Mergers and Acquisition – Practice Case

OVERVIEW

The Mergers and Acquisition case allows participants to operate as hedge fund financial investors. They must closely monitor whether a friendly takeover, approved by the board of directors and key shareholders, will occur. When one company acquires another, the stock prices of both entities tend to be very volatile. Participants may own a non-majority share of the company being acquired, aiming to increase the value of these shares before selling them at a higher price than they originally paid. Participants will also experience asset mispricing due to the potential impacts of mergers and acquisitions.

KEY OBJECTIVES

DESCRIPTION

Each heat will last for 5 minutes, simulating one week of calendar time. During each heat, participants will trade two securities with distinct volatility and liquidity characteristics, allowing them to experience and adapt to different market conditions and trading environments.

MARKET DYNAMICS

Each heat features distinct voting results, acquisition outcomes, market dynamics, and parameters. Potential parameter changes can include factors such as the proportion of shareholders supporting the deal, as well as stock liquidity and volatility. The following market dynamics and parameter details will remain consistent across all heats, aiding participants in developing their trading strategies. For reference, details for an example heat involving two stocks, UFT and RTM, are provided below.

	UFT	RTM
Last Closing Price	$75.00	$30.00
Commission/Share	$0.02	$0.02
Maximum Order Size	10000	15000
Trading Limit (Gross/Net)	250000/200000	250000/200000
Liquidity	High	High
Volatility	High	Medium

The scenario involves two companies: UFT and RTM. UFT, a large and prominent company, has made an unsolicited tender offer to acquire all outstanding shares of RTM. This acquisition is anticipated to provide UFT with increased growth opportunities and diminish competition within the market. Under the terms of the deal, RTM shareholders are offered 0.40 shares of UFT plus $5.00 in cash for each share of RTM they hold. The completion of this transaction is contingent upon at least 50% of RTM’s shareholders agreeing to tender their shares by the end of the trading week.

Participants should adopt the role of a hedge fund manager and strive to accurately determine the fair value of the stocks involved. As of last Friday, the closing prices were $75 for UFT and $30 for RTM.

The stock prices for UFT in this case follow a random-walk process, where returns are drawn from a normal distribution with a mean close to zero. This implies that, at any given point in the simulation, the likelihood of the stock price increasing is equal to the likelihood of it decreasing. Given UFT’s substantial size, the acquisition is expected to have no significant impact on its share price. On the other hand, analysts in the market believe that the fair value of RTM can be estimated using the following function:

P_RTM,t+1 = P_RTM,t ∗ (1 − θ) + (0.40 P_UFT,t + $5) ∗ θ

P_RTM,t is the price of RTM share at time t and P_UFT,t is the price of UFT share at time t. θ is the probability of acquisition.

In other words, there is a possibility that the acquisition will succeed, in which case each share of RTM will be worth 0.40 times the value of one share of UFT, plus $5 in cash. If the acquisition does not succeed, the stock price of RTM will revert to its original path. The key to accurately valuing RTM’s stock is to assess the likelihood of the acquisition being completed. Each day, 20% of the shareholder base will cast their votes to accept or reject the deal, and these results will be made public. If, by the end of the week, more than 50% of shareholders have voted in favor of the acquisition, the deal will be considered successful.

Participants might observe an immediate spike in RTM’s stock price both before and after the voting outcome, potentially exceeding the current market price. This is due to investors’ short-term overreaction. RTM’s stock price is expected to stabilize near the offered price until the deal is finalized. UFT’s stock price may also experience temporary shocks due to investors’ reactions, but it is likely to recover before the acquisition is completed.

Participants are tasked with utilizing the information from the company’s news releases to accurately assess the value of RTM. To generate trading profits, they should develop a model to determine the fair price of RTM shares based on this information. Subsequently, they should execute trades that reflect their analysis of whether they believe the market is overestimating or underestimating the probability of the acquisition occurring.

TRADING LIMITS AND TRANSACTION COSTS

Each participant must comply with both gross and net trading limits as specified in the case description, which will be updated before each heat. The gross trading limit is set at 250,000 shares, and the net trading limit is set at 200,000 shares. The gross trading limit represents the total of the absolute values of all long and short positions across all stocks. In contrast, the net trading limit reflects the difference between long and short positions, with short positions offsetting long positions. These limits will be strictly enforced to ensure that participants do not exceed them.

The maximum order size and commission rates specified in the case description will remain the same for each heat. A transaction fee of 2 cents per share applies. The maximum order size is 10,000 shares for UFT and 15,000 shares for RTM.

POSITION CLOSE-OUT

At the end of each heat, any open positions will be closed based on the last traded price observed in the market. Regardless of whether the acquisition occurs, computerized market makers will enhance market liquidity toward the end of trading to prevent manipulation of the closing price.