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
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.
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).
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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Alex Dumortier, CFA has no beneficial interest any of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Pfizer is an Inside Value recommendation. Johnson & Johnson is an Income Investor selection. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.