Must-know: Analyzing the Time Warner Cable–Comcast deal (Part 10 of 11)
Scenario analysis is a key part of merger arbitrage
So, we know that the annualized spread in the Time Warner Cable (TWC) and Comcast (CMCSA) deal is just about 5%, provided everything happens according to plan. In the risk arbitrage world, a 5% spread means a deal with some “hair” on it. The market is assigning a high probability of something going wrong.
But 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. Note that there’s no breakup fee if the deal doesn’t happen.
What’s your downside if the deal breaks?
Pre-deal, Time Warner Cable was trading at $135 a share. However, the stock was being elevated by Charter Communications’ (CHTR) bid for the company. Prior to Charter’s interest, the stock was trading at $120. Depending on the reason for the deal breaking, the stock will probably end up there. However, that will depend on the reason for the deal breaking. If it broke because of bad news out of Time Warner—for example, accounting problems—then the pre-deal downside is probably a best-case scenario. On the other hand, if it broke due to intransigent regulators, then the pre-deal price is probably the right bet.
Comcast is basically unchanged from its pre-deal price. If the deal breaks for regulatory reasons, you probably won’t get hurt too much on your short side.
Look at the graph above and imagine you’re short the spread. If the deal closes, the spread goes to zero and you make your seven bucks. However, if the deal breaks, you end having to cover in the low 20s. So the risk-to-reward ratio is, say, $23 down to $7 up—or just over 3.3:1.
Other important mergers
Other important merger spreads you should consider include the Covidien (COV) and Medtronic (MDT) deal as well as the DIRECTV (DTV) and AT&T (T) deal.
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