Abbott Looks to Boost Its Diagnostics Business by Buying Alere
Scenario analysis is a key part of merger arbitrage
In the risk arbitrage world, a 4.7% expected return usually indicates a low-risk transaction. Merger arbitrage tends to correlate inversely with the VIX Index, a measure of market volatility.
In times of stress, the VIX Index increases, and hedge funds lighten their exposures. This causes spreads to widen. In this environment, financial deals, or private equity transactions, generally perform the worst, and strategic stock-for-stock transactions usually fare better.
The downside if the deal breaks
Alere (ALR) was trading at about $37 per share before its deal with Abbott Laboratories (ABT) was announced. If the deal breaks, will ALR’s share price return to its former level? The answer is probably yes, depending on the reason. 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 Alere, 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 graph above, and imagine you’re short of the spread. If the deal doesn’t break, the spread will go to zero, and you will make about $2.30.
If the deal breaks, the spread will widen to about $20.50 or so. So, the risk-to-reward ratio is (20.50 – 2.30)/2.3, or about 8:1. This ratio is indicative of a lower-risk deal, and it represents potential antitrust risk. Note that the deal has a high premium of over 50%, which means that the spread will probably trade wide for the pendency of the deal, or at least until antitrust is cleared.
Other merger arbitrage resources
Other important merger spreads include the Cigna (CI)–Anthem (ANTM) deal, which is slated to close in 2H15. 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 could look at the Health Care Select Sector SPDR ETF (XLV).
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