Extensions of the Merger Arbitrage Risk Model

Stéphane Daul
RiskMetrics Group
stephane.daul@riskmetrics.com

A traditional VaR approach is not suitable to assess the risk of merger arbitrage hedge funds. We
recently proposed a simple two- or three-state model that captures the risk characteristics of the
deals in which merger arbitrage funds invest. Here, we refine the model, and demonstrate that it
captures merger and acquisition risk characteristics using over 4000 historical deals. We then
measure the risk of a realistic sample portfolio. The risk measures that we obtain are consistent
with those of actual hedge funds. Finally, we present a statistical model for the probability of
success and show that we beat the market in an out-of-sample study, suggesting that there is a
potential “alpha” for merger arbitrage hedge funds.

1 Introduction

The merger arbitrage strategy consists of capturing the spread between the market and bid prices that
occurs when a merger or acquisition is announced. There are two main types of mergers: cash
mergers and stock mergers. In a cash merger, the acquirer offers to exchange cash for the target
company’s equity. In a stock merger, the acquirer offers its common stock to the target in lieu of cash.

Let us consider a cash merger in more detail. Company A decides to acquire Company B, for example
for a vertical synergy (B is a supplier of A). Company A announces that they offer a given price for
each share of B. The price of stock B will immediately jump to (almost) that level. However, the
transaction typically will not be effective for a number of months, as it is subject to regulator
clearance, shareholder approval, and other matters. During the interim, the stock price of B actually
trades at a discount with respect to the offer price, since their is a risk that the deal fails. Usually, the
discount decreases as the effective date approaches and vanishes at the effective date.

In a stock merger, company A offers to exchange a fixed number of its shares for each share of B. The
stock price of B trades at a discount with respect to the share price of A (rescaled by the exchange
ratio) as long as the deal is not closed.

With a cash merger, the arbitrageur simply buys the target company’s stock. As mentioned above, the
target’s stock sells at a discount to the payment promised, and profits can be made by buying the

Electronic copy available at: http://ssrn.com/abstract=1548411

52 Extensions of the Merger Arbitrage Risk Model

Figure 1
Cash deals. Share price of target (thick line) and bid offer (dotted line)

LabOne Inc. InfoUSA Inc.

46 13

12.5
44
12

11.5
42
11
Share Price

Share Price
40 10.5

10
38
9.5

9
36
8.5

34 8
31−May−05 31−Jun−05 31−Jul−05 31−Aug−05 30−Sep−05 31−Oct−05 9−Jun−05 31−Jun−05 31−Jul−05 31−Aug−05 30−Sep−05
Date Date

target’s stock and holding it until merger consummation. At that time, the arbitrageur sells the target’s
common stock to the acquiring firm for the offer price.

For example, on 8 August 2005, Quest Diagnostic announced that it was offering $43.90 in cash for
each publicly held share of LabOne Inc. The left panel of Figure 1 shows the LabOne share price. It
can be seen that the shares closed at $42.82 on 23 August 2005. This represents a 2.5% discount with
respect to the bid price. The deal closed successfully on 1 November 2005 (just over two months after
the announcement), generating an annualized return of 10.9% for the arbitrageur.

In a stock merger, the arbitrageur sells short the acquiring firm’s stock in addition to buying the
target’s stock. The primary source of profit is the difference between the price obtained from the short
sale of the acquirer’s stock and the price paid for the target’s stock.

For example, on 20 December 2005, Seagate Technology announced that it would acquire Maxtor
Corp. The terms of the acquisition included a fixed share exchange ratio of 0.37 share of Seagate
Technology for every Maxtor share. Figure 2 shows the movement of both the acquirer share price
and the target share price. On December 21, Maxtor shares closed at $6.90 and Seagate at $20.21
yielding a $0.58 merger spread. The deal was completed successfully on 22 May 2006.

More complicated deal structures involving preferred stock, warrants, or collars are common. From
the arbitrageur’s perspective, the important feature of all these deal structures is that returns depend on

Electronic copy available at: http://ssrn.com/abstract=1548411

 Introduction 53

Figure 2
Equity deal. Share prices of Maxtor (thick line) and Seagate Technology (dotted line)
Seagate Technology share prices are rescaled by the exchange ratio.

11

10

8
Share Price

3
31−Oct−05 31−Dec−05 28−Feb−06 30−Apr−06
31−May−06
Date

mergers being successfully completed. Thus the primary risk borne by the arbitrageur is that of deal
failure. For example, on 13 June 2005, Vin Gupta & Co LLC announced that it was offering $11.75 in
cash for each share of infoUSA Inc. In the right panel of Figure 1, we see that after the
announcement, the share price of infoUSA jumped to that level. The offer was withdrawn, however,
on 24 August 2005, and the share price fell to a similar pre-announcement level.

A recent survey of 21 merger arbitrageurs (Moore, Lai, and Oppenheimer 2006) found that they invest
mainly in announced transactions with a minimum size of $100 million and use leverage to some
extent. They gain relevant information using outside consultants and get involved in deals within a
couple of days after the transaction is announced. They unwind their positions slowly in cases where
the deal is canceled, minimizing liquidity issues. Their portfolios consist, on average, of 36 positions.

Finally, from Figure 3, we clearly see that the volatility of the share price before and after the
announcement is very different. Measuring the risk with a traditional VaR approach in terms of
historical volatility is surely wrong. Thus arbitrageurs typically control their risk by setting position
limits and by diversifying industry and country exposures.

We recently have developed a risk model suitable for a VaR approach that captures the characteristics
of these merger arbitrage deals (Daul 2007). In this article, we will refine this model to better describe
equity deals and also study in more detail the probability of deal success. The model will then be
tested on 4000+ worldwide deals and also compared to real hedge funds.
54 Extensions of the Merger Arbitrage Risk Model

Figure 3
Stock price of LabOne Inc. The large dot refers to the announcement date.

Share Price

31−May−05 31−Jun−05 31−Jul−05 31−Aug−05 30−Sep−05 31−Oct−05

Date

2 Risk Model

We consider only pure cash or equity deals, and introduce the following notation (see Figure 4):

St is the stock price of the target firm at time t.

t0 is the announcement date.

Λ is the deal length.

Kt is the bid offer per share at time t.

For cash deals, the bid offer is typically fixed and known at announcement date, Kt = Kt0 . For equity
deals, the bid offer is the acquirer stock price At times the deal conversion ratio ρ, Kt = ρAt . This
difference will not affect our model as the main hypothesis applies when the deal is withdrawn.
Notice further that for cash deals, the bid offer can also change over time, for example if the offer is
sweetened or if a second bidder enters the game (Daul 2007).

The announcement date t0 is evidently fixed. The deal length Λ can fluctuate and is modeled as a
random variable following a distribution

F(t) = P(Λ ≤ t). (1)

 Risk Model 55

Figure 4
Definition of parameters

Λ
K
Share Price

St
0

t0

31−May−05 31−Jun−05 31−Jul−05 31−Aug−05 30−Sep−05 31−Oct−05

Date

We will consider a model conditioned on Λ, where at time t0 + Λ (the effective date), we know if the
deal is completed (success) or withdrawn (failure).

To model this event, we introduce the binomial indicator C. With probability π, we have C = 1,
indicating deal success, and with probability 1 − π, we have C = 0, indicating deal failure. In case of
success, the stock price of the target reaches its bid offer, while when the deal breaks we have to make
further assumptions. This will consist of our main hypothesis: we model the level to which the stock
price jumps as a virtual stock price S̃t . Hence the stock price at the effective date is
(
Kt0 +Λ if C = 1,
St0 +Λ = (2)
S̃t0 +Λ if C = 0.

Since the withdrawal might be considered as negative information, the virtual stock price is subject to
a random shock J at time t0 + Λ. An illustration of this virtual stock price is shown in Figure 5. The
black line is the real stock price for a withdrawn deal, and the dotted blue line is a virtual path that the
stock price could have taken if no deal had been put in place.

The virtual stock price follows a simple jump-diffusion process

d S̃t = µS̃t dt + σS̃t dWt − J S̃t dNt , (3)

where µ is the drift (set to zero afterwards), σ is the volatility of the price before announcement, J is a
positive random shock following an exponential distribution with parameter λcash for cash deals and
56 Extensions of the Merger Arbitrage Risk Model

Figure 5
Virtual stock price

31

30

29

28
−JS
t
27
Share Price

26

25

24

23

22

21
31−Sep−05 31−Dec−05 31−Mar−06 30−Jun−06 30−Sep−06 30−Nov−06
Date

λequity for equity deals, and Nt is a point process taking values

(
1 if t ≥ t0 + Λ,
N(t) = (4)
0 if t < t0 + Λ.

Finally, the initial condition is

S̃t0 = St0 . (5)

We can easily integrate this process and get for t < t0 + Λ,

S̃t = St0 e∆Z (6)

√
where ∆Z follows a normal distribution with mean (µ− 21 σ2 )(t − t0) and standard deviation σ t − t0 .
For t = t0 + Λ we get

S̃t0 +Λ = St0 e∆Z (1 − J). (7)

 Parameters estimation and model validation 57

3 Parameters estimation and model validation

3.1 Virtual stock price

The parameters of the model are estimated using historical information on deals. The transaction
details (such as announcement date, effective date, type of deal, and so forth) are obtained from
Thomson One Banker. We consider pure cash or equity deals between public companies from 1996 to
2006 worldwide where the target company offered value is over $100 million. We consider those
deals for which we can also obtain stock prices from DataMetrics.

The daily drift µ is set to zero, and the ex-ante deal daily volatility is estimated using one year of daily
returns, equally weighted.

The intensity parameters λcash and λequity of the shock are obtained by moment matching. Conditional
on deal failure, the expected value of the stock price is
2 /2)Λ
E[St0 +Λ |C = 0] = St0 e(µ−σ (1 − λ· ). (8)
Assuming µ− σ2 /2 ≈ 0, we get
  
St0 +Λ 
E C = 0 = (1 − λ· ). (9)
St0 
Using the 131 withdrawn cash deals in our database, we get λcash = −0.07 ± 0.06; using the 33
withdrawn equity deals, we get λequity = 0.2 ± 0.1. Hence we set
λcash = 0 and λequity = 0.2. (10)

3.2 Deal length

We model the deal length Λ with a Weibull distribution having parameters a and b,
t b
F(t) = 1 − e−( a ) . (11)
This distribution is assumed to be universal. Using 1075 realized deal lengths (measured in days), we
obtain the following boundaries at 95% level of confidence:
143 < â < 154 (12)
1.43 < b̂ < 1.56 (13)
This corresponds to an average deal length of
L̄ = 135 days. (14)
58 Extensions of the Merger Arbitrage Risk Model

3.3 Test of the main hypothesis

As stated above, the main hypothesis is the “existence” of a virtual stock price that is reached only in
case of withdrawal. For cash deals, λcash = 0, meaning the stock prices after withdrawal should follow
a lognormal distribution, with volatility σi different for each deal i. Hence, the normalized residuals
 i 
St +Λ
0
log Si i
t
ui = √0 (15)
σi Λi
should follow a standard normal distribution. The p-value of a Kolmogorov-Smirnov test using the
131 withdrawn deals is 93%, implying that we cannot reject at all the main hypothesis.

For equity deals, λequity = 0.2, and the residuals defined as above do not follow a normal distribution.
Instead we study the residuals
Sti +Λ
vi = 0 i . (16)
St0
This should be distributed as
e∆Zi (1 − J), (17)

where ∆Zi follows a normal distribution with parameter σi different for each deal. We set the
volatility equal to the average of the σi , and use Monte Carlo to obtain a sample distributed according
to (17). We then compare this sample to our 33 withdrawn deals using a two-sample
Kolmogorov-Smirnov test. The result is a p-value of 53%. Again we cannot reject at all the
hypothesis, confirming the validity of our model.

4 Risk measurement application

We want to measure the risk of a sample portfolio consisting of 30 pure cash deals pending end of
2006. All deals are described by

• the target company,

• the bid offer K,

• the date of announcement t0 ,

• the probability of success π,

 Risk measurement application 59

Table 1
VaR using the merger arbitrage risk model and the traditional risk model
VaR level Merger Arb Model Traditional Equity Model
95% 1.37% 7.25%
99% 2.21% 10.24%

Table 2
Dispersion of historical VaRs for merger arbitrage hedge funds
VaR level 1st quartile median 3rd quartile
95% 0.81% 1.29% 1.68%
99% 2.17% 2.92% 4.90%

and are assumed independent. We set the probability of success π to the historical value of 86% (see
Section 5).

We forecast the P&L distribution of the portfolio at a risk horizon of one month using Monte-Carlo
simulations. For each deal, one iteration is as follows:

1. Draw an effective date using the Weibull distribution.

2. If the risk horizon is subsequent to the effective date, draw a completion indicator. If the risk
horizon is before the effective date, the deal stays in place.

3. If the completion indicator indicates failure, draw a virtual stock price, and calculate the loss. If
the completion indicator indicates success, calculate the profit.

Table 1 reports the VaRs at two different confidence levels obtained from model, as well as VaRs
obtained from modeling the positions as simple equities following a log-normal distribution. We
notice that our model produces lower risk measures, consistent with our expectation.

For more evidence, we compare these monthly VaRs with the historical monthly VaRs of 41 merger
arbitrage hedge funds obtained from the HFR database. Table 2 shows that the dispersion of the hedge
fund VaRs contains our model’s results. We conclude that our new model consistently captures the
risk of a merger arbitrage hedge fund, and that the traditional model likely overstates risk.
60 Extensions of the Merger Arbitrage Risk Model

5 Probability of success

In the risk measurement application above, the probability of success was unconditional on the deal,
and set to the historical estimate using all deals worldwide from 1996 to 2006
Nsuccess 4176
Phistorical = = = 86%. (18)
Ntotal 4879
A deal-specific probability of success can be inferred from the observed spread in the market as in
(Daul 2007),
Pimplied = P ($, St0 , K, rfree) . (19)

Alternately, we may fit an empirical model. We will use a logistic regression and assume that the
probability of success is a function of observable factors Xi as
1
Pempirical = . (20)
1+ e− ¤i bi Xi
If the factor sensitivity bi is positive, then larger Xi lead to higher probability of success, assuming
other factors are constant.

We consider the following factors:

• Target attitude:
1 Friendly
Xi = 0 Neutral
− 1 Hostile

• Premium: the relative extra amount the bidder offers. Its magnitude should be an indicator of
the acquirer’s interest.
K − St0
Xi =
St0
• Multiple: the ratio of enterprize value (EV), calculated by adding the target’s debt to the deal
value, to the EBITDA, an accounting measure of cash flows.
EV
Xi =
EBITDA
• Industrial sector: By acquiring a target in the same industrial sector, the acquirer increases its
market share. This could influence deal success.
1 same sectors
Xi =
0 different sectors
 Probability of success 61

Table 3
Logistic regression on 1322 deals
Factor bi p-value
Constant -1.09 0.04
Target attitude 1.79 0.00
Premium 0.76 0.17
Multiple 0.44 0.00
Industrial sectors 0.33 0.15
Relative size 0.44 0.00
Deal type 0.34 0.16
Trailing number of deals -0.29 0.19

• Relative size of acquirer to the target

 
Acquirer assets
Xi = log .
EV

• Deal type (
1 cash
Xi =
0 equity

• Trailing number of deals. The number of deals is cyclical; the position in that cycle should
influence deal completion.
Ndeals in last 12 months
Xi =
yearly average of Ndeals

We have 1322 realized deals (completed or withdrawn) with all factors available. Table 3 shows the
results obtained from the logistic regression. We see that attitude, multiple and relative size are very
relevant factors (very small p-values). The premium, having the target and the acquirer in the same
industrial sector and the deal type are relevant to some extent. The sensitivity for the trailing number
of deals is counterintuitive: it appears that a large number of deals announced might catalyze less
convincing deals.

To assess the predictive power of our model we perform an out-of-sample test, and compute the
so-called cumulative accuracy profile (CAP) curve. The model parameters are fit using the 873 (66%)
oldest deals. We then infer the probability of success for the remaining 449 (34%) deals. After sorting
the deals by their probability of success obtained with the statistical model (from less probable to
most probable), the CAP curve is calculated as the cumulative ratio of failures as a function of the
cumulative ratio of all deals.
62 Extensions of the Merger Arbitrage Risk Model

Figure 6
CAP curve for the out-of-sample test (OOS) and the implied probability of success

0.8

0.6

0.4 OOS

implied
0.2

0
0 0.2 0.4 0.6 0.8 1

The 449 out-of-sample deals have an overall failure ratio of 10.2%. If the model were perfect, then
the first 10.2% of deals as sorted by our model would have contained all of the failed deals, and we
would have CAP(x) = 1 for x ≥ 10.2%. If the model were useless, the ordering would be random, and
we would have CAP(x) = x. In Figure 6 we show the result for the out-of-sample test, the
market-implied probability of success and the two limiting cases. We clearly see that our model beats
the market, suggesting that there is a potential “alpha” for merger arbitrage hedge funds. Further
looking closer at the lower left corner we notice that the CAP curve for the statistical model follows
the perfect limiting case up to about 5%. This means that our statistical model ranks the first half of
the withdrawn deals perfectly as the worst ones.

6 Conclusion

The specifics of merger arbitrage deals can be captured introducing a binomial completion indicator
and a virtual stock price modeled as a simple jump-diffusion process. This model has been validated
using a large set of deals. A merger arbitrage hedge fund would benefit from using this model to
measure the risk of his portfolio in a VaR framework and/or perform stress tests using the probability
 Conclusion 63

of deal success for example.

Finally we have developed a statistical model for the probability of success and showed in a
out-of-sample analysis that its forecasting power is superior to the market predicting power.

References
Daul, S. (2007). Merger arbitrage risk model. RiskMetrics Journal 7(1), 129–141.
Moore, K. M., G. C. Lai, and H. R. Oppenheimer (2006). The behavior of risk aribtrageurs in
mergers and acquisitions. The Journal of Alternatives Investments Summer.