Scenario analysis: A key part of merger arbitrage
We know that the annualized spread in the Informatica merger is about 4%, provided everything goes according to plan. In the risk arbitrage world, a 4% spread is maybe a bit tight for a private equity transaction.
Generally speaking, your base-case assumption has to be that the deal closes as advertised and that you earn the spread. After all, a merger agreement is a contract. If the consortium tries to walk away without a MAC (material adverse change) occurring, the buyer could sue and demand specific performance. In other words, Informatica could ask a judge to force the consortium to do the transaction. Note there is a reverse termination fee, but it appears to be relatively narrow
What’s your downside if the deal breaks?
Before Elliott’s 13D, Informatica was trading at $38.43 a share. If the deal breaks, does the stock go back to that amount? That is probably as good a guess as any.
Look at the above graph and imagine that you’re short the spread. If the deal closes, the spread goes to zero and you make about $0.83. However, if the deal breaks, you end up having to cover around $8. So, the risk-to-reward ratio is $8 down to $0.83 up. It’s a risk-to-reward ratio of around 10 to 1. As a general rule, risk-to-reward ratios in the 15x–20x range are typical. This is a private equity transaction with a pretty small takeover premium.
In this case, it’s hard to see what would break the deal aside from a MAC on the part of Informatica. In that case, the downside is probably worse than $38.
Merger arbitrage resources
Other important merger spreads include the deal between Baker Hughes (BHI) and Halliburton (HAL) or the merger between Pharmacyclics (PCYC) and AbbVie (ABBV). For a primer on risk arbitrage investing, read Merger arbitrage must-knows: A key guide for investors.
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