What’s the Risk-to-Reward Ratio of the St. Jude Medical-Abbott Deal?
Huge Deal in the Healthcare Space: Abbott Buys St. Jude Medical
Scenario analysis
In the risk arbitrage world, a 10% expected return usually indicates a higher-risk transaction. This is probably about right given that there’s some overlap and a cap on divestitures. Note that Abbott (ABT) is also in a deal with Alere (ALR). Currently, there are issues with the deal.
Downside if the deal breaks
St. Jude was trading at about $60 per share before the deal was announced. If the deal breaks, will it 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 St. Jude, then that price is probably a best-case scenario. Old timers will remember the Guidant-Johnson & Johnson (JNJ) deal. Merger arbitrage professionals panicked after Guidant announced problems with its pacemakers. This caused Johnson & Johnson to declare a Material Adverse Effect and terminate the deal. Boston Scientific (BSX) ended up buying Guidant at a reduced price.
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 $4.40.
If the deal breaks, the spread will widen to about $24. So, the risk-to-reward ratio is (24 – 4.4)/4.4 or about 5:1. It’s 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.
Other merger arbitrage resources
Other important merger spreads include the Cigna (CI)-Anthem (ANTM) deal. It’s slated to close in 2H16. 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 S&P SPDR Healthcare ETF (XLV)
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