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Is the Cigna-Anthem Merger a Setup?

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Nov. 20 2020, Updated 12:49 p.m. ET

The annualized return is probably about right

As a general rule, hostile deals trade through the terms of the proposed transaction. This is mainly because investors know the buyer will have to improve its price to get a board recommendation, and the board is listening for the words “best and final” before it recommends an offer.

Second, Cigna (CI) has been put “in play,” which means other buyers will be taking a look. The spread is wide, but there are major unanswered questions, especially in best efforts language regarding regulatory approval. So it makes sense to give this one a wide berth.

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Watch what Cigna does, not what it says

Notwithstanding the frosty letters between the two companies, Cigna has been in negotiations with Anthem for months, and it’s clearly interested in a transaction if it makes sense. In fact, Cigna wanted more stock in lieu of cash than Anthem (ANTM) was willing to offer. Companies that aren’t interested in being bought by a certain competitor generally don’t push for more stock. Management issues will remain, but at the end of the day, the Cigna board’s fiduciary duty is to get the best deal for shareholders, not them.

What’s the risk, what’s the reward?

Take a look at the above graph. It gives the potential risk and reward for the transaction. As you look at the graph, imagine that you’re short the spread. The spread is currently about $22 per share. On May 28, before all the chatter about M&A (merger and acquisition) in the space, the spread was trading closer to $48 per share.

Remember, these are assumed terms, not necessarily what Anthem will offer. In fact, the potential upside is probably greater than $22 per share, because Anthem will have to bump its offer to get a recommendation. So the risk-reward ratio is $48 down and $22 up, which is a risk-reward ratio of about 2.2x.

That’s a very low risk-reward ratio, but it’s important to remember that the whole sector is being supported by potential M&A, and this deal is mainly cash. So if the entire sector devalues, say in response to an unfavorable ruling in King vs. Burwell, you would have exposure on the downside.

Overall, the spread is probably about right, given the low risk-reward ratio and the elevated internal rate of return. There are too many uncertainties remaining to pile into the trade at this point.

Other merger arbitrage resources

Other important merger spreads include the Hospira–Pfizer deal. The Hospira (HSP) and Pfizer (PFE) merger is set to close in 2H15. For a primer on risk arbitrage investing, read Merger arbitrage must-knows: A key guide for investors.

Investors who are interested in trading in the healthcare sector should look at the S&P SPDR Healthcare ETF (XLV).

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