How to Profit from Big Merger Deals?

What is Merger and Acquisition?

A merger involves two companies combining to form a single entity, often aimed at enhancing competitive edges, expanding market reach, or achieving synergies. There are different types of mergers: horizontal mergers, which involve companies in the same industry; vertical mergers, which integrate companies at different stages of production processes; and conglomerate mergers, which unite firms from unrelated business activities. Companies merge for several reasons, including realizing synergies to enhance performance and reduce costs, expanding into new geographic or product markets, and leveraging advantageous fiscal conditions for tax benefits.

Highly Recommended Trading Strategy: Merger Arbitrage

Merger arbitrage is a highly specialized trading strategy that typically offers steady, low-volatility returns, independent of broader stock market fluctuations. When considering merger arbitrage, it's essential to keep a few key risk factors on your radar.

Price

Price is the first (and often the most significant) factor in merger arbitrage. Takeovers can be either friendly or hostile. In a friendly merger, both companies agree on the terms and the price to be paid, with these details released in the official announcement. The offer price is usually set at a premium over the current share price to persuade shareholders to accept the offer.

In a hostile takeover, the parties haven't reached an agreement, and the target company's primary contention is almost always that the price is too low and materially undervalues the firm. This dispute can be resolved if the bidder is willing to increase the price, which often happens. The initial bid typically tests the waters, leaving room for negotiation.

Once the news spreads that the company is a potential takeover target, another bidder may enter the fray and offer a higher price. If you’re a shareholder of the target company and another bidder emerges, you're in a favorable position. This development usually means the stock is about to rise again, allowing you to sell at an even higher price.

Regulatory Issues

Regulatory issues can be a significant obstacle in mergers and acquisitions. Takeovers and mergers typically require approval from regulators, competition authorities, and other bureaucratic entities. The approval process can be swift and straightforward, but in some cases, it can drag on for months, especially if the company operates in a politically sensitive industry or if the merger would significantly limit competition, potentially creating a monopoly. These complexities can jeopardize the entire deal.

Material Adverse

Material adverse clauses can unravel a merger if the target company's business deteriorates significantly before the transaction is finalized. These clauses allow the bidder to back out, effectively saying, "This isn't what I bargained for," and walking away from the deal.

It's worth noting that merger arbitrage returns are tied to M&A deals, making them relatively independent of broader stock market trends. For instance, an energy stock may rally on acquisition news even if the rest of the sector is declining. This characteristic makes merger arbitrage an excellent portfolio diversifier. Typically, a merger arbitrage fund manager can achieve annual returns in the high single digits during a good year and low single digits during a bad year.

Successful Merger Deal: BHP and Anglo American

BHP's Options and Actions:

BHP has proposed a buyout offer of $42.7 billion to acquire Anglo American. This follows a previous rejection of a $39 billion offer by Anglo-Americans.

BHP's options include sweetening the buyout offer, making a hostile bid, or potentially walking away if a deal isn't reached by the deadline of May 22, 2024.

BHP has emphasized its track record with successful spin-offs and mergers as evidence of its capability to manage the integration and restructuring that would follow acquisition.

Anglo American's Response and Strategy:

Anglo American has rejected BHP’s revised offer, stating that it undervalues the company. The board has not engaged with BHP regarding the revised proposal.

In response to the takeover attempts, Anglo American has unveiled plans to restructure its business, focusing on energy transition metals like copper and divesting from less profitable operations such as coal, nickel, diamond, and platinum businesses.

Investor and Market Reactions:

Some Anglo American investors have expressed that the company’s restructuring proposal lacks compelling details and does not offer a clear advantage over BHP’s offer.

BHP’s shares have seen an increase, suggesting market approval of its pursuit or strategy regarding Anglo American.

Regulatory and Stakeholder Considerations:

Any potential deal would need to navigate significant regulatory hurdles, especially concerning Anglo American’s South African operations. BHP has indicated the necessity of Anglo American’s management cooperation to clear these hurdles.

South African stakeholders have shown mixed reactions, with some investors open to a revised offer from BHP, while others, including political figures and unions, have expressed reservations or opposition.

Deadline and Future Possibilities:

BHP has until May 22, 2024, to make a binding offer. If no agreement is reached, BHP must wait at least six months before making another attempt.

There is also the potential for other mining giants like Glencore and Rio Tinto to enter the fray with their bids, adding complexity to the situation.

In summary, the situation between BHP and Anglo American is dynamic, with significant financial, operational, and geopolitical implications. The outcome will likely reshape the landscape of the global mining industry, particularly in the strategic commodities like copper, crucial for the global energy transition.

How to Trade, then?

Anglo American's share price is currently trading around £26.70 ($33.40), approximately 6.5% higher than the initial bid. According to UK takeover rules, BHP has until May 22nd to make a better offer. Essentially, it's "put up or shut up" time. Your decision here will depend on your risky appetite. For now, the best trading strategies seem to be:

Buy Anglo American: This strategy assumes that BHP will return with a better offer or that another company will enter the fray and spark a competitive bidding war. If new bids emerge, the stock could potentially gain 10% to 20%, which would be quite favorable. However, if no new bids materialize, the stock could decline by a similar margin.

Avoid the Situation: Instead of getting involved in the uncertain outcome of the merger, consider capitalizing on the potential shortage in copper supply. You can do this by investing in the iShares Copper and Metals Mining ETF (ticker: ICOP; expense ratio: 0.47%). If you live outside the US, the iShares Copper Miners UCITS ETF (MINE; expense ratio: 0.55%) is a suitable alternative. Additionally, you could invest directly in one of the ETF's largest holdings, such as Freeport-McMoRan or Antofagasta.

Short Anglo American: If you believe there won't be a higher bid from BHP or any other company, you might anticipate Anglo American's share price to decline. In this case, you could consider shorting the stock—borrowing Anglo American shares and selling them on the market—with the expectation of profiting by buying them back at a lower price.

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