Scenario analysis is a key part of merger arbitrage
In the risk arbitrage world, a 13.9% expected return usually indicates a higher-risk transaction. 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 merger between Marriott International (MAR) and Starwood Hotels & Resorts (HOT) was announced, HOT was trading at about $68 a share. If the deal breaks, does it go back there? The answer is probably yes, depending on the reason for the deal breaking. If the deal breaks because the companies cannot get antitrust approval, then $68 is a good bet. If it breaks because of bad news out of HOT, then $68 is probably a best-case scenario.
Let’s first look at this deal as a normal risk arbitrage spread. Look at the arbitrage spread graph above, and imagine you’re short of the spread. If the Starwood-Marriott merger closes, the spread goes to zero, and you make about $5.35. If the deal breaks, you lose about $12.00. However, this spread is a function of the value of the Vistana spin-off, which we don’t have yet. The companies gave an estimate of $7.80. However, that is a function of Interval Leisure Group’s stock price, and we don’t know the exact ratio of stock that HOT shareholders are going to get. In other words, the actual consideration of the transaction is a moving target. This makes determining the risk-to-reward ratio difficult. It also explains why the spread is so wide.
Other merger arbitrage resources
Other important merger spreads 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 hotel sector can look at the PowerShares Dynamic Leisure and Entertainment Portfolio (PEJ).