A Response to Arbitrage Pricing Theory – MBA Mondays with Darwin

Initially,  I meant this response as a comment to a recent blog post, Arbitrage Pricing Theory – MBA Mondays with Darwin, however as I began to write, it has taken on a life of it's own.

I commend Darwin in his endeavor to educate the general public, however to quote Darwin himself from a previous post :

“Not only do I disagree with his opinion, but I'm concerned that his advice is actually dangerous and gullible readers will lose money as a result.”

I realize that merger or risk arbitrage is presently alluring due to the raft of deals! coming to the fore.  In Risk Arbitrage back on?, I gave the reasons why many arbitrageurs are gearing up for what could be a banner year. I would caution, however that the subject is somewhat daunting, the scope of which cannot be covered in a single blog post.

That being said, I believe a little more color would dissuade any notion that putting on a risk arb trade is as easy and profitable as Darwin suggests. Hopefully I will enable readers to have a better understanding of the process of trading a merger deal .  Risk arb hedge funds have done rather poorly for the past few years, due to amongst other things the length of time a deal takes to go through which really screws with your return.

Merger Arbitrage – Whilst I agree with the basic outline of Darwin's merger arb paragraph, I think he is doing his readers a disservice by the rather simplistic overview of Risk Arbitrage given.  The announcement of a merger deal is merely the first scene of the first act of a production that could give Wagner's Ring Cycle a run for it's money.

Due to the scope of the subject matter, I will merely address the points Darwin has raised. He mentions that the price never reaches the theoretical price of the offer, this is technically not true as sometimes the price exceeds the offer price. Depending on whether the acquirer is paying a large enough premium, or if the offer undervalues the target, the target stock price will react accordingly.

Perhaps there is an alternative bidder as in the deal cited – AVIS(CAR) /Dollar Thrifty(DTG).  Initially the deal was between Hertz(HTZ) and Dollar Thrifty(DTG), The terms consisted of an exchange ratio of 0.6366 HTZ + $25.92/share in cash, and a $6.88/share special cash dividend to be paid by DTG immediately prior to the transaction's closing.

But the biggest reason the prices do not converge is it is not a “done deal”. There are many hoops to jump through beyond the initial announcement.  Typical timing for a non hostile, non regulated deal is 90-120 days.  That gives it enough time to clear the HSR antitrust act hurdle, and get SEC, DOJ , FTC and respective shareholders approvals.  Should it be in a regulated industry such as utilities, as in the recent Duke/Progress merger, timing increases to 1 year on average, to clear the additional regulatory bodies.

Now we get to the sexy, exciting, risky part of risk arb. The calculations have to work for you to even consider the trade.  How is the offer structured? all cash? cash and stock? In the deal cited, AVIS(CAR) initially offered $39.25 cash and 0.6543 CAR for every DTG in July 2010. That spread blew up(DTG stock price traded at a premium to the offering price) as the market thought the offer was not reflecting the inherent value of DTG.

Lets take Darwin's hypothetical:

“So, let's say you went out and bought shares on Monday and within a month, the FTC ruled that the deal could go through.  That would be a gain of ~$3 per share (6%) in a month, which is well over 70% annualized.”

AVIS(CAR) upped the offer to $45.79 cash and the same ratio 0.6543 in September 2010, for a theoretical offer price tonight of $53.24 vs  RTG ask price of $49.9 for a $1.69 spread or a spread premium of 3.27%.  To get the spread you have to lock it in  - so for every 1 DTG you buy , you have to sell .6543 CAR.

As a retail investor you would get shitty borrow rates – if your broker can get the borrow that is – right there your 3.27% return is more like 2%. The retail investor can bump returns up with leverage(like hedge funds) – which you also have to pay for - so that cuts further into your return. Depending on the broker, there will be a short interest credit(interest on the short sale of CAR – but again as a retail customer, its bupkiss)…

As an alternative to buying the target and shorting the acquirer,  you can utilize a buy-write(selling calls against a long stock position) or put purchase strategy to alter the risk reward profile.  In this example, Buy 100 DTG and sell a DTG Call or Buy 100 DTG, sell 65 CAR and buy 1 DTG put.  A word of caution, the put purchase strategy would cut sharply into your return, but your risk would be greatly reduced also.

I will end here as I guess 80% of you are no longer interested. For those of you that are interested, shoot me an email. I  would agree with Darwin that the deal is looking dicey but only in terms of what the eventual company would look like.  I think there will likely have to be some divestitures which might play havoc with the accretive numbers Avis is pumping out..

To wit, I am all for education, however there is no short cut or easy way. There are no cliff notes either. The work and risk involved should be made crystal clear, it is NOT easy.  Look at the mutual funds that thought they could replicate a risk arbitrage strategy. It is by no means impossible, but it takes a lot more work than the normal investor is willing to put in.

Happy Trading!