Abbott Labs and Alza

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Thus, we find a decrease in risk but a probably more than proportional decrease in returns from the put option and hence, it is not advisable for Smith to go for the same. Smith also needs to decide whether he should close the position, hold it or increase the exposure given the recent developments. The spreads have widened to 5 thus making it more attractive to invest in the merger. However, even the risks have increased due to recent developments. In order to decide the course of action Green Circle should take, we observe that despite some negative events, positive happenings pointing to the possibility of the merger have also taken place in the recent past. Moreover, in spite of the FDA issue, both the managements still seem to be working together to make the merger happen. The merger is known to make tremendous strategic sense and the complimentary expertise of the two companies makes them almost a perfect match. There is a possibility, however, that the terms of the merger may be revised. This revision might happen if the prices of Abbott fall drastically in which case the number of shares to be issued per share of Alza would go up. Green Circle would only stand to gain from this and thus, we recommend that they invest the rest of the allowed funds in the merger deal without going for the put options.

4. Generally speaking, what factors contribute to deal failure? In addition to deal failure, what else can also jeopardize an arbitrageur’s return in an M&A process?

In general speaking, the deal failure mainly due to 2 reasons. First, the future share price of Abbott may decline due to several resaons and hence reduce the attractiveness of the offer to Alza, for examples, a potential rivalry product maybe appproved by FDA and directly compete with one of the most profitable joint-venture product of Abbott; nevertheless, the increasing performance of Alza such as the newly approved products of Alaz may increase the future profitability of the company, in which a $53 per share of Abbott may possibly undervalue Alza.

Second, as a pharmaseutical firm, the compliance issue regarding to the manufacturing problems of Abbott may seriously affect the reputation of the company and hence heavily affect the profitability and the share price of the company, therefore, the shareholders of Alza finally oppose the merge of two companies.

For the arbitrageur return, other than the deal failure, the increasing share price of the targeted company will narrow down the deal spread of the transaction,which will then decrease the potential gain of investing in this merger plan; furthermore, sometimes if the targeted company’s share price increases and even exceed the offer price, the deal will possibly failure.

5. Estimate the beta of M&A risk arbitrage. Run a CAPM regression, using the monthly risk-free rate (in the excel file provided), monthly market returns (in the excel file provided), and monthly returns of the Barclay Merger Arbitrage Index (available free on the internet, Google the link to the data) from January 1997 to December 2012. What is the beta of the Barclay Merger Arbitrage Index? Why it is a positive number (not zero)? What about the intercept? Is it zero or positive? A positive intercept suggests that the Barclay Merger Arbitrage Index outperforms the CAPM benchmark. Why could this happen if the market is efficient (in another word, according to CAPM, we should expect a zero intercept if the market is efficient)?

According to CAPM regression of monthly returns of Barclay Merger Arbitrage Index from Jan 1997 to Dec 2012 as follow.

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We can get the regression equation:

R-Rf=0.0039+0.12*(Rm-Rf).

So the beta of the Barclay Merger Arbitrage Index is 0.12. The positive number of beta is caused by the intent of arbitrage of the index is to hedge market risk. Moreover, the volatility of the index must be positively related to the fluctuation of whole stock market, which means the number cannot be zero.

According to the formula, the intercept is 0.0039, which means BMAI always has excess return of 39 basis point over CAPM benchmark. Usually, in an effective market, arbitragers cannot get excess return, because they only get public information to make investment decision. However, in some M&A cases, arbitragers can earn excess return by using private information through some unique channels, the alpha of BMAI can be positive.

References

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