Is the Freescale–NXP merger worth the risk?
The Freescale–NXP merger: An arbitrageur's take on the deal (Part 6 of 12)
Scenario analysis is a key part of merger arbitrage
In the risk-arbitrage world, a 2.8% spread means a deal is pretty safe. And, we know that the annualized spread in the Freescale–NXP merger is just about 2.8%—provided that everything happens according to plan.
Generally speaking, your base-case assumption has to be that the deal closes as advertised and that you earn the spread. After all, a merger agreement is a contract. If NXP Semiconductors (NXPI) tries to walk away without a MAC (material adverse change) occurring, Freescale Semiconductor (FSL) could sue it and demand specific performance. In other words, Freescale could have a judge force NXP to do the deal.
What’s your downside if the deal breaks?
Before the deal, Freescale was trading at $36 per share, but there were already press reports that the company was in merger talks. The true pre-deal price is about $34.50. If the deal breaks, does the stock go back there? That’s probably a good bet. Freescale had just reported good numbers, and the stock gapped up in late January.
Risk-to-reward ratio
Look at the above graph and imagine you’re short the spread. If the deal closes, the spread goes to zero and you make about $0.95. But, if the deal breaks, you end up having to cover around $2. So, the risk-to-reward ratio is $2 down to $0.95 up. It’s a risk-to-reward ratio of 2:1. That said, this analysis assumes NXP gives up all of the gains that it picked up on the deal announcement—NXP gapped up about $15 a share.
Short-covering after the deal breaks could provide some support for NXP, at least initially, as arbitrageurs unwind their positions. After the smoke clears, however, those risk-to-reward ratios should play out.
Of course, the reason for the deal breaking is key. If it broke because the deal couldn’t get regulatory approval, then pre-deal prices are a good bet. If it broke because Freescale lost a major customer—not due to the merger—then the pre-deal price is a best-case scenario.
Other merger arbitrage resources
Other important merger spreads include the Hospira–Pfizer deal. The Hospira (HSP) and Pfizer (PFE) merger is also set to close in 2H15. For a primer on risk arbitrage investing, read Merger arbitrage must-knows: A key guide for investors.
Investors who are interested in trading in the semiconductor sector should look at the Market Vectors Semiconductor ETF (SMH).
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