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What’s the Risk-to-Reward Ratio of the Lexmark Transaction?

Lexmark Gets a Buyer after a Long Sales Process

(Continued from Prior Part)

Scenario analysis

In the risk arbitrage world, a 21% expected return usually indicates a higher-risk transaction. This is surprising given that the main buyer, Apex, is a strategic buyer. This isn’t like a typical private equity deal where the return is all about a turnaround and cheap financing.

Downside if the deal breaks

Lexmark (LXK) was trading at about $34.66 per share before the deal was announced. If the deal breaks, will Hatteras return to its former level? The answer to that question is “it depends.” If the deal breaks for regulatory reasons, then that price is probably a good bet. If it breaks because of a material adverse effect out of Hatteras, then that price is probably a best-case scenario. Lexmark was trading at 31.06 before it announced that it was examining strategic priorities. However, that price is probably stale. Typically, arbs will look at the recent worst-case scenario to peg the downside. Yes, this is probably overly conservative, but it’s how they typically look at things.

Let’s look at this deal as a normal risk arbitrage spread. Look at the arbitrage spread in the above graph and imagine that you’re short of the spread. If the deal closes as expected, you will make about $2.60.

If the deal breaks, the spread will widen to about $16. So, the risk-to-reward ratio is (16 – 2.6)/2.6 or about 5:1. This is a reasonable risk-to-reward ratio for this environment. Lately, arbitrageurs have been shelled with a number of deals breaking or getting blocked by regulators. Allergan and Pfizer terminated their deal. Baker Hughes-Halliburton and Staples-Office Depot have been blocked by regulators. Currently, arbitrageurs are feeling some pain. This will be reflected in spreads.

Merger arbitrage resources

Other important merger spreads include the deal between Cigna (CI) and Anthem (ANTM) and KLA-Tencor (KLAC) and Lam Research (LRCX). 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 tech sector can look at the iShares Global Technology ETF (IXN).

Continue to Next Part

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