takeovers and market price indications: Softbank/Arm Holdings

Softbank is bidding £17 per share for ARM, an offer that management of the chip design company has quickly accepted.  ARM closed in London at £16.61 yesterday, after trading as high as £17.52 in the initial moments of Monday trading–the first time the London market was open after the bid announcement.

What is the price of ARM telling us?

Let’s make the (reasonable, in my opinion) assumption that the price of ARM is now being determined by the activity of merger and acquisition specialists, many of whom work in companies mainly, or wholly, devoted to this sort of analysis.

These specialists will consider three factors in figuring out what they’re willing to pay for ARM:

–the time they think it will take until the takeover is completed (let’s say, three months),

–the cost of borrowing money to buy ARM shares (2% per year?) and

–the return they expect to make from holding the shares and delivering them to Softbank.

They’ll buy if the return is high enough.  They’ll stay on the sidelines otherwise.

Suppose they think that without any doubt the Softbank bid for ARM is going to succeed–that no other bidder is going to emerge and that the takeover is going to encounter no regulatory problems (either delays or outright vetoing the combination).  In this case, the calculation is straightforward.  The only real question is the return the arbitrageur is willing to accept.

I haven’t been closely involved in this business for years.  Although I know the chain of reasoning that goes into determining a potential buy point, I no longer know the minimum an arbitrageur considers an acceptable.  If it were me, 10% would be the least I’d accept if I thought there were any risk;  5% might be my lower limit even if I saw clear sailing ahead.  If nothing else, I’m tying up borrowing power that I might be able to use more profitably elsewhere.

Let’s now look at the ARM price.

At £16.61, ARM is trading at a 2.3% discount to the offer price.  An arbitrageur who can borrow at 0.5% for three months stands to make a 1.8% return by buying ARM now.  Ugh!  The only way to make an acceptable return, if the assumptions I’ve outlined above are correct, is to leverage yourself to the sky.


From this analysis, I conclude two things:

–the market is not worrying about any regulatory impediments to the speedy conclusion of the union.  Quite the opposite.  Otherwise, someone would be shorting ARM.

–buyers seem to me to be speculating in a very mild way that a higher bid will emerge.  If they had strong confidence in another suitor coming forward, the stock would be trading above £17.  If they were 100% convinced that there would be no new offer, I think the stock would be trading closer to £16.25, a point which would represent an annualized 20% return to a purchaser using borrowed money.




short selling as an investment tool: risk arbitrage

what it is

Risk arbitrage is an investment strategy based on exploiting pricing anomalies in mergers and acquisitions.  It’s one of the older hedge fund-like activities in the financial markets.

Let’s say that company A, which is trading at $30 a share, announces a bid to acquire company B, which is trading at $50 a share.  The bid is for stock, at a proposed rate of two shares of company A stock for each share of company B.

after a bid is announced

The bid will have two consequences:

–company B is “in play.”  Chances are it won’t survive as an independent company.   B’s top management and board of directors will be focussed on obtaining a higher price than A has initially offered, and possibly on finding a more suitable (or la least, different) merger partner (see my post on black and white knights).

–the way professional investors evaluate B’s stock changes.  Right now, and for as long as acquisition is a possibility, B’s stock no longer exists as an independent thing.  In the simplest case, one where the merger is friendly, no other bidder is in sight, regulatory and shareholder approval appears assured and the date for merger is also reasonably certain, B’s stock is already A’s stock under a different name.

In this case, the arbitrage is straightforward.  Shares of A are trading at $30.  Shares of B, which are really A shares in disguise, are trading at $25.  Therefore, the arbitrageur buys B and sells A short until the two prices–adjusted for the cost of money until the merger is completed–converge.

Life isn’t always this simple.  Arguably, a skillful risk arbitrageur doesn’t want it to be, either, since in the plain vanilla case just described, the arbitrage opportunity is gone in a flash.  The arbitrageur’s analysis of a bid situation typically has three parts:

1.  What is the true value of company B to a trade buyer, or–arbitrageur’s nirvana–a private equity firm?

2.  What are the chances of achieving this value?  In particular, who would pay the full price?  …will that entity bid?  …what regulatory obstacles would he face?

3.  What happens if the bid on the table is withdrawn?

The calculation of the price B should be trading at is a straightforward expected value.  The arbitrageur’s decision to buy or not will be a return on invested funds keyed off it.

what the price of B is saying

Figuring that it would take six months after announcement for an agreed merger to take place, the cost of funds should only amount to one or two percent of the price paid for B shares.  In this case, B shares should initially trade, I think, somewhere around $57 (remember it’s a 2-for-1 deal) and gradually drift up toward the $60 offer price.

Sometimes, the price of B spikes above the offer price.  This usually indicates that arbitrageurs believe a better bid is in the offing, either from company A or from another party.

Sometimes, the price of B goes up, but only modestly.  This typically signals arbitrageurs’ beliefs that regulatory or other hurdles diminish the chances of the combination ever taking place.

Occasionally, the price of A will drop sharply, indicating the stock market doesn’t like the deal at all.  In an agreed merger, this will drag B’s stock down with it.  Often, there’s good reason for investor worry.  On the other hand, a bid announced in March of last year would doubtless have unleashed a torrent of selling in A’s stock.

before a bid–prospective arbitrage vs. value investing

Actual arbitrage is event-driven.  What do arbitrageurs do all day if all their capital is committed to deals?  Like other professional investors, they go to conferences or to the gym.  Maybe they blog, although that would be hard to get past the compliance department.

On the other hand, what if there are no deals?  Sometimes, arbitrage firms try to anticipate areas where merger and acquisition activity may be brewing and buy shares of likely acquisition targets.  When I started writing this section I was tempted to say that in doing so, these firms act just as ordinary value investors would.  While it’s true that growth investors end up holding acquirers and value investors their targets, I don’t think my thought is quite right.

It is possible, I think, to identify broad areas where, conceptually at least, industry consolidation is likely.  For example, when the EU began to drop customs controls at the borders between member countries, this unleashed a multi-year wave of mergers and acquisitions in the grocery industry.  Supermarkets wanted to rationalize their distribution networks and achieve larger scale to give them more bargaining power with their suppliers.  This, in turn, triggered a second wave of consolidation, this time among packaged goods companies, as they sought to reestablish their negotiating advantage over the supermarkets.

At present, the computer hardware and software industries strike me as ones where consolidation will continue.  Also, China seems to me to be very eager to turn its dollar holdings into physical assets by buying companies that either will provide that country with natural resources or that will be distribution outlets for its finished goods.  Washington, however, like Paris, seems bent on preventing this from happening in the US.

short selling as an investment tool (II): hedged vs. unhedged

Short selling is involved a number of hedging strategies.  Short sellers, however, like any investors, can run both unhedged and hedged positions and portfolios.


It’s important to distinguish between a hedged position and a diversified position.  Both are ways of reducing risk.  But they’re not the same.  Diversification is having three cows in case one stops giving milk.  Hedging is having one cow but taking out an insurance policy in case the animal drops dead.

You can have a diversified portfolio consisting solely of short positions, just as you can have one that is made up completely of long positions.  In both cases, you’re at least somewhat protected against the risk that one or two positions go wrong.  But in the former case, you’re still exposed to the possibility that the overall market rises sharply.  In the latter, you still have the risk of a sharp market decline.

Dyed-in-the-wool short sellers run unhedged short portfolios.  Operating this way means taking on a lot of risk, and requires a person who is temperamentally suited to the short side and has a considerable degree of skill. The reason is the more open-ended possibility of loss if the positions move the wrong way. But the structure is pretty straightforward.

You can have as an objective either to have the names you’re short to lose money in absolute terms, or simply to underperform an index like the S&P 500.


It’s much more common for short positions to be components of a hedged portfolio, that is, one that includes long positions as well.  Three ways to do this:

1.  One of the oldest instances of hedged portfolios is risk arbitrage, a merger and acquisition strategy, where a manager typically buys the stock of the target and sells the acquirer short, after a deal is announced.  More about this in a post next week.

2.  Another is the original hedge fund, what would be called today a market-neutral strategy, where the manager holds equal dollar amounts of both long and short equity.  If you were to read the marketing literature for this kind of portfolio, the managers might say things that would lead you to believe that by doing so they have hedged away the risks associated with overall market movements.  Maybe so.  Personally, though, I think it’s very hard for a manager not to let a directional bias–his thoughts about where we are in the business cycle–seep into both long and short active positions.  In other words, if you think the market is going down, you’d be short cyclicals and long defensives, and vice versa.)At the very least, performance has two components:  (out)performance of the long positions against the index pus (under) performance of the shorts.

3.  What are called pair trades have become popular over the last decade or so, both with high net worth individual investors and with modern hedge funds (which, to my suddenly curmudgeonly eyes, have nothing more than a fee structure in common with the traditional ones described in the last paragraph).  Pair trades consist of two stock ideas, one long and one short, typically both in the same industry and probably covered by the same industry analyst–who is the one suggesting the trade (and hoping the management of the company on the short side doesn’t find out).

The concept is to reduce the active bet you’re making to one about the relative operating efficiency of two companies in the same or allied industries.  In theory, factors relating to the strength of the global economy or the health of the industry involved are taken out of the equation this way.  Like the market-neutral strategy, gains or losses are supposed to come from what’s different about the two members of the pair.

Examples from the recent past might be:

Long Toyota, short GM

Long HP, short Dell

Long McDonalds, short Starbucks

or even

Long Wal-Mart, short Target (weak economy)

Long Target, short Wal-Mart (strong economy)

In the first two cases, the contrast is between strong management and weak management (of course, Toyota turned out not to be so strong in the end).  In the last three, and very clearly in the last two, strength/weakness of the economy has snuck back in.

My thoughts

Pair trades—small positions only!—while riskier than simple long positions and requiring careful/continual monitoring, strike me as okay for individuals to try their hands at.  The rest of the short-related world–hedged or not–should be left to professionals.