Interesting EV question about trading after a buyout announcment

[schnoodleC]

A stock I own Oak Brook Bank (FOBB) is being bought by MB Financial for a mixture of cash and stock that puts FOBB at a premium of ~37% more than what it was trading it. Now, right after the deal was announced FOBB went up about 28-29%, leaving what seems to me to be a fairly large spread of 8-9% left below the buy out price. FOBB gained another 3% by the end of the day, then 2% each of the following 2 days.

The question is did the idea of buying in right after the announcment to exploit the spread between the price of FOBB and the buyout price have positive expected value? If so, how big a spread is required in such situtations (when would you have to have jumped in) ?

The way I see it, if the deal falls through, then FOBB would drop back down, but the question is how far? Would it go below its pre-offer price because the market would be scared about why the deal fell through or would it stay above because the market would continue to recognize the value of FOBB (on its own and as a buy out target)? Of course, the other question is, what is the probability that the deal would fall through?

So: EV of buying FOBB after announcment = ((1-P1) * (1+Y%)) - (P1 * -x%)
where P1 is the probability that the deal will fall through, Y is the percentage gain expected if the buy out goes through (the spread) and X is the percentage drop in FOBB if the deal does fall through.

If p1 = 5%, Y = 8% and X = 29% (FOBB goes back to pre-announcment level) then the ROI of such a trade would be (1.026 - .0145) = 1.011 or 1.1%. This is positive expected value but quite lower than you might imagine from an 8% spread and while positive it might not be worth the varience that your portfolio would face from such a trade.

However, if p1 was only 1% then we'd get 1.0692 - .0029 = 1.066 or 6.6%. A much better number that would clearly make this a good trade.

Throughts?

P.S. Anyone know of any other good regional banks that are takeover targets? [img]/images/graemlins/cool.gif[/img]

[AvivaSimplex]

You also need to factor in the time value of money. If your money is locked up in FOBB, it's not earning 5% interest in a money market account. Most mergers take 6 months or so to complete, so you need to subtract 2.5% from your EV.

Also consider that whatever you choose for p1 is a wild ass guess.

[adios]

I didn't go through all the math but I believe you're approaching the problem correctly. One of the reasons there is a spread is due to the fact that the deal may not go through. You can also capture the spread which might be worth doing if you thought the deal was going to go through. Short the acquirer and go long the aquiree in equal $ amounts. Of course if the deal falls through you might lose on both sides. We've discussed this topic many moons ago. Ray Zee basically stated that he's had decent success buying the acquiree (I have too after taking his advice) and Ray also pointed out that the market doesn't always have these deals analyzed all that well so the spread is often too high.

[hawk59]

This is called deal arb and there are funds that only do this sort of thing. I would guess that deals where the numbers are really in your favor are few and far between.

[schnoodleC]

Yes, I know and I agree. However, we appear to have a case here where the arbitragers seemed slow to react. Most likely due to the fact that FOBB was a small and not widely followed stock with a low market cap. The spread started at 8% and closed to 1% in just a few days. Whether this is because it took the arbitragers a few days to analyze the risk of the deal or just because FOBB is small, I cannot say.

I due think its a worthy discussion to have so that we can recognize these opportunities when they are worthy and come along. At the same time it is good to recognize when these type of opportunities aren't as good as they seem.

[schnoodleC]

Very good point! Of course, your money isn't locked up really. You needn't hold on to the stock until the merger goes through. To make money you only have to hold on until the spread between the current price and the buy out price shrinks to an acceptable level for you to make a nice profit.

In this case, it took only a few days for the stock to rise 7 of the 8% in the spread, giving you a 7% profit if you bought right after the merger was announced. Of course, things won't always work at as well and the time value of your investment should be a part of the compensation.

[adios]

[ QUOTE ]
Yes, I know and I agree. However, we appear to have a case here where the arbitragers seemed slow to react. Most likely due to the fact that FOBB was a small and not widely followed stock with a low market cap. The spread started at 8% and closed to 1% in just a few days. Whether this is because it took the arbitragers a few days to analyze the risk of the deal or just because FOBB is small, I cannot say.

[/ QUOTE ]

Basically Ray's point was that many of these deals involving smaller cap, less widely held stocks "fly under the radar screen" if you will.

[hawk59]

[ QUOTE ]
Very good point! Of course, your money isn't locked up really. You needn't hold on to the stock until the merger goes through. To make money you only have to hold on until the spread between the current price and the buy out price shrinks to an acceptable level for you to make a nice profit.

In this case, it took only a few days for the stock to rise 7 of the 8% in the spread, giving you a 7% profit if you bought right after the merger was announced. Of course, things won't always work at as well and the time value of your investment should be a part of the compensation.

[/ QUOTE ]

The time value of money is something that is factored into the spread. For example, say a deal is slated to be completed in one year. And say 1 year treasuries are at 5%. Well then the spread is going to be 5% from the time value of money and then a further discount based on the perceived risk of the deal. So if this deal was announced and there was a 10% spread then I would consider that very normal and not mispriced.