Unaffected share price

The moment a takeover is announced, the target's share price moves. Traders buy it because they expect a higher price to be paid.

So the price on the screen after the announcement is no longer a clean number. It already contains part of the deal.

The unaffected share price is the price before the deal — the workbook calls it the current share price before the deal. That is the base the acquirer has to beat.

Why does the acquirer have to beat it? Because the target's board will only approve a sale if the acquisition price is significantly higher than the company's current share price. So a premium is not a courtesy. It is the price of a board resolution.

For a fund running merger arbitrage, this is the anchor for the whole trade. Measure the premium from the wrong price and the spread you think you are capturing is partly gone already.

Where it sits. Chapter 10, section 10.1.4.2 (Merger Arbitrage Strategy), one of the event-driven strategies. When an Acquiring Company makes its best offer, it typically needs to pay a premium over the Target Company's unaffected equity share price, or the current share price before the deal, because the Target's board is only likely to approve if the acquisition price is significantly higher than the current price.

What the arbitrageur then does.

• A long position in the Target's equity shares, to capitalise on the spread between the Target's current share price and the Acquisition Price on completion of the deal.
• A short or long position in the Acquiring Company's shares. The workbook gives two reasons a short is taken: deal-completion uncertainty — until final allotment, board, regulatory and shareholder approvals can all fail or be delayed — and premium mis-valuation. If the premium paid to the Target is over-valued, the Acquirer's share price is at risk of falling; if under-valued, it is likely to rise.

The link to valuation. The valuation method used to compute the Fair Market Value of one share of the Target drives the conversion ratio, and hence the arbitrage. So the unaffected price is not only a trading benchmark; it feeds the ratio itself.

The workbook's own numbers (Example 10.7). Merger of Company CF into Company ID, announced 15 January 2018 at 11:01 a.m., both boards having approved:

The 11:00 a.m. Target price of Rs 39.25 is the price before the deal — the unaffected price. The 3:30 p.m. close of Rs 41.10 is not: it already carries the announcement.

And the workbook itself computes off the earlier prices. Using the 11:00 a.m. prices and the 139:10 conversion ratio, it derives a fair price for Company ID of 139 x 39.25 / 10 = Rs 545.58 against a market price of Rs 540.00, concludes ID is under-valued, and justifies buying it.

No look-back period is stated. The workbook defines the unaffected price by reference to the announcement — the price before the deal — and gives no number of days, no volume-weighted window and no averaging rule. Where a paper wants a stated window it says so; this one does not, so do not supply one.

One inconsistency to carry into the exam. The same page describes the ratio as 139:10, i.e. shareholders of Company ID will be issued 139 shares of Company CF for every 10 shares in the company — while the arithmetic it then performs treats 139 CF shares as exchangeable for 10 ID shares. The prose and the computation point opposite ways. Both are on the page; cite the section and work with the arithmetic the workbook actually performs.

The workbook's Example 10.7, read for the price that matters.

Fund MAS is a Category III AIF running a merger arbitrage strategy on Company ID and Company CF. On 15 January 2018 the merger of CF into ID is announced at 11:01 a.m. as a full-stock deal at a conversion ratio of 139:10. Both boards have approved, so deal-failure risk is minimal, and the fund takes long positions in both companies at 11:02 a.m.

By the 3:30 p.m. close, ID is at Rs 567.80 and CF at Rs 41.10:

Company ID:  1,00,000 x Rs 567.80 = Rs 5,67,80,000
Company CF: 10,00,000 x Rs  41.10 = Rs 4,10,00,000
Total value                       = Rs 9,77,80,000
Total invested                    = Rs 9,32,50,000
Return on investment              = 4.86% in one day

Now see what the unaffected price is doing. CF's unaffected price was Rs 39.25. It closed at Rs 41.10 — a rise of Rs 1.85, or 4.71%, purely on the announcement.

An analyst who measured the acquirer's premium from Rs 41.10 rather than Rs 39.25 would understate it by Rs 1.85 a share. On CF's 10,00,000 shares in this trade, that is Rs 1.85 crore of premium invisible in the analysis.

And a fund that arrived an hour late paid Rs 41.10 for the same shares: Rs 4.11 crore instead of Rs 3.925 crore, giving up Rs 18.50 lakh of the very spread it was trying to capture. Merger arbitrage is largely a race to transact against the unaffected price before it disappears.

The valuation link. Using the unaffected prices, the fair price of ID is 139 x 39.25 / 10 = Rs 545.58 against a market price of Rs 540.00. ID was under-valued on the ratio offered, which is why Fund MAS bought the acquirer as well as the target.

Chapter 10, section 10.1.4.2 (Merger Arbitrage Strategy), inside the event-driven strategies. Example 10.7 is worked in full with times, prices and the 4.86% one-day return, which makes it a favourite for a numerical question.

Expect: what the unaffected share price is (the target's price before the deal), why a premium is needed (the target's board approves only at a price significantly above the current price), why the acquirer is shorted (deal-completion uncertainty and premium mis-valuation), and a computation using the 11:00 a.m. prices and the 139:10 ratio to test whether the acquirer is under- or over-valued.

• Unaffected means before the announcement, not the latest traded price. In Example 10.7 the unaffected price is the 11:00:00 a.m. Rs 39.25, not the 3:30 p.m. close of Rs 41.10.
• The premium is measured over the unaffected price. Measuring it from a post-announcement price understates it, because part of the premium is already in the quote.
• The workbook states no look-back window. There is no stated number of days or averaging rule. Do not import one.
• The acquirer can be bought as well as sold. The workbook shorts the acquirer for deal risk and premium mis-valuation — but in Example 10.7, with both boards and regulators already on board, it says the fund should ideally go long the acquirer too.
• Over-valued premium hurts the acquirer, not the target. If the premium is over-valued the acquirer's share price is at risk of falling; if under-valued, of rising. Candidates reverse this.
• The conversion ratio sentence and the conversion ratio arithmetic disagree in the workbook. The prose says 139 CF shares are issued for every 10 ID shares; the computation divides 139 x CF price by 10 to value ID. Note both and cite section 10.1.4.2 rather than choosing.
• This is merger arbitrage, not activist investing. Both are event-driven, but the activist strategy takes a large stake to change the company; merger arbitrage trades the announced spread.