Best Idea in the Universe: Profiting from Professional Networking
Current Favorite: LinkedIn Corp (LNKD)
ArbitrOption’s investable universe includes risk arbitrage and special situation opportunities with three basic characteristics:
- a pending corporate event must be disclosed by the company’s management or Board of Directors (no “rumortrage”)
- the pending corporate event must have a calculable terminal value and timeline
- the company must have exchange-listed options with suitable expiration dates and strike prices
At the time of our initial trade, our option spread on LinkedIn was expected to produce returns more than 500 PERCENT better than ArbitrOption’s equity-trading peers.
ArbitrOption’s investment process can be broken down to five stages:
- Idea Generation
- Investment Research
- Portfolio Management
Idea Generation: Profiting from professional networking
On June 11, 2016, business-oriented social media network LinkedIn (LNKD) announced that it had agreed to be acquired by Microsoft (MSFT) for $196 per share, a 49.53% premium to the previous closing price. As you can see in the chart of LNKD’s stock price below, the stock moved up following the announcement and has appreciated toward the $196 takeout price.
LinkedIn: Share price from 6/11/16 to 9/2/16
Investment Research: The usual process, but a dash of mystery
Before we can identify the right trade on a deal, we need to forecast terminal values and a completion date. Per usual, we first confirm deal terms in the press release issued by LNKD:
The deal is expected to close this calendar year and is subject to approval by LinkedIn’s shareholders, the satisfaction of certain regulatory approvals and other customary closing conditions.
The transaction is not conditioned on financing, but MSFT does expect to issue new debt for most of the $26.2 billion acquisition price. Despite the premium that MSFT is paying, the deal is expected to become accretive to MSFT within two years of completion. Interestingly, MSFT reiterated its intention to complete an existing $40 billion share repurchase by the end of 2016. These are substantial financial commitments, but MSFT’s $102.6 billion in cash is sufficient to cover the bill, even if it became subject to a 35% repatriation tax.
Conditions of the Deal: Weird and Weirder
The acquisition may not be subject to financing, but there are some other conditions that will have to be met before it can be completed. The merger agreement tells us that shareholders will be asked to approve the deal, and antitrust regulators will also have to give it their blessing. It also says that LNKD and MSFT will use their respective reasonable best efforts to file antitrust notifications promptly.
LNKD filed its preliminary proxy statement on July 1; that’s where investors first learned that the antitrust jurisdictions are the United States, Canada, and the EU. Although China isn’t on the list of conditions, the Chinese Ministry of Commerce’s recent decision to investigate Comcast’s acquisition of Dreamworks could prompt MSFT to try to protect itself from a post-deal probe by filing for approval now.
Then things got a little weird. The definitive proxy statement was filed July 22; it set the shareholder vote for August 19 but didn’t provide any details regarding the status of the antitrust approval processes. With a merger agreement that calls for prompt filing, and a known set of jurisdictions, it’s surprising that the notifications had not yet been filed. Or maybe they had been filed, and the companies were just choosing not to disclose the details. The problem with that theory is that while the filings for antitrust approval by U.S. and Canadian authorities are shared by the companies at their own discretion, the EU Competition on Commission publishes notification documents as they come in – and so far, no sign of filings.
And then things got a little weirder. Shareholders voted on August 19, but MSFT and LNKD didn’t publish the results of the vote for three days, until August 22. Then, instead of issuing the customary press release to notify shareholders, the only notification was the filing of an 8-K at the SEC. The approval was overwhelming, with 97% of votes cast in favor of approval, but the 8-K says nothing about the remaining conditions to the deal and does not update when the acquisition is expected to be completed.
Is there reason to be concerned about antitrust delays? LNKD is the premier social media network for business professionals. MSFT is a leading technology firm with top market positions in operating systems, business productivity software, gaming platforms, cloud servers and services, and search advertising, among other sectors. The overlap between the two companies is non-existent; we have no concern that this transaction could somehow create anti-competitive behavior.
However, MSFT has a problematic history with the U.S. and EU antitrust authorities. It feels farfetched, but a conspiracy theorist might posit that MSFT and LNKD chose to delay their antitrust filings to consult with regulatory authorities first, in an effort to smooth the path.
Estimating the Timeline: Antitrust filings, wherefore art thou?
When the buyout was first announced, LNKD and MSFT said they expected it to be completed this calendar year. That estimate was repeated on 7/22 in the definitive proxy statement, but has not been heard again despite shareholders’ approval in late August. The EU Competition Commission’s website has no listing for a filing from the companies. The U.S. Department of Justice and Federal Trade Commission don’t disclose details of antitrust reviews. Canada’s Competition Bureau only provides updates once a month, on or after the 10th calendar day, for merger reviews completed during the previous month. Although the merger agreement obliges the companies to file their notifications promptly, it appears that “promptness” is a detail left open to interpretation.
In truth, MSFT and LNKD could probably hold off on filing their notifications until October 31st and still be reasonably confident the deal would close by the end of the year. The apparent lack of forward motion is unusual, but not necessarily problematic. There just isn’t much here for an antitrust regulator to dig into. Perhaps the U.S. and Canadian notifications have been held in abeyance while MSFT consults with EU regulators, to confirm that neither the conglomerate effects theory nor concerns about big data could prolong the review. Regulators will also need to think through the impact of combining LinkedIn and Yammer within a single corporate entity.
If we apply a wastefully conservative assumption and believe that a) antitrust notifications have not yet been filed and b) they won’t be filed until the end of September, the timeline of conditions would appear as follows:
We can conceive of no reason why it would take until the end of September for LNKD and MSFT to make their antitrust filings. Still, given our risk-averse nature, we must be conservative when making assumptions about deal developments.
Applying the Research: Finding the right trade
LNKD’s expected stock price if the merger is completed is $196, the acquisition price. The expected value if the acquisition fails is $138 – LNKD’s share price prior to the June 11 announcement, adjusted for changes in comparable companies’ stock prices.
Now we have an expected completion date and an expected terminal value. Based on current option prices, ArbitrOption believes the best investment is a bullish call spread, buying a January 2017 $190 call and selling a January 2017 $195 call. This position will achieve its maximum profit if LNKD is trading at or above $195 when the options expire. If the deal is completed before the options’ expiration, the options’ deliverables will be adjusted to cash and the options’ expirations will be accelerated by the Options Clearing Corporation.
Trading: The math behind the LNKD bullish call spread
In each trade, ArbitrOption aims for annualized return greater than 10% and a risk/reward ratio that is superior to that of the stock. In the LNKD trade, the maximum acceptable cost that ArbitrOption could pay for a January 2017 $190 /$195 bullish call spread would be $4.71. That price is found by taking the lesser of a) the maximum cost that would allow a 10% annualized return, or b) the cost that matches the current risk/reward ratio of the stock.
To generate a 10% annualized return, an event that lasts 142 days (the period between the June 11 announcement and October 31 expected completion date) would have to produce a 3.89% return. The maximum post-commission cost for this call spread that would still produce a 10% annualized return is $4.81.
10% / (365 / 142) = 3.89%
$5.00 option spread / (1 + 3.89%) = $4.81 maximum cost that would permit a 10% annualized return
At $192.64, with a success value of $196 and a failure value of $138, the risk / reward ratio in the stock is 54.64 / 3.36, or 16.26x (note that a lower multiple is superior because it represents less risk relative to greater return). The maximum price that could be paid and still achieve a superior risk / reward ratio is $4.71.
$4.71 risk / $0.29 reward = 16.26x
Since June 13, ArbitrOption has bought January 2017 expiration $190/$195 call spreads that risk 8.58% of the portfolio. The call spreads were bought at prices that will produce an 9.94% return on investment if LNKD is worth $195 or more when the options expire. Assuming the deal is completed on October 31 and the options are accelerated by the OCC, the annualized return will be 38.7%.
Portfolio Management: Tracking approvals
As we monitor developments in the transaction process, we continue to await details of all necessary filings. We anticipate that the transaction could close as early as this month, if filings have been made but not yet disclosed. That is an unlikely development, but not impossible. The next check will be the Canadian Competition Bureau’s update on or about September 10th, which would reveal if the deal was notified and cleared in August. In the absence of information from LNKD and MSFT, we are estimating that antitrust filings will be made by the end of September.
ArbitrOption is actively watching for new developments, and will increase the portfolio’s exposure to LNKD if circumstances allow us to add to the position at attractive prices relative to the risk.
Exit: Upon deal closing, or options expiring
Barring changes in the expected outcome, ArbitrOption will exit its position as options expire or when the transaction closes, whichever comes first.
An investor who bought LNKD for $192.21 on June 13 would earn $3.79 if the transaction is completed at $196, or a return-on-investment of 1.97%. On an annualized basis the return is 7.67%. In contrast, an investor in the option spread described above takes on a defined risk (no exposure to downside estimation error) and earns a return-on-investment of 9.94%. The annualized return of the option spread is 38.7%, over 500 PERCENT that of the stockholder.