What’s the Downside if the AGL Resources Deal Breaks?
Southern Company Bets on a Natural Gas Future with AGL Resources
Scenario analysis is a key part of merger arbitrage
In the risk arbitrage world, an 8.8% expected return means a transaction with some risk to it. The wide spread could be due more to general weakness in the equity markets than anything specific with the deal though. As a general rule, regulators approve transactions, or at least, they lay out the price required to get the transaction approved. They very rarely reject deals out of hand.
Generally speaking, your base-case assumption has to be that the deal closes as advertised and that you earn the spread. After all, a merger agreement is a contract. If Southern Company (SO) tries to walk away without a MAC (material adverse change) occurring, AGL Resources (GAS) could sue Southern Company and demand specific performance. In other words, GAS could have a judge force SO to do the deal.
What’s your downside if the deal breaks?
Before the deal was announced, AGL Resources was trading at ~$49 per share. If the deal breaks, does the stock go back there? It depends on the reason for the deal breaking. If the regulators simply want too much, and the deal breaks, then the pre-deal price is probably the right bet.
Risk-to-reward ratio
Look at the above graph and imagine you’re short the spread. If the deal closes, the spread goes to zero, and you make about $4.59. But if the deal breaks, you end up having to cover around $17. So the risk-to-reward ratio is $47 down to $4.59 and up. It’s a risk-to-reward ratio of just about 10:1. Generally speaking, “safe” arbitrage deals trade with risk-to-reward ratios of 15x to 20x. That said, the timeline is so long in this case that the risk-to-reward ratio is longer.
Other merger arbitrage resources
Other important merger spreads include the Freescale-NXP transaction. The merger of Freescale Semiconductor (FSL) and NXP Semiconductors (NXPI) is expected to close by the end of the year.
For a primer on risk arbitrage investing, read Merger arbitrage must-knows: A key guide for investors.
Investors interested in trading in the utilities space should look at the Utilities Select Sector SPDR Fund (XLU).
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