Merger arbitrage is an investment strategy often used by hedge funds. There are many ways to play a merger, but the arbitrage is basically the delta between the deal as announced, and the current spread between the merging parties.
With Sirius and XM, it is an all stock deal. The terms are 4.6 shares of Sirius for each share of XM. Some Arbitrage players use a strategy where they short the buyer (Sirius) and go long the company being acquired (XMSR). Effectively, a person doing this is setting the spread. Once the deal is complete, they can use the shares they received from the ratio to settle their short position, and the spread between the two is profit.
A simpler way to look at this is simply with the proposed ratio vs. the current ratio. In theory, if you were looking to invest in Sirius, and felt that the merger would pass, you could actually wind up with more shares by investing into XMSR. This is because the stocks are currently trading at about 9% below the merger ratio.
Merger watchers often follow this ratio to gauge the street sentiment on a merger. The closer the stocks trade to the actual merger ratio, the stronger the opinion of the street that the merger will happen.
With this merger, there were many occasions where you could have gotten a 20% differential between these equities. Lately, that gap has narrowed very quickly. Why does this happen?
1. The deal is coming closer to a decision.
2. The very public filings with the FCC are now closed, and the various arguments for either side are now known.
3. Sirius and XM will shortly be certifying that they have complied with the DOJ’s second request (a request for additional information). Once certified, a 30 day clock begins for the DOJ to act. This happens unless the parties have already agreed with the DOJ that a stipulated time period will exist. Thus far, there is no public information setting a date.
4. When the “premium” gets to a certain percentage, traders who feel positive about the merger tend to buy in again, and this begins to close the gap.
5. The companies are getting very close to filing for a shareholder vote on the merger. Merger watchers should pay close attention to this specific piece of information. In theory, the date of the shareholder meeting will be in close proximity to when a regulatory decision is expected. The reason for this is that there are many things that can happen between the shareholder vote and a regulatory decision. If a material event were to happen, a second shareholder vote could be argued, and that would not only waste money, but take time as well. Additionally, and in theory, the companies would want to consummate the merger as soon as possible after regulatory approval for many reasons. It would be foolish to get regulatory approval and then send out notice for a shareholder vote. Thus, investors should be very cognoscente of the shareholder vote date.
Now that these equities are trading at under 10% to the merger ratio, these stocks will become interesting to watch. In the past weeks XM has seen the bigger upside as that delta closes. Likely, the stocks will not see this gap close much more than it already has, so the equities will likely begin to trade more in tandem. A big correction in the spread (5 points either way) is possible on certain news, but otherwise, large changes in the spread should not be expected in my opinion.
Until this point, most analysts have been able to generate their reports on these companies as stand alone entities, with some commentary on the merger. While this practice will still continue, it is now getting to the point where the merger will become much more central to the discussion. Watch for analysts to begin to assign more importance to the merger, and to outline valuations based on the merger. You should also expect to see reporting on impacts if the merger is rejected. Surprisingly, not many analysts focused on the arbitrage as a potential play, and the real benefit for an Arb player has already happened.
The month of September should be a big month in getting a better indication of the timing of the merger decision. Look for certification to the DOJ on second request compliance and an announcement of the respective shareholder votes as the next key components to the merger process.
Position – Long Sirius, Long XM