Risk Arbitragers Have Been Feeling the Pressure As Gyrating Stock Prices Affect Value of Mergers
The Wall Street Journal -- September 14, 1998
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By Shawn Young
Dow Jones Newswires
NEW YORK -- The risk is back in risk arbitrage.
The bungee-jumping stock market and a harrowing series of hits to one high-profile merger have made investors who specialize in corporate takeovers, known as risk arbitragers, or arbs, tense indeed.
"People have been spooked like they haven't been spooked in a long time," said Holt Thrasher, managing director at Broadview, a Fort Lee, N.J., merger-and-acquisitions investment bank.
The motion sickness that is making many investors queasy has been intensified for merger players because they have been slammed again and again by blows to the deal between two telecommunications-equipment makers, Tellabs Inc. and Ciena Corp.
Ciena's fortunes took a sharp turn for the worse after Tellabs agreed to buy it. Bad earnings news followed by the loss of AT&T Corp. as a potential customer torpedoed the original terms of the deal less than an hour before shareholders were to vote on them. The vote was moved back twice, and now investors question the revised deal's fate because Ciena failed to win a $100 million contract with Digital Teleport Inc., an existing customer.
On the Tellabs-Ciena deal, arbitragers have lost a lot of money, picking up a reminder that even seemingly straightforward mergers can hit black ice.
Even without a push from bad news, falling stock prices have undermined the value of mergers in which one company uses its stock as a currency to buy another company, raising the possibility that the deals themselves could unravel or be renegotiated if declines continue. Indeed, Venator Group Inc. cited unfavorable market conditions when it canceled plans Thursday to buy Sports Authority Inc.
Cash buyouts also look shaky to arbs in a falling market because of the potentially stark contrast between the fixed value of cash and the falling value of stock, according to one arbitrager.
Shares of several companies involved in gigantic mergers are trading well below the prices their merger partners will pay for them. That difference, called the spread, indicates that arbitragers and other investors aren't taking it for granted that the mergers will go as planned, even though there is currently no indication that many are coming apart.
Early this month, according to a report by Bear, Stearns & Co., spreads were wider than they have been at any point since the market meltdown of 1987.
"We think the reasons for this relate far more to arbitragers' reluctance to risk capital in view of market conditions rather than widespread problems with deals," the report said. Hedge funds, which often invest in both emerging markets and takeovers, have a double reason to be cautious as world markets gyrate, the report said.
One of the more dramatically gaping spreads exists for the proposed merger between AT&T and cable giant Tele-Communications Inc. Based on Friday's close, Tele-Communications' Class A shares were trading for 12.3% less than AT&T would have to pay for them under the companies' merger agreement.
In another example, Citicorp closed Friday at 6% less than Travelers Group Inc. would pay. The spread had been 10.6% at Thursday's close, but the companies reaffirmed their merger plan on Friday.
Ciena ended trading Friday at a 55.8% discount to the price Tellabs would pay, indicating extreme doubt about that deal.
The renewed respect for risk evident in spreads generally is a good thing, some experts said.
As the market soared and fed a torrent of pricey takeover deals, investors ranging from specialized professionals to novices buying their first mutual funds made obligatory nods to that abstraction called riskand plunged ahead.
Investors generally paid record prices for stocks, while arbitragers played narrowing spreads with confidence that mergers would go through and stocks would behave predictably. Mostly, they did.
Although the renegotiation of the merger between MCI Communications Corp. and British Telecommunications PLC last summer served as a massive hit of No-Doz for arbs, the appearance of WorldCom Inc. with a richer offer for MCI and a subsequent flood of new merger announcements emboldened investors.
A stampeding bull market can make tricky investment strategies like arbitrage seem like an easy way to make money, and some investors were lured beyond their expertise, which tended to drive prices up and narrow spreads even more, said Eric Longmire, director of research at Wyser-Pratte & Co., a New York firm that invests in such things as mergers.
Arbitrage is anything but simple. It typically involves a tandem set of investments in which the arbitrager bets that shares of the company being bought will rise and the buyer's shares will fall.
If the deal collapses or is renegotiated downward, an arbitrager loses money coming and going. The selling company's shares, which were supposed to rise, typically fall because the premium the buyer was willing to pay evaporates. Meanwhile, the buyer's shares, which were supposed to fall, often rise because the buyer will be saving money.
"For the past few years, spreads reflected no risk at all," Mr. Longmire said. "People weren't factoring in the appropriate cost for risk, and now they have been forced to. I think that's a very healthy development."
If the market stabilizes, spreads are likely to narrow in the coming weeks as several major deals, including WorldCom's purchase of MCI, close and provide arbitragers with infusions of both capital and confidence, arbitragers said.
"Needless to say," Bear Stearns said in its report, "it's difficult to say when to buy into a panic."
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