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Arbs Not Always to Blame When Acquiring Company's Stock Falls

Arbitragers are frequently convenient whipping boys for companies who see their stock price collapse upon the announcement of a merger. The implication is clear: The deal is a good one for the acquirer, and the market would indeed recognize this if not for the pernicious activity of risk arbitragers who are mindlessly shorting shares as soon as the deal is announced.

Beware the simple explanation.

While there certainly are examples of deals where arb short-selling to lock in a merger spread may contribute to a rout, the accusation seems to be made 10 times for every one time it is true.

Lately, it seems as if every deal announcement brings with it a collapse in the acquirer's shares. Watson Pharmaceutical's (WPI) shares traded from $45 to $38 Thursday on its deal with Schein Pharmaceutical (SHP); International Paper's (IP) stock is down from $40 to $33 since it surfaced for Champion International (CHA); Terra Network's (TRRA) shares are down from $54 to $43 since its deal with Lycos (LCOS); and QLogic's (QLGC) share price collapsed from $100 to $75 the day its deal with Ancor Communications (ANCR) was announced.

In a difficult market like this, holders and analysts are much more skeptical when assessing the impact of a merger from the acquirer's perspective. Insignificant amounts of near-term earnings dilution take on increased significance. Concern about increased leverage and integration risk outweighs optimism over cost cuts and revenue synergies. The result is the pummeling we've recently come to expect.

UAL's (UAL) initial 9-point decline Tuesday demonstrates this nicely. Its bid for US Airways (U) is a $60 per share cash deal. There is no reason to be short UAL shares if you are an arbitrager. UAL stock slumped for the simple reason that the market dislikes the deal.

Depending on whom you ask, UAL: 1) overpaid; 2) is unlikely to gain enough through synergies to make the acquisition financially rewarding; or 3) is likely to commit way too much senior management attention over the year it will take to resolve all the regulatory and labor issues.

It's also tough to blame arbs for the decline in Watson's stock. That deal included a tender offer that will retire at least two-thirds of Schein's shares for cash, with at most one-third being converted into stock. The deal's structure, while complex, doesn't encourage arbs to short very much Watson. The decline is for fundamental reasons.

Where arb pressure is most likely at work is in the straightforward, fixed exchange ratio deals without a walkaway price. A walkaway is a term in a merger agreement that lets one or both of the parties terminate the merger agreement if the acquirer's share price declines by more than a fixed amount before the deal closes.

As long as price alone can't break the deal, an arb is inclined to lock in the spread without having to think too much about the absolute prices he is buying and selling at. This could, if done in sufficient size, wreak havoc on the share prices of both the target and the acquirer. Most Internet deals are structured this way, reflecting the mutual distrust over each other's market valuation. In a rising market like we saw in 1999, no one really notices the downward pressure of arb short-selling. There haven't been many deals of this nature announced lately, however.

If you want to see the effect of arb selling on a stock, look at the decline in AT&T's (T) share price over the last month. Probably the single most widely held arbitrage situation, AT&T's acquisition of MediaOne (UMG) involves a fixed cash component of $30.85, a fixed exchange ratio of .95 shares, and a variable amount of cash to compensate for a decline in AT&T shares below 57. This variable cash payment maxes out at $5.41 if AT&T is below 51 during an averaging period.

The variable cash payment is, effectively, a put spread on AT&T settled at the deal's close. By owning a share of Media One, you are long a fraction of put struck at 57, and short a fraction of a put struck at 51. When AT&T was above 57 a few months ago, that spread was worth much less than its maximum value. Like any option position, you can compute the amount the value changes based on a change in the underlying security, in this case AT&T common shares (called delta). Many arbitrageurs took into account the delta value of this put spread and reduced accordingly their hedge ratio below .95 by the put spread's delta value. As AT&T fell further, arbs had to sell more shares short to shore up their hedge ratio, which proved insufficient. The further AT&T fell, the more shares had to be sold.

While AT&T declined for far more important reasons than arbitrage short-selling, I think the effect of this has contributed to the collapse of AT&T shares.

I wish there were an easy way to make money from the insight of when selling is arbitrage-related and when it is not. As far as I can tell, there really isn't any. Sometimes the fundamental selling gets overdone and shares rebound; other times they stabilize or fall further. Best I can tell, there's nothing systematic about it. But it is helpful to at least understand why the stocks are moving as they do, even if there is no immediate gratification in a quick trade.

David Brail is the president and portfolio manager of Palestra Capital, a Manhattan-based hedge fund that focuses on risk arbitrage, and has been an investor in risk arbitrage and bankruptcy securities since 1987. At the time of publication, Palestra Capital was long Media One, Schein and Lycos, short AT&T, long and short AT&T puts and long Terra puts and short Terra calls, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brail appreciates your feedback at dbrail@thestreet.com.

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