June 03, 2014

The recent high profile merger announcement between Comcast and Time Warner Cable (TWC) is a market place reminder that shares of the selling company’s stock trade at a discount to the acquisition price until the deal closes.  A week after the Comcast acquisition of TWC was announced, TWC’s shares were trading at a 5.4 percent discount to the merger price.  If TWC had not found Comcast as an escape hatch from the acquisition clutches of Charter Communications, one would expect a deeper discount from the acquisition price.  The price premium offered by Comcast was a modest 17.5 percent over the pre-announcement closing price of TWC, which had been driven up as a result of the market’s awareness that the sale of TWC was in play. 

The pattern observable in the public market of the acquired company’s shares rising in price after the announcement, but falling short of 100 percent of the deal price is applicable to a private company’s shares before the sale closes.  This pricing behavior and difference from the deal price presents an opportunity for wealth transfer planning for private businesses under contract for sale but before the deal closes.

At the end of 2007 during a period of vibrant merger and acquisition activity I wrote an article(1)  discussing in detail the discount opportunity available to private business owners during the period between reaching agreement to sell and the date of closing. As the volume of acquisition activity is currently on the increase the prospects for efficient wealth transfer remain as applicable today as they did in 2007.

Risk or merger arbitrage in the public markets is a well-established strategy to achieve an investment return on buying the stock of a company being acquired.  The risks in public or private markets involve failure of the deal as originally structured.  Those risks include outright collapse and termination of the deal, a delay in when the deal closes, or due diligence findings that result in a lower price than originally set.  Pricing these risks is the basis for a discount from the deal price.  A deal with more perceived risk of closing on time and at the set price will command a higher discount than a sure thing.  Such risks diminish and the discount shrinks as the closing date approaches.

By their nature private company deals normally involve more arbitrage risks than their public company counterparts. Less is known about the private company at the outset of the deal giving the due diligence phase of the sale process greater potential to uncover surprises.   The factors that threaten completion of the deal are many, but often include such items as ability to obtain financing, the amount of sales proceeds in escrow, impasses over representations and warranties, potential lawsuits, and environmental issues.

The concept and acceptance of a risk arbitrage discount(2)  was addressed by the Tax Court in the Mueller case more than 20 years ago. The court concluded that a modified arbitrage analysis with associated discount, rather than traditional analysis of fundamentals, is the preferable method for valuing the shares of the company, inasmuch as the corporation was then subject of a takeover bid on the valuation date.  In that particular case based on the specific merger risk identified, the court found that a 21 percent discount from the takeover price was appropriate.

The analysis of the applicable discount for wealth transfer purposes is fact specific to each situation and deal structure. Nevertheless, the public markets continue to demonstrate that a risk arbitrage discount exists on takeover targets until the deal is done.

 

(1) Radd L. Riebe. Discounts Before The Deal Is Done, Trusts & Estates, Vol. 146/No. 12. (December 2007). 37-41.
(2) Estate of Bessie I. Mueller v. Commissioner of Internal Revenue, T.C. Memo 1992-284 (May 18, 1992)