Post-announcement merger arbitrage
So I have an example from an old colleague on a mergerI thought was interesting. The stock traded at $7.80/share, the company had a takeover offer on the table for €8.00/share. Whether the deal was successful or not would be known in 6 weeks. The resulting gain of 2.6%, or rather a 25% annualised gain. Not too shabby.
But digging deeper shows some flaws. Prior to the announcement, the target company traded at €6/share. This means that at €7.80/share, the market prices in a 90% chance the deal gets approved by all stakeholders (regulators, shareholders, comp authorities etc).
For this to yield a positive expected outcome, you need to believe the probability of approval is greater than 90%.
Based on a probability-weighted basis, it doesn't look good!
Where it gets interesting is extrapolating this example to pre-covid. In early Feb 2020, my colleague's portfolio was up 5%. He didn't think covid was going to be a big deal in terms of the economic impact at the time. But he did believe that if it spiralled out of control, it would have some pretty hair-raising consequences.
He ran a scenario where the market continues to advance at its historic averages: somewhere between 5-7% p.a. The market was already up 1.4% at the time of the year, so by staying invested, he should expect further gains of roughly 1-2% over the next 3 months. What happens if covid does hit the market? Let's say it resulted in a bear market, something like a real bear drop of 20-25%. What probabilities do you need to believe in for this to be a 0 expected outcome event?
My question may be elementary but how do you think he arrived at the probability numbers? especially the 90% chance the merger goes through?