaction is announced. They unwind their positions slowly in cases where the deal is canceled, minimizing liquidity issues. Their portfolios consist, on average, of 36 positions. Finally, from Figure 3, we clearly see that the volatility of the share price before and after the announcement is very different. Measuring the risk with a traditional VaR approach in terms of historical volatility is surely wrong. Thus arbitrageurs typically control their risk by setting position limits and by diversifying industry and country exposures. We recently have developed a risk model suitable for a VaR approach that captures the characteristics of these merger arbitrage deals (Daul 2007). In this article, we will rene this model to better describe equity deals and also study in more detail the probability of deal success. The model will then be tested on 4000+ worldwide deals and also compared to real hedge funds.

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Extensions of the Merger Arbitrage Risk Model

Figure 3 Stock price of LabOne Inc. The large dot refers to the announcement date.

31May05 31Jun05 31Jul05 31Aug05 30Sep05 31Oct05 Date

Risk Model

We consider only pure cash or equity deals, and introduce the following notation (see Figure 4): St is the stock price of the target rm at time t. t0 is the announcement date. is the deal length. Kt is the bid offer per share at time t. For cash deals, the bid offer is typically xed and known at announcement date, Kt = Kt0 . For equity deals, the bid offer is the acquirer stock price At times the deal conversion ratio , Kt = At . This difference will not affect our model as the main hypothesis applies when the deal is withdrawn. Notice further that for cash deals, the bid offer can also change over time, for example if the offer is sweetened or if a second bidder enters the game (Daul 2007). The announcement date t0 is evidently xed. The deal length can uctuate and is modeled as a random variable following a distribution F(t) = P( t). (1)

Share Price

Risk Model

55

Figure 4 Denition of parameters

St

Share Price
0

t0

31May05 31Jun05 31Jul05 31Aug05 30Sep05 31Oct05 Date

We will consider a model conditioned on , where at time t0 + (the effective date), we know if the deal is completed (success) or withdrawn (failure). To model this event, we introduce the binomial indicator C. With probability , we have C = 1, indicating deal success, and with probability 1 , we have C = 0, indicating deal failure. In case of success, the stock price of the target reaches its bid offer, while when the deal breaks we have to make further assumptions. This will consist of our main hypothesis: we model the level to which the stock price jumps as a virtual stock price St . Hence the stock price at the effective date is St0 + = Kt0 + if C = 1, St0 + if C = 0. (2)

Since the withdrawal might be considered as negative information, the virtual stock price is subject to a random shock J at time t0 + . An illustration of this virtual stock price is shown in Figure 5. The black line is the real stock price for a withdrawn deal, and the dotted blue line is a virtual path that the stock price could have taken if no deal had been put in place. The virtual stock price follows a simple jump-diffusion process d St = St dt + St dWt J St dNt , (3)

where is the drift (set to zero afterwards), is the volatility of the price before announcement, J is a positive random shock following an exponential distribution with parameter cash for cash deals and

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Extensions of the Merger Arbitrage Risk Model

Figure 5 Virtual stock price

31

30

29

28

JS

27 Share Price

26

25

24

23

22

21 31Sep05

31Dec05

31Mar06 Date

30Jun06

30Sep06 30Nov06

equity for equity deals, and Nt is a point process taking values 1 if t t0 + , 0 if t < t0 + .

N(t) =

(4)

Finally, the initial condition is St0 = St0 . We can easily integrate this process and get for t < t0 + , St = St0 eZ (6) (5)

1 where Z follows a normal distribution with mean ( 2 2 )(t t0) and standard deviation t t0 . For t = t0 + we get St0 + = St0 eZ (1 J). (7)

Parameters estimation and model validation

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Parameters estimation and model validation

3.1 Virtual stock price

The parameters of the model are estimated using historical information on deals. The transaction details (such as announcement date, effective date, type of deal, and so forth) are obtained from Thomson One Banker. We consider pure cash or equity deals between public companies from 1996 to 2006 worldwide where the target company offered value is over $100 million. We consider those deals for which we can also obtain stock prices from DataMetrics. The daily drift is set to zero, and the ex-ante deal daily volatility is estimated using one year of daily returns, equally weighted. The intensity parameters cash and equity of the shock are obtained by moment matching. Conditional on deal failure, the expected value of the stock price is E[St0 + |C = 0] = St0 e( Assuming 2 /2 0, we get E
2 /2)

(1 ).

(8)

St0 + C = 0 = (1 ). St0

(9)

Using the 131 withdrawn cash deals in our database, we get cash = 0.07 0.06; using the 33 withdrawn equity deals, we get equity = 0.2 0.1. Hence we set cash = 0 and equity = 0.2. (10)

3.2 Deal length

We model the deal length with a Weibull distribution having parameters a and b, F(t) = 1 e( a ) .
t b

(11)

This distribution is assumed to be universal. Using 1075 realized deal lengths (measured in days), we obtain the following boundaries at 95% level of condence: 143 < a < 154 1.43 < b < 1.56 This corresponds to an average deal length of L = 135 days. (14) (12) (13)

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Extensions of the Merger Arbitrage Risk Model

3.3 Test of the main hypothesis

As stated above, the main hypothesis is the existence of a virtual stock price that is reached only in case of withdrawal. For cash deals, cash = 0, meaning the stock prices after withdrawal should follow a lognormal distribution, with volatility i different for each deal i. Hence, the normalized residuals log ui =
Sti
0 +i Sti0

i i

(15)

should follow a standard normal distribution. The p-value of a Kolmogorov-Smirnov test using the 131 withdrawn deals is 93%, implying that we cannot reject at all the main hypothesis. For equity deals, equity = 0.2, and the residuals dened as above do not follow a normal distribution. Instead we study the residuals Sti + (16) vi = 0 i . St0 This should be distributed as eZi (1 J), (17)

where Zi follows a normal distribution with parameter i different for each deal. We set the volatility equal to the average of the i , and use Monte Carlo to obtain a sample distributed according to (17). We then compare this sample to our 33 withdrawn deals using a two-sample Kolmogorov-Smirnov test. The result is a p-value of 53%. Again we cannot reject at all the hypothesis, conrming the validity of our model.

Risk measurement application

We want to measure the risk of a sample portfolio consisting of 30 pure cash deals pending end of 2006. All deals are described by the target company, the bid offer K, the date of announcement t0 , the probability of success ,

Risk measurement application

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Table 1 VaR using the merger arbitrage risk model and the traditional risk model VaR level 95% 99% Merger Arb Model 1.37% 2.21% Traditional Equity Model 7.25% 10.24%

Table 2 Dispersion of historical VaRs for merger arbitrage hedge funds VaR level 95% 99% 1st quartile 0.81% 2.17% median 1.29% 2.92% 3rd quartile 1.68% 4.90%

and are assumed independent. We set the probability of success to the historical value of 86% (see Section 5). We forecast the P&L distribution of the portfolio at a risk horizon of one month using Monte-Carlo simulations. For each deal, one iteration is as follows:

1. Draw an effective date using the Weibull distribution. 2. If the risk horizon is subsequent to the effective date, draw a completion indicator. If the risk horizon is before the effective date, the deal stays in place. 3. If the completion indicator indicates failure, draw a virtual stock price, and calculate the loss. If the completion indicator indicates success, calculate the prot.

Table 1 reports the VaRs at two different condence levels obtained from model, as well as VaRs obtained from modeling the positions as simple equities following a log-normal distribution. We notice that our model produces lower risk measures, consistent with our expectation. For more evidence, we compare these monthly VaRs with the historical monthly VaRs of 41 merger arbitrage hedge funds obtained from the HFR database. Table 2 shows that the dispersion of the hedge fund VaRs contains our models results. We conclude that our new model consistently captures the risk of a merger arbitrage hedge fund, and that the traditional model likely overstates risk.

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Extensions of the Merger Arbitrage Risk Model

5 Probability of success
In the risk measurement application above, the probability of success was unconditional on the deal, and set to the historical estimate using all deals worldwide from 1996 to 2006
historical

Nsuccess 4176 = 86%. = Ntotal 4879

(18)

A deal-specic probability of success can be inferred from the observed spread in the market as in (Daul 2007), (19) implied = ( , St0 , K, rfree ) . Alternately, we may t an empirical model. We will use a logistic regression and assume that the probability of success is a function of observable factors Xi as
empirical

1 1+ e
i bi Xi

(20)

If the factor sensitivity bi is positive, then larger Xi lead to higher probability of success, assuming other factors are constant. We consider the following factors: Target attitude: Xi = 1 Friendly 0 Neutral 1 Hostile

Premium: the relative extra amount the bidder offers. Its magnitude should be an indicator of the acquirers interest. K St0 Xi = St0 Multiple: the ratio of enterprize value (EV), calculated by adding the targets debt to the deal value, to the EBITDA, an accounting measure of cash ows. Xi = EV EBITDA

Industrial sector: By acquiring a target in the same industrial sector, the acquirer increases its market share. This could inuence deal success. Xi = 1 same sectors 0 different sectors

Probability of success

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Table 3 Logistic regression on 1322 deals Factor Constant Target attitude Premium Multiple Industrial sectors Relative size Deal type Trailing number of deals bi -1.09 1.79 0.76 0.44 0.33 0.44 0.34 -0.29 p-value 0.04 0.00 0.17 0.00 0.15 0.00 0.16 0.19

Relative size of acquirer to the target Xi = log Deal type Xi = 1 cash 0 equity Acquirer assets . EV

Trailing number of deals. The number of deals is cyclical; the position in that cycle should inuence deal completion. Ndeals in last 12 months Xi = yearly average of Ndeals We have 1322 realized deals (completed or withdrawn) with all factors available. Table 3 shows the results obtained from the logistic regression. We see that attitude, multiple and relative size are very relevant factors (very small p-values). The premium, having the target and the acquirer in the same industrial sector and the deal type are relevant to some extent. The sensitivity for the trailing number of deals is counterintuitive: it appears that a large number of deals announced might catalyze less convincing deals. To assess the predictive power of our model we perform an out-of-sample test, and compute the so-called cumulative accuracy prole (CAP) curve. The model parameters are t using the 873 (66%) oldest deals. We then infer the probability of success for the remaining 449 (34%) deals. After sorting the deals by their probability of success obtained with the statistical model (from less probable to most probable), the CAP curve is calculated as the cumulative ratio of failures as a function of the cumulative ratio of all deals.

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Extensions of the Merger Arbitrage Risk Model

Figure 6 CAP curve for the out-of-sample test (OOS) and the implied probability of success
1

0.8

0.6

0.4

OOS

0.2

implied

0 0

0.2

0.4

0.6

0.8

The 449 out-of-sample deals have an overall failure ratio of 10.2%. If the model were perfect, then the rst 10.2% of deals as sorted by our model would have contained all of the failed deals, and we would have CAP(x) = 1 for x 10.2%. If the model were useless, the ordering would be random, and we would have CAP(x) = x. In Figure 6 we show the result for the out-of-sample test, the market-implied probability of success and the two limiting cases. We clearly see that our model beats the market, suggesting that there is a potential alpha for merger arbitrage hedge funds. Further looking closer at the lower left corner we notice that the CAP curve for the statistical model follows the perfect limiting case up to about 5%. This means that our statistical model ranks the rst half of the withdrawn deals perfectly as the worst ones.

Conclusion

The specics of merger arbitrage deals can be captured introducing a binomial completion indicator and a virtual stock price modeled as a simple jump-diffusion process. This model has been validated using a large set of deals. A merger arbitrage hedge fund would benet from using this model to measure the risk of his portfolio in a VaR framework and/or perform stress tests using the probability

Conclusion

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of deal success for example. Finally we have developed a statistical model for the probability of success and showed in a out-of-sample analysis that its forecasting power is superior to the market predicting power.

References
Daul, S. (2007). Merger arbitrage risk model. RiskMetrics Journal 7(1), 129141. Moore, K. M., G. C. Lai, and H. R. Oppenheimer (2006). The behavior of risk aribtrageurs in mergers and acquisitions. The Journal of Alternatives Investments Summer.