John Paulson, the man who made over $3 billion personally in 2007 by betting against subprime mortgages, is going back to his roots with a bet that Pfizer's acquisition of Wyeth will close. (Paulson began his investing career at Gruss Partners, a risk arbitrage firm.) He's doing it in size, too – Paulson & Co's latest 13-F filing shows Wyeth
Deal math
These are the terms of the acquisition: for each share of Wyeth, Pfizer is offering 0.985 share of the combined company and $33 in cash. Once the deal closes, the arbitrageur who bought one Wyeth share and goes short 0.985 Pfizer shares -- which would be returned using the 0.985 given at the deal's close -- at yesterday's closing prices stands to make:
(0.985)(15.19) + 33 - 44.87 = $3.09,
for a 6.89% return -- a 14.4% annualized return if the deal closes in mid-November, halfway through the fourth quarter. Not a bad return if it is low-risk -- i.e. if the deal has a high probability of closing.
A low-risk deal?
How does Paulson go about analyzing the risk that the deal won't close? He describes his process in "The Risk in Risk Arbitrage." Let's examine how the Pfizer/Wyeth deal stacks up against some of the favorable characteristics that Paulson looks for in a low-risk merger arbitrage:
- Definitive Agreement. Pfizer and Wyeth have a definitive agreement in place (rather than an agreement in principle). Pass.
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Large Acquirer. There are only two pharmas with a market cap greater than Pfizer's: Johnson & Johnson
(NYSE:JNJ) and Roche. Merck(NYSE:MRK) is tied up with its bid for Schering-Plough(NYSE:SGP) and Roche just acquired Genentech. The risk of a third party coming along and spoiling the party by making a bid for Pfizer is small. Pass. - Strategic rationale. Pfizer has a rationale -- strengthening a pipeline that isn't ready to replace blockbusters going off patent -- but it's not clear that a combination of this size is the optimal solution to the problem. Pass (grudgingly).
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No financing condition. In this case, there are very limited financing conditions. Pfizer's lenders, which include JPMorgan Chase
(NYSE:JPM) , Bank of America(NYSE:BAC) , and Goldman Sachs(NYSE:GS) , can decline financing if Pfizer experiences a material adverse change or fails to maintain a minimum credit rating (e.g. "A2/A long term stable/stable"). Given the stability of its business and its AAA credit rating, I don't expect any surprises on this front. Pass.
From a first glance, the arbitrage does look low-risk. However, a proper analysis is a lot more comprehensive than the few points I've jotted down here. These situations are fascinating, and it's worthwhile going through the thought process to analyze them -- many of the great value investors have experience in merger arbitrage. However, I agree with another super-investor, Joel Greenblatt, that it is generally unsuitable for individual investors. Caveat emptor!
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