From: Sanjay Bakshi
Sent: Sun 22/10/2006 20:22
To: BFBV
Subject: Adventures of a Risk Arbitrageur
Dear Students,
Some time ago, I had told you about a deal on which I was working. This was the deal involving the acquisition of Matrix Laboratories by Mylan. I had, at that time said, that there are multiple ways of looking for opportunities in this deal. I had disclosed one such way to you. This involved taking a long position in the stock and simultaneously selling the shares expected to be received back (due to over-tendering) in the futures market. The second leg of that trade would have involved selling the surplus shares as and when received in the spot market and simultaneously squaring up the short futures position. These trades, if they had been initiated, soon after announcement of the deal, had an expected pre-tax, hedged return of more than 25% p.a. after considering trading and hedging costs. For details of this trade see the text of a note prepared by Ankur Jain, one of my colleagues, who is three years senior to you. The note is at the bottom of this mail.
Such returns are considered to be mouth-watering by many hedge fund managers primarily because of low correlation to overall market.
However, this very fact, attracts more capital in this game which makes returns in the strategy described above less attractive for new capital. That brings me to the second way of looking at this deal.
Given that (1) this is a large transaction involving a liquid stock; and (2) the stock is trading in futures market, it was clear to me that much capital will enter this trade. One way of validating this is to see what happened to the November futures contract, which was the relevant contract for hedging purposes in this deal (assuming no delays - wrong assumption - more about that later). A few days after the announcement of the deal, sure enough, the November futures contract started to trade below the spot price and the gap kept on increasing progressively and at one time reached more than Rs 15 per share. That is, the November futures were trading Rs 15 below the spot in September. Why would that happen? All of you know the mathematical relationship between spot and futures prices. Futures are supposed to trade a premium not discount to spot. Why were November futures trading at a discount to spot?
Well part of the answer is that too much money was chasing this deal. The strategy of buying shares in the spot market and selling them in the futures market for November delivery depressed the price of November contract for technical reasons. Such technical reasons often create very interesting anomalies for exploitation by the alert investors. Let me explain. (I am listening to Sarah Brightman as I type this - I love this girl's voice :) - so I am in the mood to share some of my secrets with you :)
Well this offer was to open on 20 October 2006 and close on 8 November 2006 and the surplus shares and money for shares accepted would have reached us by 23 November. This means that the November contract was the relevant contract because its settlement date was after 23 November. And that's exactly why the November contract went to discount to the spot price.
One of the key risks in risk arb is that of unexpected delays. Well, in this case a delay did take place. See the following news reported on 19th October.
http://www.business-standard.com/common/storypage.php?leftnm=lmnu1&subLeft=1&autono=262276&tab=r
What did the delay mean? Well in this case it means that the November contract was no longer the relevant contract for hedging because by the time the surplus shares would come back after the delay, it would be past the settlement date for the November contract (futures contracts are settled on the last Thursday of every month.) Now what that that imply?
If November is no longer the right contract for hedging then people who were selling November contracts for hedging would now have to shift to December. That required them to buy back the November contract which would create demand for this contract on the long side. Looked another way, there was no logic anymore for the November contract to trade at a discount to the spot price. So how does one make money in this? One way is to go long November contract and short December contract. Another way is to just go long November contract in the expectation that the discount will vanish.
And vanish it did- It HAD to didn't it? The market may be foolish for a while but it does not remain foolish forever. This window of opportunity was available for just a few hours - too little for the unaware investor -but just right for the alert one.
Total pre-tax realized return came to 15% flat on invested capital over just a few hours - the annualized returns need not be computed as they would look obscene :)
SB
P.S.: "The answer is out there, Neo, and it's looking for you, and it will find you if you want it to." - Trinity in "The Matrix"
Text of Note prepared on 6 September 2006
MATRIX LABS
On August 28, 2006, Mylan Labs announced the acquisition of 51.5% stake of Matrix Laboratories through a Share Purchase Agreement between Mylan (acquirer) and Mr N Prasad (Promoter of Matrix Labs) and the other Persons Acting in Concert.
The acquisition of 51.5% stake in the Indian company triggered the SEBI Takeover Code, 1997 which required the acquirer, Mylan Labs to come out with an open offer to buy at least 20% of the outstanding equity from the public shareholders of the acquired company, Matrix Labs. Also, post acquisition 5% of the outstanding shares are going to continue remain with Mr. N Prasad.
On August29, 2006, Mylan Labs came out with an open offer to buy 20% of the outstanding shares of the company from the public shareholders (except the parties to the Share Purchase Agreement).
Date of opening of offer: October 20, 2006
Date of closing of offer: November 08, 2006
Last date by which cash will be received: November 23, 2006
Investment Rationale
The excel sheet shows the shareholding pattern of the company. 51.5% has been acquired by Mylan. Also 5% is going to remain with Mr N Prasad. Thus, for the open offer of 20%, the % of eligible shares for tendering is (100-51.5-5) = 43.5%.
In our view, there might be some "brain dead" investors which in turn might increase the acceptance ratio during the open offer. Even if there are 3-4% investors who do not tender their shares during the open offer, the acceptance ratio will be 50%.
For 100 shares that we buy at Rs 274/ share, 50 might be accepted in the open offer at Rs 306/share and the rest 50 shares will be returned to us.
To hedge the risk of the price of the returned shares falling down, we can hedge our position using the availability of the Matrix Labs stock in the F & O Market.
The calculations have been taken for 6 F&O contracts because the deal will take 3 months and we will have to take 3 pairs of buy-sell.
The calculations show that for a fully hedged position in this trade, over a 78 day period ( Sep 07,2006- Nov 23, 2006) , the annualised returns after all costs of trading is close to 25.22%.
