In Search of Merger-Arbitrage Plays

 | Nov 30, 2011 | 12:30 PM EST
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Arbitrage may be the holy grail of investing: It's the one mechanism or activity that investors are constantly seeking but hardly ever seem to find. Arbitrage, in the purest sense of the word, is what all investors are after: a riskless return. 

Imagine that you could buy a pound of coffee in one market for $5 and sell the same pound of coffee in another market for $6. You don't need a knack for numbers to see that in such an environment, you would buy all the coffee you could in one market and sell it in the other market for a guaranteed $1 profit. 

Arbitrage, in theory, should not exist. As soon as investors realize the price inefficiency, they would all buy the cheap coffee and sell the expensive coffee until both prices converge. But arbitrage does exist because of market inefficiencies, although not for long. 

Merger arbitrage is a very fertile hunting ground for investors looking to lock in returns within a specific period of time. Naturally, merger arbitrage should not exist. Once a deal is announced, the target company's share price usually jumps to the target price and hangs around there until the deal closes. Yet that is not always how it works; the target company's share price often sits well below the offer price for a period of time after the deal is announced. 

There are obvious reasons why this can happen. First, the market may not believe in the ability of the buyer to consummate the deal. A recent example is Carl Icahn's effort to buy Clorox (CLX) for $84 a share. Even after Icahn's offer, shares in Clorox hovered around $70. The market was right; Icahn backed off. Second, antitrust or other regulatory issues may ultimately prevent the deal from going through; this hurdle can usually be overcome, but regulatory issues can delay deals, and that then causes the market to lose interest and create an arb trade. 

Yet sometimes the market can be wrong. The key to any merger arb trade is to assess the probability of the deal going through against the possible upside. I've identified a couple of pending mergers, and if they are completed, investors stand to make a tidy return in a relatively short period of time.

Advanced Analogic Technologies (AATI) agreed to be acquired by Skyworks Solutions (SWKS) for $6.05 in September. Advanced Analogic currently trades for $4.50. The deal is expected to close on Dec. 31, 2011, and it would represent a 30% profit in a month, or a 360% annualized profit. Skyworks has been talking about not buying Advanced Analogic, but the belief is that Skyworks is angling for a lower price. Even at $5 or more a share, investors would collect a tidy return.

Express Scripts (ESRX) is in the process of acquiring rival Medco Health Solutions (MHS) for $67 a share. Medco shares currently trade for $55. The deal is expected to close in June 2012. The seven-month return of 21% translates into a 36% annualized return.

El Paso (EP) is set to be acquired by Kinder Morgan (KMI) for about $28 a share in cash, stock and warrants. This deal is all but certain to go through. Even so, El Paso shares trade for $25. The deal is expected to close in the first quarter of 2012, and investors can pocket a 12% return in four months or less. Of course, the cash and stock combination creates the possibility to lose the arb profit if the share price of Kinder Morgan fluctuates. Investors can hedge that, though, by shorting Kinder Morgan shares proportionate to deal terms.

A recovering economy makes companies more confident about buying other companies, thereby increasing the probability that deals go through. Fishing for merger arbitrage plays is an intelligent way to pocket gains in a relatively short period of time, irrespective of market direction.



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