1. Profitability and Characteristics of Risk Arbitrage : Evidences from Leveraged Buyouts in the U.S. Professors: Sue-Fung Wang Keh-Luh Wan Student: Chiu-Nan Tsai Graduate Institute of Finance National Chiao Tung University Dec. 11, 2008 1 2008 NTU International Conference on Finance

2. Outline 1. Introduction 2. Literature review 3. Research design 3.1. The components of risk arbitrage returns 3.2. Variables definition 3.3. Research hypotheses 4. Sample collection and description 4.1. Sample collection 4.2. Distribution of spread returns, risk arbitrage returns and durations 4.3. Descriptive statistics of variables 4.4. Dollar payoffs and realized arbitrage returns in the portfolios 2

3. Outline 5. Model 5.1. Model selection 5.2. Regression analysis 5.3. The predicting of stock reversal 6. Empirical results 7. Conclusions 3

4. Introduction There has been no research of leveraged buyouts (LBOs) on risk arbitrage. --Recent empirical studies reported that arbitrageurs can earn substantially excess returns of 10-20%. LBOs are the thriving activities around the world in recent years. There is still some criticism of LBOs. -- Lone Star Funds was guilty of stock manipulation (Feb, 2008) 4

5. LBOs in the U.S. (1991~2006) 5

6. What is risk arbitrage? Risk arbitrage is a trading strategy that attempts to profit from spreads (the difference of offer price and the market price on the announcement day). For leveraged buyouts, arbitrageurs usually take a long position of the target firms’ stocks, and hold to the completion day. 6

7. 2. Literature Review (1) Time series analysis An annual abnormal return for the cash offers are 4% (Mitchell & Pulvino, 2001) Cross sectional analysis (1) Risk arbitrage for cash tender offers can earn annual abnormal returns of 24.01% (Jindra & Walkling, 2001). (2) Risk arbitrage for cash offers generates 11.35% of annual excess returns in limited arbitrage (Baker & Savasoglu, 2002). 7

8. 2. Literature Review (2) Arbitrage spreads returns have positive relation with durations on cash tender offers. (Jindra & Walkling, 2004). The shorter deals seemed to significantly outperform the longer deals in the North America (Zollo, 2004). The beta of private equity funds is not a significant driver of performances. (Zollo & Ludo, 2006; Ljunqvist & Richardson, 2003). Risk arbitrage returns tend to be positively related to the target firm’s size (Jindra & Walkling, 2004; Baker & Savasoglu, 2002) 8

9. 2. Literature Review (3) Most researchers reported that risk arbitrage returns tend to increase with the magnitude of bid premiums (Jindra & Walkling, 2001; Mitchell & Pulvino, 2002; Baker & Savasoglu, 2002). Liquidity (1) Arbitrage return is negatively related to the stock liquidity (Cornelli & Li,2000). (2) There is no reliable relation between excess arbitrage returns and bid- ask spreads (Chen & Kan, 1995) (3) The higher bid-ask spread will be, the greater the proportion of informed investors (Agrawal et al., 2004). 9

10. 3. Research design Where i is per deal P O is the offered price of target firms P F is the final price sold to the acquirers P is the closing stock price on the announcement day is the spread returns is the revision returns is the accumulated dividend is the percentage of transaction cost 3.1 The components of risk arbitrage returns ; 10 (Jindra &Walkling, 2004)

11. Offer price Announcement dateCompletion date (effective date) Unrevised Downward Upward Closing price Duration 11

12. Table 1 The statistics for spread returns across direction of revision and duration 12 Duration Returns (%) Short (<93 days) Medium (93-183 ) Lon (>183 days) Total UpwardMean1(SR) Mean2 (TR) 4.77 14.05 6.38 13.98 14.20 33.72 8.45 20.58 Numbers16252970 UnchangedMean1 (SR) Mean2 (TR) 9.60 11.40 57.40 26.13 Numbers911626 DownwardMean1 (SR) Mean2 (TR) 10.54 2.03 13.13 2.39 13.68 -1.22 12.45 0.97 Numbers5910737203 TotalMean1 (SR) Mean2(TR) 8.30 8.56 10.30 9.26 28.43 29.97 16.01 15.93 Numbers8414372299

13. 3.2.Variables definition (1) Spread returns (SR) (P o is the offer price; P is the market price on the announcement day). Duration (Dur) The period of the announcement date and the completion or withdrawal date. Beta (Beta) A loading factor in the market model.(Target firms stock returns and market returns, S&P 500 NYSE/AMEX/NASDAQ value-weighted market index). 13

14. 3.2. Variables definition (2) Price-to-book ratio (P/B) Book value is target equity value at the end of the most recent fiscal year prior to the announcement, and market value is the target market value on the announcement date. Bid premiums (BP), P o is the offer price, and P b is the closing price one day prior to the announcement day. 14

15. 3.2. Variables definition (3) Bid-ask spread ratio (Spread) Abnormal spread divided by normal spread ( bid-ask spread is where are the asking price and the bid price on transaction day). (1)Abnormal spread for this measurement is the average ratio in the interval of t = -42 to t = +2. (2) Normal spread is the average ratio in the interval of t = –50 to t = –25; t is the announcement date. 15

16. 3.3. Research hypotheses H1: Given offer price and durations, spread returns will be negatively relative with revision returns and positive with durations. H2: Target firms with both higher bid premium and liquidity have to yield higher spread returns. H3: Target firms with less liquidity could easily reverse their price on the completion date. 16

17. 4.1. Sample collection Period:1991~2006. Region: U.S.A All LBOs are friendly and cash offering. Total samples are 331 (249 successful and 82 failed deal). 17

18. 4.1. Sample collection (2) We deleted the samples by following principle: (1) Observations without merger announcement dates, completion dates, deal size, offer price and bid premiums. (2) The transaction values are smaller than 10 millions. (3) The deal type is stock offer and other type. (4) Rumor deal and secondary LBOs (5) All target firms are listed companies whose stock price can not be acquired from the CRSP. 18

19. Table 2 The transaction value and numbers of LBOs (1991~2006) Completed SDC dataSample (cash offer) YearCash offerSuccessFailure NumbersValues(mm$)NumbersValues (mm$)NumbersValues (mm$) 1991856119453139 19929810,098320818 1993938,5925367148 1994857,81644404256 199510513,17932,51471158 19969518,77071,9674136 199710521,802218,7734591 199810520,234226,572143,160 199913132,3813713,253112,508 200018735,0203711,804127,537 20018610,786153,5305259 20027823,655111,0844448 20037622,004102,44223,313 200413864,5841517,74151,521 2005163113,6792852,012411,407 2006186295,5822785,47145,466 Total1816704,303249666,4588237,845 19

20. Table 3 Distribution of the spread returns, revision returns and duration (1) (%)MeanMinQ1MedianQ3MaxStandard Dev. Spread returns11.46-18.282.61436.0314,11275.0020.51 Spread returns (Annualize) 41.71-109.58.1417.4035.17946.9396.23 Revision returns-4.34-137.50-2.58-0.370.0061.8521.59 Revision returns (Annualize) -21.87-1373-8.88-1.010.00371.85109.28 Total returns7.12-65.260.654.2412.32261.3625.55 Total returns (Annualize) 19.84-683.71.9113.5133.47899.9893.52 Duration1411487.512718142575.43 20

21. Table 4 Distribution of the spread returns, revision returns and duration (2) (%)MeanMinQ1MedianQ3MaxStandard Dev. Panel A: successful deal Spread returns9.22-18.282.485.0512.5080.0012.24 Spread returns (Annualize) 28.14-104.37.1015.7631.47300.2142.33 Revision returns1.05-29.27-1.08-0.210.0053.278.75 Revision returns (Annualize) 0.85-111.3-3.93-0.610.00191.5622.96 Total returns10.27-40.082.055.0814.0586.6715.27 Total returns (Annualize) 28.99-146.36.5316.3133.46300.2146.22 Duration141229112617342571.51 Panel B: Failed deal Spread returns19.34-6.886.1911.3420.76275.0036.23 Spread returns (Annualize) 89.60-109.512.9728.7799.69946.93181.85 Revision returns-23.35-137.50-38.44-21.62-0.2661.8537.32 Revision returns (Annualize) -102.08-137.50-136-77.76-0.33371.85210.91 Total returns-4.01-65.26-26.17-9.397.61261.3644.69 Total returns (Annualize) -12.48683.7181.52-19.1637.70899.98176.38 Duration135146312818540588.5 21

22. Table 5 Distribution of durations Range (days) Numbers of obs Proportion (%) Cumulative Proportion (%) DownwardUnrevisedUpward <3062.002.0402 [30,60)3010.03122433 [60,90)4013.382526410 [90,120)5819.40494198 [120,150)5117.06624029 [150,180)3612.04742628 [180,210)237.69821346 >2105518.3910028324 Total2992032670 22

23. 4.2. Descriptive statistics of the characteristic of firms and deals (1) Most target firms are small cap firms (2) Manufacturing, Service and Trade sectors. (3) 75% of firms yield less than 20 % sales growth. (4) Private equity funds prefer target firms with stable cash flows and lower debts. (5) Most target firms (about 75%) enjoy high liquidity. (6) Bid premiums in our final observations are 29% on average. 23

24. 4.3. Dollar payoffs and realized returns in two portfolios 24

25. 5.1. Regression analysis where i : ith deal offer SR : spread returns RR : revision returns BP : bid-premium s Dur : durations P/B: price-to-book ratio Beta : market model loading factors Spread : bid-ask spread ratio 25

26. 5.2. The predicting of stock reversal X i : all independent variables Dur : duration for every deal. P/B : price-to-book ratio Beta : market model loading factor Rm : market return BP : bid-premium Spread : bid-ask spread ratio 26

27. 6.1. Results of regression analysis (1) 27 OLSGLS2SLS Intercept-0.0683* (0.0223) -0.0005 (0.9756) -0.1208** (0.0000) RR-0.2195** (0.0000) -0.1994** (0.0000) -0.1776** (0.0000) BP0.4685** (0.0000) 0.2178** (0.0000) 0.7624** (0.0000) Duration0.0002 (0.0649) 0.0003** (0.0000) 0.0002 (0.0733) P/B0.0017 (0.5829) -0.0054 (0.7640) -0.0269 (0.2327) Beta-0.0301* (0.0172) -0.0022 (0.9197) -0.0104 (0.4126) Spread (t=-42,+2) 0.0104 (0.4966) -0.0064 (0.6391) -0.0034 (0.7102) p-value of F<0.0001** 0.0001** Adj-R 2 0.45880.54630.4566 Durbin-Watson1.981.911.97 White heteroscedasticity <0.001**0.1036<0.001** Normality test<0.001**

28. 6.1. Results of regression analysis (2) 28 SuccessFailure OLSGLS2SLSOLSGLS2SLS Intercept0.0090 (0.7134) -0.0001 (0.9723) 0.0074 (0.8195) 0.4163 (0.0172) -0.0836 (0.3633) -0.5757** (0.0069) RR-0.2683** (0.0000) -0.2457** (0.0000) -0.2681** (0.0000) 0.0246 (0.8949) -0.0138 (0.8981) 0.4169* (0.0126) BP0.1264** (0.0000) 0.1782** (0.0000) 0.1377** (0.0049) 0.1386* (0.0123) 0.0429** (0.0031) 1.0473** (0.0000) Dur0.0003** (0.0027) 0.0004** (0.0000) 0.0004** (0.0029) -0.0003 (0.5094) -0.0003 (0.1998) -0.0011** (0.0030) P/B0.0001 (0.8051) -0.0028** (0.0088) -0.0006 (0.8141) -0.2720 (0.0798) 0.0991 (0.2060) 0.4984** (0.0064) Beta-0.0010 (0.9456) -0.0018 (0.9431) -0.0029 (0.8372) -0.1185** (0.0014) 0.0806 (0.4199) -0.0063 (0.8551) Spread (t=-42,+2)-0.0041 (0.5780) -0.0081 (0.5799) -0.0039 (0.8061) -0.0397 (0.5361) 0.0184 (0.6797) 0.0168 (0.6435) p-value of F<0.001** 0.0004**0.3333<0.001** Adj-R 2 0.29630.59750.26100.28070.38470.5225 Durbin-Watson1.942.112.022.040.881.84 White heteroscedasticity <0.001**0.14820.0003**<0.0001**0.9603<0.0001** Normality test<0.0001** 0.0002**<0.0001**

29. 6.1. Results of regression analysis (3) 29 Small bid premiumLarge bid premium OLSGLSOLSGLS Intercept0.0641** (0.0006) 0.0675** (0.0031) 0.0255 (0.8445) -0.0018 (0.5790) RR-0.1500** (0.0003) -0.1573** (0.0034) -0.3228** (0.0004) -0.2152** (0.0003) Dur<0.0001 (0.8979) <0.0001 (0.9616) 0.0005 (0.0888) <0.0001 (0.6259) P/B-0.0016 (0.4713) -0.0064 (0.2031) -0.1245* (0.0299) -0.0163** (0.0065) Beta0.0096 (0.3597) 0.0153 (0.4308) -0.1144** (0.0001) 0.0927 (0.1457) spread (t=-42,+2)-0.0051 (0.5582) -0.0070 (0.4773) 0.0912 (0.4503) 0.1737** (0.0001) p-value of F0.0076**0.0304*0.0001**<0.0001** Adj-R 2 0.09140.09880.18780.8316 Durbin-Watson1.901.761.472.01 White heteroscedasticity0.0476*0.4726<0.001**0.2078 Normality test<0.0001**

30. 6.2 Results of predicting of stock reversal 30 Model 1Model 2 (Robustness) Intercept0.2439 (0.07010) 0.8338* (0.0297) Dur-0.0049** (0.0032) -0.0048** (0.0043) P/B0.1324* (0.0503) 0.1258* (0.0433) Beta-0.2074 (0.2746) -0.1763 (0.3427) BP0.4182 (0.2919) 0.4470 (0.2760) Spread (t=-42,+2)0.8494 (0.1210) Spread (t=-1,+1)0.2795 (0.1497) P-value of LR statistic0.0013**0.0024** McFadden R 2 0.05400.0524 Correlogram-Q test (lag=2) 0.386 0.292 0.348 0.402

31. 7. Conclusions Spread returns have negative relation with revision returns. Spread returns are significantly related to durations and bid premiums. Deals with shorter duration and higher P/B tend to reversal during the deal. Our result reveals that a portfolio of risk arbitrage positions in leveraged buyouts produces annual arbitrage returns of 20%. 31