Valeant makes yet another acquisition: Salix Pharmaceuticals (Part 10 of 12)
Scenario analysis is a key part of merger arbitrage
So, we know that the annualized spread in the Salix–Valeant merger is just about 8.1%—provided that everything happens according to plan. In the risk arbitrage world, a 8.1% spread means a deal with some “hair” on it. The market is assigning some sort of probability that something can go wrong.
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 Valeant (VRX) tries to walk away without a MAC (material adverse change) occurring, Salix (SLXP) could sue it and demand specific performance. In other words, Salix could have a judge force Valeant to do the deal.
What’s your downside if the deal breaks?
Before the deal, Salix was trading at $152 per share. If the deal breaks, does the stock go back there? Probably not, because there were press reports that Salix was talking to people, and the company announced it was seeking strategic alternatives. The stock bottomed around $88 per share after the announcement of its inventory problems came to light. That is probably a good enough guess as any because (a) you can’t rely on these forecasts because the inventory issues are still being worked out, and (b) much depends on a FDA decision.
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 $2.25. However, if the deal breaks, you end up having to cover around $60. So, the risk-to-reward ratio is $60 down to $2.25 up. It’s a risk-to-reward ratio of 27:1. As a general rule, 20:1 risk-to-rewards are reserved for safe transactions, so this indicates something else is going on. Read on.
Other merger arbitrage resources
Other important merger spreads include the deal between Hospira (HSP) and Pfizer (PFE). 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 healthcare sector should look at the Health Care Select Sector SPDR Fund (XLV).
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