The Risk-to-Reward Ratio of the Life Time Fitness Merger
Assessing the Life Time Fitness Merger (Part 6 of 11)
Scenario analysis: A key part of merger arbitrage
We know that the annualized spread in the Life Time Fitness merger is about 4.9%, provided everything goes according to plan. In the risk arbitrage world, a 4.9% spread is about right for a private equity transaction.
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 the consortium tries to walk away without a MAC (material adverse change) occurring, Life Time Fitness could sue and demand specific performance. In other words, Life Time Fitness could ask a judge to force the consortium to do the transaction.
What’s your downside if the deal breaks?
Before the deal, Life Time Fitness was trading at $67.20 a share. If the deal breaks, does the stock go back to that amount? Probably not. There was a story in the press that Life Time Fitness was in talks to be acquired and the stock was trading around $57 before that.
Look at the above graph and imagine that you’re short the spread. If the deal closes, the spread goes to zero, and you make about $1.00. However, if the deal breaks, you end up having to cover around $14. So, the risk-to-reward ratio is $14 down to $1.00 up. It’s a risk-to-reward ratio of 14 to 1. As a general rule, risk-to-reward ratios in the 15x to 20x range are typical.
In this case, it’s hard to see what would break the deal aside from a MAC on the part of Life Time Fitness. In that case, the downside is probably worse than $57.
Merger arbitrage resources
Other important merger spreads include the deal between Salix Pharmaceuticals (SLXP) and Valeant Pharmaceuticals (VRX) or the merger between Pharmacyclics (PCYC) and AbbVie (ABBV). 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 consumer discretionary sector should look at the Consumer Discretionary Select Sector SPDR Fund (XLY) or the iShares Global Consumer Discretionary ETF (RXI).
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