-Risk Arbitrage on merger between BT and MCI Financial Trading and Investing Case Study Name: Xuwu...

-Risk Arbitrage on merger between BT and MCI

Financial Trading and Investing Case Study Name: Xuwu Liu RIN: 661010891

Time Line (Brief)

Nov 1st,

1996

• Opportunity emreged• Farallon began to gather information for the deal

Nov 3rd,

1996

• Agreement was made• Farallon began to prepare for trading position

Nov 4th,1996 to July 9th,

1997

• The market had more and more confidence on the merger• Farallon continually added to its position.

July 9th,

1997 and after

• Unexpected announcement was made by MCI• The market was in chaos and Farallon faced hard decision.


Time Line (Detail)

• Time: November 1, 1996:

• Events: Information circulated about the possible merger between BT and MCI.

• Farallon Capital Management’s Action: Started collecting information and prepared themselves for a potential position.


Time Line (Detail)-Continued• Time: November 3, 1996

• Event: BT announced it had come to an agreement with MCI for an acquisition. And there were preliminary estimates that the merger would be completed within nine to twelve months.

• Farallon Capital Management’s Action: – Reached some conclusions about the prospects for the merger:

• Market Trend- a more integrated international market• Company Specific factors- BT knows well about MCI; great synergy effects potential• Regulation Barrier- little antitrust concerns; good chance of waiving the FCC’s

ownership limit– Designed trading strategy:

• Came to the conclusion that the appropriate spread for the deal should be about 12% (difference between the price paid by BT and the market price of MCI)

• The current narrow spread is because the market hasn’t fully understand the effects of U.K.’s Advance Corporation Tax

• Initially take opposite of the usual merger arbitrage position by going long BT shares and selling short MCI shares.


Time Line (Detail)-Continued

• Time: November 4, 1996 to July 9, 1997

• Event: Spread widened; regulatory hurdles became less of a concern

• Farallon Capital Management’s Action: Reverse its initial position by going long MCI shares and short BT shares, and continually add to its positions.


Time Line (Detail)-Continued• Time: July 9, 1997 and after

• Events: – MCI announced that the cost to enter local telephone market was

substantially higher than expected, and its core long distance business will have a lower than expected earnings led by heightened competitive pressure. MCI guided future earnings expectation was down almost 50%.

– It seemed BT was surprised by the MCI’s announcement and has the potential to renegotiate the contract or even terminate the merger.

– Debate raged on Wall Street regarding the prospects of the MCI merger.– Both MCI and BT’s stock prices declined and Farallon Capital Management

had lost money on the position.

• Farallon Capital Management’s Action: Was Being Discussed


How to execute Risk Arbitrage

• Spot Opportunities

• Select deals for further review

• Due diligence

• Take trading positions


How to execute Risk Arbitrage

• Spot Opportunities– Monitor the market to see if there is any “rumor”

about potential mergers and if there is any new announcement of mergers.

• Select deals for further review– Filter out “noises” and decide what are the

deals that worth further investigation.


How to execute Risk Arbitrage• Due diligence

– Understanding the potential risks and returns

– Valuations

– Understanding the impacts of the merger on the acquirer and the target firm

– Based on various sources of information

• Wall Street equity analyst• investors relations department of companies affected by a merger announcement• Lawyers• other industry experts• competitors of the company• major institutional shareholders• investment bankers• political consultants• trade journals• newspaper reporters• other arbitrage funds.


How to execute Risk Arbitrage• Take trading positions

– Two ways: • Cash purchase of the target firm’s stock if the merger is a

cash deal• Purchase the target company’s stock and sell short the

stock of the acquiring company if the merger is a stock-for-stock deal

– Gradually commit more capital as the picture of the merger getting more and more clear.


M&A Arbitrage: Risk and Return

• Risk: The merger doesn’t happen as expected, which cause the target’s stock price reverse to the level before the merger announcement(ignoring general market movement), and since the arbitrager is taking a long position in target’s stock, this will lead to a loss to the arbitrager.

• Return: If the merger happens as expected, then the arbitrager will profit from the long side of the position, and the net profit is equal to the bid price from the acquirer for the target firm minus the arbitrager’s purchase price for the target firm’s stock.


What to do with Farallon’s position and with the hedge?

• Current Situations(July 1997):

– Farallon is not heavily leveraged, which means Farallon can take some losses and can hold the position for a longer time.

– Lost money on the position, but because both the BT and MCI’s stock prices decline, it lose money on the long position but is gaining money on the short position, which means the situation is not too bad.

– Farallon had not had a down month since 1989, which means it is probably important to maintain this record because after a long time of good performances a negative return will look very unusual and may draw a lot of attention from the investors.



• Implication from the decline of market price:

– Since the BT’s stock prices has declined, if we ignore the overall market movement, the decline of BT’s stock price means the market is still expecting the merger to happen.

– At the same time, the MCI’s stock price also declined, again if we ignore the overall market movement during the same period, the decline of MCI’s stock implied that the market believes the probability of the merger decreased, or the market believes the merger will be based on an renegotiated new contract.


What to do with Farallon’s position and with the hedge?• Strategies and potential outcomes:

– If the merger fails, as long as Farallon didn’t clear its positions, it will suffer a loss.

– If the contract renegotiated, as long as Farallon didn’t clear its positions, the event will bring uncertainty to its position. The reason is that the market already expects a certain level of renegotiation, so the impact of the actual renegotiated contract depends on whether the difference between the new and old contract is larger or smaller than it is expected.

– If the arrangement is proceed anyway, as long as Farallon didn’t clear its positions, it will profit from its positons.



Hold the position as it is Gradually reduce the position Clear the position

Merger FailedBT: Up

MCI: DownImpact on position: Negative

BT: UpMCI: Down

Impact on position: Negative

BT: UpMCI: Down

Impact on position: None

Contract Renegotiated

BT: UncertainMCI: Uncertain

Impact on position: Uncertain


Impact on position: Uncertain



Merger proceed as

planned

BT: DownMCI: Up

Impact on position: Positive

BT: DownMCI: Up

Impact on position: Positive

BT: DownMCI: Up


• So the final decision is based on an assessment of the probabilities of different outcomes (failed, renegotiated, proceed), and based on the assessment of Farallon’s capacity (both financial and reputational) to withstand the potential losses.


-Risk Arbitrage on merger between BT and MCI Financial Trading and Investing Case Study Name: Xuwu...

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