The big news in the merger & acquisition (M&A) market this week is AT&T Inc. (NYSE: T)’s massive $85 billion proposed buyout of Time Warner Inc (NYSE: TWX). Time Warner’s share price has rallied following the buyout deal, but it is still well short of AT&T’s offer price. That makes the potential deal a major risk arbitrage opportunity for traders.
A typical bullish stock trader buys a stock and hopes that a combination of market movement, stock fundamentals, trading momentum, and company news will drive the share price higher. However, risk arbitrage traders keep things simple.
When a potential M&A deal is announced, it doesn’t become official until shareholders vote on the deal and the deal gains regulatory approval. Between the time a deal is announced and the time it becomes official, shares of the buyout target often trade at a discount to the buyout price due to the chance that the deal will not close. Typically, this discount is very small (1-2% or less). Patient risk arbitrage traders buy the stock at the discounted price and hold until the deal is completed, pocketing the small spread.
Risk arbitrage traders have a well-defined, guaranteed upside, assuming the deal is finalized.
AT&T’s bid for Time Warner comes in at $110/share, yet Time Warner shares are trading at only $86.74. For risk arbitrage traders, the deal provides a 26.8% upside. Why such a large discount?
In a nutshell, the market isn’t convinced the deal will be approved by regulators.
One of the major drivers of this concern could be Time Warner’s dubious M&A history. The company’s $164 billion merger with AOL during the peak of the Dot Com Bubble back in 2000 was one of the most disastrous mergers of all-time.
A proposed 2014 blockbuster merger between Comcast Corporation (NASDAQ: CMCSA) and Time Warner Cable was dropped after resistance from regulators. That failed cable deal is likely still fresh in traders’ minds.
Like the market, many analysts are skeptical of the massive deal between TIme Warner and AT&T. However, AT&T CEO Randall Stephenson did his part to reassure investors on a conference call the Monday following the deal’s announcement.
Stephenson emphasized the deal’s major selling point to regulators: vertical integration. In recent history, the Justice Department has focused on blocking deals that combine competitors. AT&T and Time Warner, on the other hand, are not competitors. Time Warner supplies AT&T with programming, making the deal a “vertical merger.”
“In fact, I’m not sure I know of a situation where vertical integration has been blocked by the government in our two sectors,” Stephenson concluded.
If the Justice Department sticks to its pattern of allowing vertical integration, it could be only a matter of time before the AT&T/Time Warner merger becomes official. If it closes, risk arbitrage traders have an opportunity for 26.8% upside. However, the regulatory process could be a long, drawn-out process, and there’s no guarantee regulators won’t block the deal.
Disclosure: the author holds no position in the stocks mentioned.
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