The Deal Closing Probability (DCP) is a figure calculated and assigned to the probability of a merger and acquisition deal being successfully completed. Merger Arbitrage Limited uses the FREE data supplied in our merger arbitrage spread list spreadsheet as a starting point for making the DCP calculation. This figure can be contrasted with Deal Failure Probability (DFP). It is simply the result of subtracting the DCP statistic from 1 as both figures sum to 100%.
A figure of less than 100% implies a spread is available as there is a less than perfect chance that the deal will consummate as expected. A figure in excess of 100% implies the market anticipates a higher offer or even a bidding war. This can in turn be built into the model and the DCP recalculated with the possibility of a higher or competing offer. By increasing the potential payout from a successful takeover, the trader ensures the DCP figure remains with a 0%-100% range.
If the trader calculates the probability of the deal closing equates to the current market price, buying a long stock position in the target firm should not be initiated as there is no “edge”, or alpha in the strategy. Alternatively speaking, there is no arbitrage in the Merger Arbitrage.
Deal Closing Probability Examples
By assigning a probabilistic value to the closing of a deal, traders are able to better compare different deals to each other. They are also able to make comparisons against a fundamental approach. Many academic studies have identified fundamental factors prevalent in determining the likelihood of a takeover being successful. Factors such as regulatory clearance or relative size of acquirer and target are frequently cited. Using factors such as these in a logit equation can give a comparable figure to the market observed deal completion probability.
For example, if the observed market data implies a high DCP it clearly expects the deal to close. However, upon analysis, the trader may believe the risk of a request for additional information by the Department of Justice (DoJ) under HSR or the Federal Trade Commission (FTC) has been under appreciated and from a fundamental analysis believes the market price of the target stock is too high. In this case, where regulatory intervention is considered a very real possibility, the trader has identified a possibility where shorting the deal could be profitable, a trading strategy sometimes referred to as reverse arbitrage.
