The number of acquirer shares exchanged for each target share is known as the exchange ratio or “merger exchange ratio“. In a share swap, or stock deal (or even a deal that involves part payment of the merger consideration in acquirer stock), the acquiring company pays for the target stock by issuing new additional shares. This form of payment can take one of two forms
- A fixed exchange ratio
- A floating exchange ratio
We shall discuss the fixed exchange ratio. This is the ratio of how many new acquirer shares are given in exchange for each target share and remains fixed over the course of the deal. This figure can have any number of decimal points or be any multiple thereof. It will primarily be dependent on the price of each individual stock and the acquisition premium the acquirer wants to pay.
In some cases, the acquirer may select a payment structure that also includes cash or other forms of compensation referred to as “Earn outs” such as CVR‘s. These may reduce the number of acquirer shares needed for payment, but the ratio will still exist. If the deal is considered a merger, where the two (or more) firms are considered equal there will still be at least one of the partners that receives new stock for their existing holding, resulting in the requirement for the ratio.
Merger Exchange Ratio Example
When trading a merger arbitrage investment strategy, it is vitally important the investor accurately notes the ratio. This figure is often referred to in a press release as the deal is made public and can also be found in the filings made with the SEC pertaining to the deal. On January 28, 2020, BorgWarner (BWA) announced a deal to acquire Delphi Technologies (DLPH) in press release stating,
Under the terms of the agreement, which has been approved by the boards of directors of both companies, Delphi Technologies stockholders would receive a fixed exchange ratio of 0.4534 shares of BorgWarner common stock per Delphi Technologies share. Upon closing of the transaction, current BorgWarner stockholders are expected to own approximately 84% of the combined company, while current Delphi Technologies stockholders are expected to own approximately 16%.
The figure required by merger arbitrageurs in order to accurately trade the merger arbitrage spread is 0.4534. For each DLPH share held long, the trader needs to short sell 0.4534 shares of BWA. Holding 300 shares of DLPH requires shorting a number shares of BWA. This is calculated as
300 * 0.4534 = 136 (rounded to 0 d.p.)
A short positon of 136 shares of BWA is established in order to remain fully hedged against any change in the value of the spread. If the deal consummates successfully on these terms (see below), the investor will receive 136 BWA shares in exchange for the DLPH position and subsequently zero out the BWA short position.
Additional Issues
It is important the trader stay abreast of merger arbitrage deals as the terms of the merger agreement are subject to change. This is especially true during such times as the COVID-19 pandemic. News sources such as the specialist individual “Deal” pages and the weekly commentary supplied by Merger Arbitrage Limited give traders access to this vital information. Following on from our previous example, BWA subsequently asserted DLPH “materially breached the definitive transaction agreement“. This led to a revision of the terms of the merger agreement announced on May 6, 2020
As part of resolving the dispute, the parties have also agreed to a revised exchange ratio pursuant to which Delphi Technologies’ shareholders will receive 0.4307 shares of BorgWarner common stock for each Delphi Technologies share.
So what does this mean for the trader? Previously the required short position in BWA was calculated as
300 * 0.4534 = 136 (rounded to 0 d.p.)
This however has now changed to
300 * 0.4307 = 129 (rounded to 0 d.p.)
The trader only required a short position of BWA totalling 129 shares. Having previously initiated both a long and short position in the target and acquirer stock respectively, the investor will now be required to PURCHASE 7 shares of BWA stock (136-129) in order to maintain a perfect hedge. This means reducing the BWA short position. Fewer shares will now be received in acquirer stock upon successful consummation of the merger and once again accurately nullify the current short position. Although this real life example had only a small change, larger alterations can result in a significant increase in risk and could result in a significant reduction in profitability if not adjusted accordingly.
