Scenario analysis is a key part of merger arbitrage
In the risk arbitrage world, an 18.8% expected return usually indicates a high-risk transaction. Merger arbitrage tends to correlate inversely with the VIX Index, a measure of market volatility.
In times of stress, the VIX Index increases, and hedge funds lighten their exposures, which causes spreads to widen. In this environment, financial deals, or private equity transactions, like Apollo and ADT, generally perform the worst, and strategic stock-for-stock transactions usually fare better.
The downside if the deal breaks
ADT (ADT) was trading at about $27 per share before its deal with Apollo (APO) was announced. If the deal breaks, will ADT’s share price return to its former level? The answer is probably yes, depending on the reason. If the deal breaks for regulatory reasons, then that price is probably a good bet. If it breaks because of a material adverse effect out of ADT, then that price is probably a best-case scenario.
Let’s 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 deal doesn’t break, the spread will go to zero, and you will make about $2.30.
If the deal breaks, the spread will widen to about $16 or so. So, the risk-to-reward ratio is (16 – 2.30)/2.3, or about 6:1. This ratio is indicative of a medium-risk deal, and it represents potential antitrust risk and the risk associated with private equity buyers. Note this transaction is somewhat different than the typical LBO in that there is a strategic partner. It isn’t strictly a “buy Company XYZ at X times EBITDA, turn it around, and sell it at X+Y times EBITDA.” Those spreads perform the worst in times of financial stress because the economics of the deal are 100% dependent on cheap financing.
Merger arbitrage resources
Other important merger spreads include the deal between Baker Hughes (BHI) and Halliburton (HAL) and KLA-Tencor (KLAC) and Lam Research (LRCX). 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 tech sector can look at the iShares Global Technology ETF (IXN).