Risk-to-Reward Ratio for the Valspar and Sherwin-Williams Deal
Big Deal in the Paint Sector: Sherwin-Williams Buys Valspar
Scenario analysis
In the risk arbitrage world, a 10.4% expected return usually indicates a high-risk transaction. In this case, the risks include getting the reduced consideration of $105 per share as well as the risk of the deal breaking.
Downside if the deal breaks
Valspar (VAL) was trading at about $84 per share before there was speculation in the press about a deal. If the deal breaks, will Valspar 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 Valspar, then that price is probably a best-case scenario.
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 doesn’t break, the spread will go to zero and you will make about $9.65.
If the deal breaks, the spread will widen to about $30. So, the risk-to-reward ratio is (30 – 9.65)/9.65 or about 2:1. However, if regulators demand more than $650 million in divestitures, you aren’t getting $113 anymore. If that happens, the spread drops to $1.65 and your risk-to-reward is (30 – 1.65) / 1.65 or 17:1. In this case, the risk-to-reward ratio is even more uncertain than it usually is. If you handicap a coin toss for whether the Fed requires $650 million or not, then the probability-weighted spread is $5.65 and the risk-to-reward ratio is (30-5.65)/5.65 or about 4:1. Given the elongated timeline for the deal, that spread looks about right.
Other merger arbitrage resources
Other important merger spreads include the Dow Chemical (DOW) and DuPont (DD) deal. It’s slated to close in 2H16. The Apollo-ADT (ADT) merger is another important deal. 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 retail sector should look at the Materials Select SPDR (XLB).
Browse this series on Market Realist: