Scenario analysis is a key part of merger arbitrage
In the risk arbitrage world, a 1.4% expected return usually indicates a potentially competitive merger. This is strange given that there is no obvious competing buyer. Merger arbitrage tends to inversely correlate with the VIX Index, a measure of market volatility. In times of stress, the VIX Index increases, and hedge funds lighten their exposure. This causes spreads to widen. In this environment, financial deals, or private equity transactions, generally perform the worst, and strategic stock-for-stock transactions usually fare better.
What’s the downside if the deal breaks?
Before the Plum Creek Timber-Weyerhaeuser merger was announced, Plum Creek Timber was trading at ~$40 per share. If the deal breaks, will the stock return to this share price? That is probably a decent bet, provided that the reason for the deal breaking is an antitrust issue and not any sort of material adverse change out of Plum Creek Timber (PCL).
The spread is trading slightly negatively (about 6 cents), but the positive dividend carry gives the deal a positive spread. In scenarios like this, the risk-to-reward ratio doesn’t really tell you much. As a general rule, “safe” merger arbitrage spreads trade with a risk-to-reward ratio of around 15:1, so the proper spread should be around 50 cents, assuming the deal doesn’t have antitrust problems, which this one appears to have.
Arbitrageurs may be setting up the spread and waiting to see what the background section of the proxy statement says. The spread is trading at a strange level, and it doesn’t appear there was anything unusual in the closes of Plum Creek Timber or Weyerhaeuser (WY).
Other merger arbitrage resources
Other important deals include the merger between Cigna Corporation (CI) and Anthem (ANTM), which is set to close at the end of 2016. 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 REIT sector can look at the Vanguard REIT ETF (VNQ).