In the risk arbitrage world, a 2.1% expected return usually indicates an extremely low-risk transaction and one where there is the possibility of a topping bid. Ordinarily, this spread would not be trading so tight, as professional arbitrageurs have been licking their wounds lately after the breakup of deals like Pfizer-Allergan, Baker Hughes-Halliburton, and Staples-Office Depot. When strategies like merger arbitrage have bad months, hedge funds and FOFs (funds of funds) allocate capital out of that strategy into other strategies. This causes spreads to widen as arbitrageurs reduce their exposure.
Downside if the deal breaks
Demandware (DWRE) was trading at about $48 per share before the deal was announced. If the deal breaks, will it return to its former level? It depends. There is probably no reason why Salesforce would abandon its merger with Demandware unless there was a material adverse effect out of Demandware, or a competing buyer was willing to pay more than CRM was willing to pay.
Demandware has already reported earnings, and there probably isn’t too much that could go wrong over the next 45 days. The worst thing that could happen (aside from accounting fraud, where all bets are off) would be a major customer leaving Demandware, and the merger agreement provides Demandware some protection there. So if the deal breaks, it will probably be for something terrible out of Demandware like an accounting problem, which means a $48 per share downside is probably a best-case scenario.
Similarly, the true upside is more than 19 cents per share. The upside is what a competing buyer would pay in a bidding war. So, in reality, the risk-reward ratio is pretty much not applicable here.
That said, let’s look at this deal as a normal risk arbitrage spread. Look at the arbitrage spread in the above graph and imagine that you’re short of the spread. If the deal closes as expected, you will make about $0.19. If the deal breaks, the spread will widen to about $27. So, the risk-to-reward ratio is about 141 to one. This is a hideous risk-reward ratio and shows that arbs are betting heavily that there will be a topping bid.
Merger arbitrage resources
Other important merger spreads include the deal between Cigna (CI) and Anthem (ANTM) 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).