Merger spread analysis
To perform merger arbitrage, the investor will generally buy the stock of the company being acquired, sell short the relevant ratio of the acquirer’s stock, if applicable, and wait for the deal to close. When the merger is completed, the investor will exchange the stock of the company being acquired for the deal consideration.
In the case of Anthem (ANTM) and Cigna (CI), we don’t have a deal. We just have a bear hug letter. We don’t have the exact terms of the transaction, either. But we do know that Anthem is proposing to acquire Cigna for $184 in cash and stock.
Anthem is dividing up the consideration with 68.6% cash and 31.4% stock. The cash consideration is therefore $126.22 ($184 * .686), and the stock consideration is $57.78 ($184 * .314). However, we don’t know the ratio of stock because we don’t know what reference price Anthem is using.
In the presentation and press conference, Anthem refers to the deal premium based on Cigna’s stock price on May 28. That date is as good as any to fix the Anthem stock ratio. On May 28, Anthem closed at $164.22, so $57.78 worth of Anthem works out to a ratio of .3518 ($57.78 / $164.22). At current prices, that works out to an arbitrage spread of $22.21.
Anthem and Cigna are the number-two and number-four players, respectively, in health insurance. This pretty much guarantees an in-depth antitrust review. Health insurers have a federal antitrust exemption, but state regulators will certainly be concerned about service levels falling. Anthem is building in a lot of time for a regulatory review and guiding for an end of 2016 close.
Based on these assumed terms and taking the company’s timing guidance at face value, that works out to be an implied rate of return of 8%. Of course, since Cigna rejected the proposal, Anthem will have to raise its bid in order to get a deal. So the spread is ultimately bigger than advertised.