Risk Arbitrage

An Investor's Guide

Keith M. Moore

• Publisher: Wiley
• Year: 2018
• Print ISBN:
  9780470379745
• Edition: 2
• eBook ISBN:
  9781118233856
• Topic: Business
• Subtopic: Finance
• Index: Business

The definitive guide to risk arbitrage, fully updated with new laws, cases, and techniques

Risk Arbitrage is the definitive guide to the field and features a comprehensive overview of the theory, techniques, and tools that traders and risk managers need to be effective. This new edition is completely updated and fully revised to reflect the changes to laws and technology and includes new case studies and a detailed discussion of computer-based trading systems. Readers gain deep insight into the factors and policies that affect merger transactions, and the new developments that allow individuals to compete with professionals in managing risk arbitrage portfolios. The book provides techniques for computing spreads and determining risk, with practice exercises that allow readers to become confident with new methods before using them professionally.

The current wave of corporate mergers, acquisitions, restructurings, and similar transactions has created unprecedented opportunities for those versed in contemporary risk arbitrage techniques. At the same time, the nature of the current merger wave has lent such transactions a much higher degree of predictability than ever before, making risk arbitrage more attractive to all types of investors. Risk Arbitrage provides the essential guidance needed to participate in the business.

• Get up to date on the most recent developments in risk arbitrage
• Examine new mergers and the legal changes that affect them
• Learn how computers and trading systems have affected competition
• Use the tools that enable risk determination and spread computation

Both the growth in hedge funds and the changing nature of the merger and acquisition business have affected risk arbitrage processes and techniques. For the finance professional who needs expert guidance and the latest information, Risk Arbitrage is a comprehensive guide.

CHAPTER 1
Introduction

Most U.S. corporations are domiciled in the state of Delaware, so I travel there often from my home in New York to cover court cases that can greatly affect the price of securities involved in a merger. The job of the arbitrageur covering a court case is to attempt to analyze the case and estimate which side will prevail before any decision is rendered by the court and also to estimate how the security prices will move given the outcome of the case. Once these factors are determined, the goal is then to set up positions in the securities that should prove profitable should the expected outcome occur and prices react as expected. Many times, it is a difficult job to determine the needed estimates and perform the required analysis.

A few years ago, I traveled to Delaware, because a few months earlier, the Cooper Tire & Rubber Company had agreed to be acquired by Apollo Tyres Ltd. Each Cooper Tire shareholder was to receive $35 cash per share at the closing of the $2.5 billion merger. The merger closing was subject to Cooper Tire shareholder approval as well as various U.S. and foreign government approvals. The $35 price tag represented about a 43% premium over Cooper Tire's existing stock price. After the merger was announced, Cooper Tire's stock price traded up $9.26 per share, closing at $33.82 on the first day after the merger announcement. The $1.18 spread between the $35 merger price and the Cooper Tire stock price did not indicate any of the troubles that the deal and Cooper shareholders would face over the next five or six months.

Exhibit 1.1 shows the price behavior of Cooper Tire both before the deal was announced as well as after the terms of the merger were disclosed.

EXHIBIT 1.1 Cooper Tire Stock Price Chart

Source: Used with permission of Bloomberg Finance LP.

Shortly after the merger was negotiated and announced, trouble broke out at Cooper Tire's joint‐venture in China. The facility in China was 65% owned by Cooper Tire and 35% owned by an entity named Chengshan Group (CCT). The controlling shareholder of the Chengshan Group was Che Hongzhi, and unbeknownst to Cooper Tire shareholders, including arbitrageurs, Che Hongzhi had been planning to acquire the remaining 65% ownership of the unit from Cooper Tire. Once the merger was announced, Che Hongzhi proceeded to orchestrate a plan to try to derail the merger.

Only days after the merger announcement, labor unrest at the Chinese plant was initiated. Initially, there were verbal protests. By the end of June, the CCT labor union sent a threatening letter to Cooper Tire employees and the Company. Shortly thereafter, a labor strike occurred, and eventually, Che Hongzhi had the plant stop manufacturing tires under the Cooper name. More amazingly, Che also locked out all Cooper employees from the plant, refused to pay invoices for materials, and would not supply any financial information to its 65% owner. These actions, especially withholding financial data, became a key factor in whether the transaction would be completed.

After the merger was announced, problems at the Chinese joint‐venture were not the only issues that Cooper and Apollo had to deal with. Cooper's domestic union, the United Steelworkers, filed grievances against Cooper, claiming the merger would be a transfer of control, which would trigger the need to negotiate a new labor contract. Ultimately, Cooper and Apollo agreed to arbitrate the USW claim; on September 13, 2013, the arbitrator issued an opinion indicating that a new labor contract would need to be negotiated in order for the parties to complete the merger.

The prospect of needing to negotiate a new labor contract complicated the merger process tremendously. Cooper's relationship with the USW had been strained for years and now the USW had an advantage heading into labor talks. In order to close the deal, Cooper needed a new contract and needed it quickly in order for Apollo to be able to complete the financing to pay for the merger.

As the Chinese joint‐venture and USW events unfolded, Cooper became concerned that Apollo was developing “buyer's remorse.” After negotiating mergers, in some cases, the buying party may develop second thoughts about its deal and may look for a way to get out from under the merger contract. Since Apollo was not advancing the USW contract talks at the speed that Cooper expected, concern for Apollo's desire to complete the deal grew. Ultimately, Cooper's board of directors decided the best way to protect the interests of Cooper and its shareholders was to bring a lawsuit seeking to force Apollo to complete the transaction. The legal action Cooper was seeking was “specific performance” where the Delaware Court was being asked to force Apollo to take all the steps to complete the transaction.

Cooper's lawsuit was filed on October 4, 2013, after Apollo was unable to come to an agreement with the USW and Cooper became concerned that since the merger pact with Apollo contained a “drop‐dead” date of December 31, 2013, that would allow Apollo to walk away from the merger obligation. Time was critical to get the deal closed, and the lawsuit seeking specific performance was a possible path to the merger's completion from Cooper's point of view.

Cooper's move to file the suit added to the uncertainty already created by the problems with the Chinese joint‐venture and the UAW contract dispute. News of the lawsuit began to surface in the markets late in the trading day on October 4. However, the full effect of the suit was not reflected in the Cooper stock price until trading began on the following trading day, Monday, October 7. As can be seen in Exhibit 1.2, Cooper's stock declined dramatically. At Monday's closing price of $25.72, the spread between the stock price and the proposed $35 takeover price was a huge $9.28 per Cooper share!

EXHIBIT 1.2 Cooper Tire Stock Price Reaction after Lawsuits

Source: Used with permission of Bloomberg Finance LP.

The lawsuit was filed in Delaware's Court of Chancery and was assigned to Vice Chancellor Sam Glasscock III. While I had traveled to Wilmington, Delaware, for several days of expert testimony before Vice Chancellor Glasscock on the case, the final hearing with closing arguments had been scheduled to be heard in Georgetown, Delaware, where Vice Chancellor Glasscock generally heard his assigned proceedings. So I shared a cab with several other arbitrageurs for an additional road trip to Georgetown.

Once in court, we all had to go through what have become standard court procedures. One of the more annoying procedures is forfeiting our cell phones to the court's guards. Unlike other members of the public, attorneys generally do not have to give up their phones since they are subject to court rules and can be disciplined for improper behavior. However, the system, like most, is not perfect. During the days of testimony in the Wilmington courthouse, a number of us in the court (who were observers to the testimony) noticed that reports of the proceeding seemed to be seeping back to the financial markets through subtle price changes in Cooper's stock price prior to court‐ordered breaks. Once a recess took place, all observers would try to get their phones returned in order to report on the recent developments in the courtroom.

After a day or so, it became clear that someone in attendance was not playing by the rules. Just before a courtroom session was supposed to reconvene, I heard a commotion a few rows away from me. As the confrontation continued, I realized that a representative of a hedge fund that owned shares in Cooper had witnessed another observer using his cell phone to communicate court developments to his office. His phone had not been commandeered because he was an attorney who was licensed to practice in Delaware and was on retainer to another hedge fund to report the proceedings of the trial. Ultimately, the violator was told if he touched his phone during the proceedings one more time, the party who noticed the behavior would immediately stand up and notify the Vice Chancellor of the violation. Needless to say, there didn't seem to be any more violations. Now everyone could concentrate on what the Vice Chancellor might ultimately decide in the case.

Once admitted to the court, there is usually a scramble for what are perceived to be the “choice” seats. I generally try to position myself at the end of a row to allow for easy exit in case I want to report back to the office on an important development in the proceedings. In Georgetown, I followed my normal habits by finding an end seat in the second row. If need be, I would leave the courtroom, retrieve my phone from the court guards, exit the building, and make the call. I had followed that procedure a number of times in the Wilmington hearings and was getting a mini‐workout since the cell phones in Wilmington had to be housed in mini‐lockers in a parking garage a building away from the courthouse.

However, in this final hearing in Georgetown, it was a more difficult decision to leave the proceeding to make a call for fear that I might miss something that could be even more important than the item I was reporting in the call. As in other cases, I tried to avoid this dilemma by partnering with a friend in the business. One of us would leave to make a call, and the other would take detailed notes and fill in the other partner upon his return to the courtroom. During the hours of testimony and arguments that day in the Georgetown Courthouse, we used the procedure numerous times to keep our respective offices up to speed.

During that day's proceedings, the Vice Chancellor directed both sides to address a number of issues including how the definitive merger agreement should be interpreted in regard to the financing commitment. Additionally, the Vice Chancellor also wanted the parties to discuss the requirements for a comfort letter and the likelihood that Cooper would be able to file its third‐quarter earnings report on a timely basis. Before the Vice Chancellor could decide whether Cooper was entitled to specific performance, which would force Apollo to complete the merger, he had to decide the critical issues as to what level of effort Apollo was required to execute to solve the contract situation with the United Steel Workers.

All through the hearing, my main focus was on trying to determine how Vice Chancellor Glasscock would rule. I was using all the facts, my interpretation of the court filings, and the testimony in the case to help determine how the Vice Chancellor would rule. What was different in this case compared to many others I followed in my career was that until recently, my function consisted of managing the investment portfolio, and in doing so, the main functi...

Table of contents

• Cover
• Title Page
• Table of Contents
• About the Author
• CHAPTER 1: Introduction
• CHAPTER 2: What Is Risk Arbitrage?
• CHAPTER 3: The Risk Arbitrage Industry
• CHAPTER 4: Estimating the Return on a Risk Arbitrage Position
• CHAPTER 5: Estimating the Risk of Arbitrage Transactions
• CHAPTER 6: Estimating the Probability of a Transaction's Occurrence
• CHAPTER 7: The Risk Arbitrage Decision Process
• CHAPTER 8: Hostile Takeovers
• CHAPTER 9: Trading Tactics
• CHAPTER 10: Portfolio Management
• CHAPTER 11: The Exciting World of Risk Arbitrage
• APPENDIX A: Tender Offer Document
• APPENDIX B: Airgas/Air Products—Text of Court Decision
• APPENDIX C: Whole Foods Markets—Excerpts from Proxy Statement
• APPENDIX D: Straight Path Communications—Excerpts from Proxy Statement
• APPENDIX E: Straight Path Communications—Excerpts from STRP's 8‐K Filed on April 13, 2017
• Acknowledgments
• Index
• End User License Agreement