-Risk Arbitrage on merger between BT and MCI - PowerPoint Presentation

Slide1

-Risk Arbitrage on merger between BT and MCI

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide2

Time Line (Brief)

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide3

Time Line (Detail)

Time: November 1, 1996: Events: Information circulated about the possible merger between BT and MCI

.

Farallon

Capital Management’s Action

: Started collecting information and prepared themselves for a potential position

.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide4

Time Line (Detail)-Continued

Time: November 3,

1996

Event:

BT announced it had come to an agreement with MCI for an acquisition. And there were preliminary estimates that the merger would be completed within nine to twelve months

.

Farallon

Capital Management’s Action:

Reached some conclusions about the prospects for the merger:

Market Trend- a more integrated international market

Company Specific factors- BT knows well about MCI; great synergy effects potential

Regulation Barrier- little antitrust concerns; good chance of waiving the FCC’s ownership limit

Designed trading strategy:Came to the conclusion that the appropriate spread for the deal should be about 12% (difference between the price paid by BT and the market price of MCI)The current narrow spread is because the market hasn’t fully understand the effects of U.K.’s Advance Corporation TaxInitially take opposite of the usual merger arbitrage position by going long BT shares and selling short MCI shares.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide5

Time Line (Detail)-Continued

Time: November 4, 1996 to July 9, 1997Event: Spread widened; regulatory hurdles became less of a

concern

Farallon

Capital Management’s Action:

Reverse

its initial position by going long MCI shares and short BT shares, and continually add to its positions.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide6

Time Line (Detail)-Continued

Time: July 9, 1997 and after

Events:

MCI announced that the cost to enter local telephone market was substantially higher than expected, and its core long distance business will have a lower than expected earnings led by heightened competitive pressure. MCI guided future earnings expectation was down almost 50%.

It seemed BT was surprised by the MCI’s announcement and has the potential to renegotiate the contract or even terminate the merger.

Debate raged on Wall Street regarding the prospects of the MCI merger.

Both MCI and BT’s stock prices declined and

Farallon

Capital Management had lost money on the position

.

Farallon

Capital Management’s Action:

Was Being Discussed

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide7

How to execute Risk Arbitrage

Spot OpportunitiesSelect deals for further reviewDue diligence

Take trading positions

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide8

How to execute Risk Arbitrage

Spot OpportunitiesMonitor the market to see if there is any “rumor” about potential mergers and if there is any new announcement of mergers.

Select deals for further

review

Filter out “noises” and decide what are the deals that worth further investigation.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide9

How to execute Risk Arbitrage

Due diligence

Understanding

the potential

risks and returns

Valuations

Understanding the impacts

of the merger

on

the acquirer and the target

firm

B

ased on various sources of informationWall Street equity analystinvestors relations department of companies affected by a merger announcementLawyersother industry expertscompetitors

of the companymajor institutional

shareholders

investment bankers

political consultants

trade journals

newspaper reporters

other

arbitrage funds

.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide10

How to execute Risk Arbitrage

Take trading positionsTwo ways:

C

ash

purchase of the target firm’s stock if the merger is a cash

dealP

urchase

the target company’s stock and sell short the stock of the acquiring company if the merger is a stock-for-stock

deal

Gradually commit more capital as the picture of the merger getting more and more clear.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide11

M&A Arbitrage: Risk and Return

Risk: The merger doesn’t happen as expected, which cause the target’s stock price reverse to the level before the merger announcement(ignoring general market movement), and since the arbitrager is taking a long position in target’s stock, this will lead to a loss to the arbitrager

.

Return:

If the merger happens as expected, then the arbitrager will profit from the long side of the position, and the net profit is equal to the bid price from the acquirer for the target firm minus the arbitrager’s purchase price for the target firm’s stock.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide12

What to do with Farallon’s

position and with the hedge?

Current

Situations(July 1997):

Farallon

is not heavily

leveraged, which means

Farallon

can

take some losses and can

hold the position for a longer time

.

Lost money on the position, but because both the BT and MCI’s stock prices decline, it lose money on the long position but is gaining money on the short position, which means the situation is not too bad.Farallon had not had a down month since 1989, which means it is probably important to maintain this record because after a long time of good performances a negative return will look very unusual and may draw a lot of attention from the investors.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide13

What to do with Farallon’s

position and with the hedge?Implication from the decline of market price

:

Since the BT’s stock prices has declined, if we ignore the overall market movement, the decline of BT’s stock price means the market is still expecting

the merger

to happen.

At

the same time, the MCI’s stock price also declined, again if we ignore the overall market movement during the same period, the decline of MCI’s stock implied that the market believes the probability of the merger decreased, or the market believes the merger will be based on

an

renegotiated new contract.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide14

What to do with Farallon’s

position and with the hedge?Strategies and potential outcomes

:

If

the merger

fails, as long as Farallon

didn’t clear its positions, it will suffer a loss

.

If the contract renegotiated, as long as

Farallon

didn’t clear its positions, the event will bring uncertainty to its position. The reason is that the market already expects a certain level of renegotiation, so the impact of the actual renegotiated contract depends on whether the difference between the new and old contract is larger or smaller than it is expected

.

If the arrangement is proceed anyway, as long as Farallon didn’t clear its positions, it will profit from its positons.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891Slide15

What to do with Farallon’s

position and with the hedge?

Hold the position as it is

Gradually reduce the position

Clear the position

Merger Failed

BT: Up

MCI: Down

Impact on position: Negative

BT: Up

MCI: Down

Impact on position: Negative

BT: Up

MCI: Down

Impact on position: None

Contract Renegotiated

BT: Uncertain

MCI: Uncertain

Impact on position: Uncertain

BT: Uncertain

MCI: Uncertain

Impact on position: Uncertain

BT: Uncertain

MCI: Uncertain

Impact on position: None

Merger proceed as planned

BT: Down

MCI: Up

Impact on position: Positive

BT: Down

MCI: Up

Impact on position: Positive

BT: Down

MCI: Up

Impact on position: None

So the final decision is based on an assessment of the probabilities of different outcomes (failed, renegotiated, proceed), and based on the assessment of

Farallon’s

capacity (both financial and reputational) to withstand the potential losses.

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891