In a world where 20% and higher annualized returns are abundant in risk arbitrage transactions, the

AOL

(AOL)

-

Time Warner

(TWX)

merger spread sticks out like a sore thumb. Its implied return is a meager 2.5%, assuming the deal closes by year's end.

Why the spread (created by selling short 1.5 shares of AOL for each share of Time Warner purchased) is this tight is a mystery. I have some theories, though.

First, some background. On Jan. 10, AOL announced its friendly blockbuster

merger with Time Warner, agreeing to exchange 1.5 shares of AOL for each share of Time Warner in a deal that should close around the end of the year.

That day, AOL shares closed at 73, valuing each share of Time Warner at 109 1/2. Time Warner shares closed that day at 92 3/4. The spread of 16 3/4 between the two implied an 18% annualized return over the approximately one year it would take to get the necessary regulatory approvals (mostly cable license transfers).

The market has received this deal skeptically. AOL has declined 20% since, despite an unchanged

TheStreet.com Internet Sector

index.

To me, that 18% return seemed inadequate relative to the risks. First of all, there is a list as long as your arm of high-quality pending mergers to choose from that offer much higher implied rates of return. Second, this deal breaks new ground. No pure Internet company has yet successfully acquired old media assets. Last year's

Lycos

(LCOS)

-

USA Networks

(USAI) - Get Report

deal was a debacle.

The AOL-Time Warner transaction also faces a long, complex and uncertain regulatory process. To me, the novelty of the deal argued for an extra-wide spread to compensate for these risks.

To put it mildly, my conservatism was badly misplaced. The spread has narrowed to about 2, a level I didn't foresee this transaction reaching until Thanksgiving.

So what are my theories about why the spread is so tight?

In most cases, I would first suspect the market believes another bidder is going to surface for the target. Target companies occasionally trade at premiums to the implied deal price if the market believes an interloper will top the original bid.

Warner-Lambert

(WLA)

is a recent successful example of this, whereas

Gleason

(GLE)

is an example of misplaced optimism where the premium turned into a discount when no other buyer emerged.

I find it difficult to believe there is another buyer for Time Warner, mostly due to its enormous $110 billion market cap. Who might bid? Some names that come to mind are

General Electric

(GE) - Get Report

,

Viacom

(VIA) - Get Report

,

Bertelsmann

and

Disney

(DIS) - Get Report

. I think these are all long shots. Of course, in this overheated merger market, nothing can be completely ruled out.

The next thought would be that, sometimes in merger-of-equals transactions, spreads are abnormally small. Examples of this include 1998's

Citicorp

merger with

Travelers

(forming

Citigroup

(C) - Get Report

as well as the pending pharmaceutical deal between

Pharmacia & Upjohn

(PNU)

and

Monsanto

(MTC) - Get Report

.

These tiny spreads are the result of the lack of downside risk in a broken deal since the original terms granted no premium to either party. It is tough to make the case that this deal fits that template. AOL is pretty clearly acquiring Time Warner, despite the CEO position going to Time Warner's Chairman and CEO Gerald Levin. Time Warner holders received a very large premium for their shares, and AOL holders will own a significant majority of the post-merger company.

Furthermore, this explanation is unlikely given the initial spread that existed the first few days after the announcement. Very little has changed structurally since the deal was announced, yet the spread has evaporated.

That leads to the next theory, which to me is the most interesting. By having the spread on, you create a low price put on the Internet sector. Here's how: Let's say Internet stocks decline precipitously. AOL, as the bellwether, will presumably go down by a proportionate amount.

At some point, the value implied by the merger's exchange ratio for a Time Warner share will be less than where Time Warner might otherwise trade based on its own fundamentals. If this were the case, Time Warner holders would likely vote down the merger, even if the Time Warner board still supported the deal.

Among insiders, only

Ted Turner

, with 10% of Time Warner, holds a meaningful stake. He is compelled by a voting agreement to vote his shares in favor, but he doesn't own nearly enough to matter in the face of a holder revolt.

By putting on the spread -- selling short 1.5 shares of AOL for each share of Time Warner purchased -- you would, in this scenario, profit more on your AOL short than you would lose being long Time Warner.

If you are skeptical of Internet valuations, this theory may be attractive to you. To me, it seems like an inefficient and uncertain way to achieve the purpose of creating a short bet on the Internet sector. Also, AOL, with its 22 million subscriber base, with real and growing cash flow and profits, could very well outperform other Internet stocks in a sector-wide meltdown.

But at least it's a viable theory. I have to admit to being flummoxed trying to come up with a better explanation. I have quizzed other arbs, analysts and brokers. Everyone seems equally puzzled. One well-connected arbitrage broker insists more arbs are short the spread than long it. In full disclosure, I am as well.

As this high-profile deal winds its way toward consummation, an interesting story will continue to be told by where the spread trades.

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 America Online shares, and had a short position in Time Warner shares, 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.