summery

Electronic copy available at: http://ssrn.com/abstract=992650

Merger Arbitrage Profitability in China

Tuan Jason1, Zhang JinXin2, Hsu Jason3 Zhang Qiusheng4 1 School of Economics and Management, Beijing Jiaotong University, P.R.China, 100044 2 School of Economics and Management, Beijing Jiaotong University, P.R.China, 100044

3 Research Affiliates, LLC, CA 91101 & Merage School of Business, University of California at Irvine, CA 92697 4 School of Economics and Management, Beijing Jiaotong University, P.R.China, 100044

Abstract：This paper examines the profitability of merger arbitrage strategies in China. Additionally, it examines the presence of insider trading in the target company, prior to the announcement of the M&A offer, in the Chinese stock market.

Using a sample of 22 tender offer bids (from January 2002 to December 2006) and applying standard event study methodology, we find that the average cumulative abnormal return (CAR) from a portfolio, which purchases long the target firm is significant at positive 17.7%, for voluntary tender offers (from day -30 to the announcement day 0). However, the average CAR form day 0 to the resolution day is significant at negative -4.14%. For mandatory tender offer, both the pre- and post-announcement average CAR are not statistically significant. These results suggest that there is no opportunity for investors to profit from a post-announcement long only strategy. In addition, the significant pre-announcement price appreciation followed by post-announcement negative return suggests insider trading. Finally, the pattern of CAR for mandatory tender offers is different from that for voluntary offers, where the mandatory tender offer events have no impact on the share price of target firm.

Keywords: Merger Arbitrage, Risk Arbitrage, Insider Trading, Pre-Bid Price Appreciation, Merger and Acquisition, Standard Event Study Methodology 1 Introduction

Merger Arbitrage is a key investment strategy employed by financial institutions and sophisticated investors in the developed capital markets. A specific type of merger arbitrage involves an investment strategy that purchases the shares of the target company immediately after the announcement of a cash tender offer. The strategy aims to take advantage of the spread between the offer price and the post-announcement market price of the target firm. Often times, the offer price represents a significant premium over the market price on announcement date. The premium may be attributed to the potential synergy from the merger. Intuitively, the target’s price should rise close to the offer price on the announcement day. However, the post-announcement market price of the target firm often represents a significant discount relative to the offer price. Two reasons account for the discount [1]. First, successful completion of the merger is not a certainty.

Second, shareholder of the target firm must earn a positive return until consummation of the merger. In general, a merger requires the approval of the target firm’s management, approval of the target firm stockholders and approval of the regulatory bodies involved. If the merger is not approved, the target stock price could decline toward preannouncement levels. If a proposed merger fails to be consummated, the arbitrager may experience a significant loss.

Since merger arbitrage is a risky investment strategy, it is not a true arbitrage and is often referred to in the finance industry as a risk arbitrage strategy. However, what makes the merger arbitrage strategy interesting is that, adjusting for the market risk associated with non-consummation, the strategy appears to be on average profitable—that is the strategy earns abnormal returns—in many developed financial markets.

Many existing academic studies have shown that merger arbitrage earns positive abnormal returns over the post-announcement period. For example, Maheswaran and Yeoh examine 193 merger and acquisition bids from January 1991 to April 2002 and find that merger arbitrage portfolio generates statistically significant excess risk-adjusted return before transaction costs[2], Jindra and Walking show that passive arbitrage portfolio outperforms the market portfolio over the period from 1981 to 1995[3]. Baker and Savasoglu report abnormal returns of about 1% per month on a portfolio of risk arbitrage positions established over the period 1978 through 1996[4]. Mitchell and Pulvino show that annualized abnormal return of merger arbitrage portfolio is around 9.5%[5]. Karolyi and Shannon conclude that the annualized risk-adjusted return is 33.9% for 37 Canadian acquisition targets during the year 1997[6]. Dukes, Frohlich & Ma show that merger arbitrage earns significantly high profit that far exceed 100%[7]. Larcker and Lys indicate that there is positive mean excess return to arbitrageurs from the time of investment to the resolution of the offer[8].

Merger and acquisition activities have increased dramatically in China over the last several years. According to China Mergers & Acquisitions Yearbook (2005), the total amount of merger and acquisition activities has reached RMB 211 billion in 2004[9]. In addition, Chinese economic reforms and robust growth have fuelled an increase in merger and acquisition activities. It is therefore important to examine the profitability of a merger arbitrage strategy in the Chinese market and to assess the relative efficiency of the

Electronic copy available at: http://ssrn.com/abstract=992650

Chinese financial market. Because of the complexity of the rules and

regulations governing merger and acquisition activities in China, there is additional complication in examining merger arbitrage strategies in China relative the developed capital markets. Many of the listed companies in China have large state ownership. The state held shares are non-circulating. In general, in acquisitions, the price offered for the non-circulating shares of the target firm is often lower than for the circulating shares.1

Historically, most of the M&A activities in China occur in the agreed acquisition form, which means that the acquirer takes over the target firm by negotiating with the major shareholders of the non-circulating shares (various state entities). It was not until June of 2003, after China Security Regulatory Commission (CSRC) issued the Administrative Measures on the Acquisition of Listed Companies, that the first public tender offer was made in China. Because of the relative short history of the market for public acquisitions in China, it is interesting to examine the efficiency of this market, by testing the profitability of traditional merger arbitrage strategy in the Chinese market.

Since the merger arbitrage strategy takes advantage of mispricing only after the intended merger has been announced, the activity is legal. On the other hand, trading before merger announcement based on non-public information is illegal. Ivan Boesky, a well-known takeover speculator in the mid 1980s was charged by the US Securities and Exchanges Commission and later convicted for insider trading in target companies prior to the announcement date. Insider trading associated with merger and acquisition deals in China is an interesting topic. Gu & Wu show that the main purpose for an acquirer to purchase listed firm in agreed acquisitions is to profit from trading in the target firm prior to the announcement[10]. He & He show the existence of illegal insider trading in China security market[11]. Zhang and Zhang & Zhu show significant existence of insider trading in acquisition and restructuring events[12,13]. In this paper, we test the data for signs of pre-announcement trading by examining the CAR in the 30 days leading to announcement using methods applied in Keown & Pinkerton and Meulbroek[14,15].

In general, there are two major types of tender offers in China, mandatory and voluntary tender offer. Prior to 2003, acquiring firms made mostly private tender offers to the shareholders of non-circulating shares to gain control of the target. Presumably, non-circulating shares could be purchased at lower prices due to the illiquidity discount. However, under the Administrative Measures on the Acquisition of Listed

1 The unique structure has caused a negative impact on corporate governance of the listed firms. In order to solve the above issues, China government has launched Full Circulation Reform in earlier 2005 to effect the full circulation of all the equity shares of listed firms.

Companies issued by CSRC, an automatic (mandatory) tender offer to the circulating shareholders is triggered when the acquirer holds more than 30% of all shares in the target firm. Chen & Zhou (2004) and Zhan (2006) study these tender offers and find that the offer price for the circulating shares is usually discounted at 10% (or more) of the market price. As a result, few shareholders of the circulating shares accept the offer[16,17]. This bidding strategy represents the bidder’s desire to circumvent the Administrative Measures. However, for voluntary public tender offers, the acquirer is usually interested in acquiring the target completely (including both non-circulating and circulating shares) and thus would offer a premium price to circulating shares. 2 Methodology 2.1 Data Selection

This study examines the profitability of merger arbitrage in tender offers in China. Our sample comprises of 24 deals (17 deals are mandatory and 7 deals are voluntary) that took place from June 2003 to December 2006. All deals are cash offers. Tab.1 shows the number of tender offers in our sample, year by year. We use the tender offer data drawn from the Shanghai Stock Exchange and Shenzhen Stock Exchange and financial data drawn from finance.yhoo.com.cn and finance.sina.com.cn. Our sample contains 9 deals where the target firm is listed in ShengZhen Stock Exchange (SZSE), and 13 deals where the target firm is listed in Shanghai Stock Exchange (SSE).

Tab.1 Number of tender offers in our sample by year

Year Tender offer deals Percent of total

2003 3 12.5%

2004 7 29.2%

2005 4 16.7%

2006 10* 41.7%

Total 24 100%

Note: We discarded 2 deals in 2006 in our data sample because of the deals had offer durations much shorter than one month. 2.2 Calculation of Raw Merger Arbitrage Return

The mode of payment (primarily cash or stock) for target firm will affect the return of merger arbitrage. In a cash offer (simplest form of merger arbitrage), the strategy simply purchases shares in the target firm immediately after the announcement when there is a discount in the post-announcement price against the offer price. The strategy then holds the shares until the merger completes. Assuming that the market risk can be effectively hedged,2 the strategy would profit from the

2 Alternatively, when the strategy is repeated many times, the market risk associated with the strategy is essentially eliminated.

discount in the market price. Because all tender offers in our sample are cash

offers, we do not need to concern ourselves with stock-exchange offer merger arbitrage strategies. 3 To implement this strategy in our research, we assumed that the arbitrager acquires the stock at the closing price on the day of the announcement. The sale price received by the arbitrageur is either the offer price or the market price at the end of the tender offer period (if the merger fails). The duration of the tender offers in our sample is generally one month and includes roughly 20 ~ 21 trading days. We eliminated from our sample any tender offer with duration less than one month. The raw return of the merger arbitrage strategy MAR is computed as:

announce i

announce i

offer iMA PPPR /)( −= (1)

where offeriP is the tender offer price for the target firm i, and announceiP is the closing market price for the target firm on the announcement day. 2.3 Calculation of Cumulative Abnormal Return

However, the simple raw return calculation does not take market risk into consideration. An alternative way is to apply standard event study techniques (developed in Ball & Brown and Fama, Fisher, Jensen and Roll[18,19]) to calculate the cumulative risk-adjusted arbitrage return. The advantage of this procedure is that the return on the market can be explicitly considered in computing the return of the arbitrager. We assume that the single-factor market model is an adequate characterization of the rate of return of a stock.

itMtiiit RR εβα ++= (2)

where itR is the daily return for firm i on day t. MtR is the daily return for market portfolio on the day t . itε is the random error(or firm-specific component of the return) for firm i on day t. ii βα , are the market model parameters for firm i .

The estimation period is defined as 90-trading-day period prior to the announcement of a tender offer. If the announcement date of the tender is denoted 0t , the estimation period consists of daily return data from day 180 before 0t (-180) to day 90 before 0t (-90). The data from day -90 to day -30 are deleted to avoid the preannouncement drift in the stock price that are typically observed prior to a merger and acquisition announcement. The test period is defined as the time period from -30 to rt , where rt is the resolution date of the tender offer. In addition, because SSE Composite Index (SSECI) is highly correlated with SZSE Composite Index, to simplify our calculation, we use 3 In stock exchange offer merger arbitrage strategies, the arbitrageurs take long position in the target firm and short position in the acquiring firm.

SSECI as proxy of market portfolio in our study. Thus we can estimate the market model parameters for each of our sample, )ˆ,ˆ( βα over the period, (-180, -90) by

itMtiiit RR εβα ++= ˆˆˆˆ (3)

where 11 /)(ˆ −−−= itititit PPPR , t is from day -180 to day -90. itP and 1−itP represent the closing price of firm i on day t and day t-1, respectively. And,

11 /)(ˆ −−−= tttMt SSECISSECISSECIR , where t is from day -180 to day -90. tSSECI and 1−tSSECI represent the closing index total return level on day t and day t-1, respectively.

Then we use the estimated parameters )ˆ,ˆ( βα to calculate the daily abnormal return,

iAR for firm i over the test period (-30, rt ) are estimated by:

Mtiti RRAR ∧∧

−−= βα (4)

The cumulative abnormal return, iCAR for firm i

over the test period (-30, rt ) is

∑ −=

= rt

t ii ARCAR

30

(5)

A positive abnormal return would suggest that there is profit beyond the compensation justified by the underlying risk. We use the t-test to test the significance of the cumulative abnormal return. We assume that CAR follows the normal distribution ~ ),0( 2σN . The t statistics is

nCARS CAR

t i

CAR /)( = (6)

Where n is the total number of the sample and

∑ =

= n

i iCARn

CAR 1

1 (7)

∑ =

− −

= n

i it CARCARn

CARS 1

22 )( 1

1 )( (8)

Dukes, Frohlich & Ma point out that the concept of adjusting for systematic risk is less relevant in the case of M&A deals, because the target firms usually experience significant reorganization or restructuring in response to tender offers[7]. As a result, the risk structure of the firm may change dramatically around the time of the tender offer. While the estimate of risk using conventional statistical procedures may be biased, the magnitude of the changes may still provide clues on relative risk in our study. 2.3 Insider Trading Test

We use the cumulative abnormal return (CAR) method to examine whether insider trading in the target firm occurred in our sample. If the CAR in the 30 days leading to the announcement of tender offer is

significantly positive, and if the CAR from the announcement day to the resolution day is not significantly positive, we interpret this as a sign of insider trading in the target firm. 3 Results

Tab.2 lists the raw arbitrage return for voluntary tender offer. The mean and median are 0.99% and 0.95% per month. We do not have consider the mandatory deals in Table1 here, because all offer prices of the 15 mandatory deals are less than the closing prices of target firms on the announcement day. On average, for the mandatory public offers, the offer prices are discounted by 19.16% from the market price of the target firm on the day of announcement. Few, if any, of the shareholders of the circulating shares accepted the offer and, of course, no arbitrageurs would take long positions in the target firm. Tab.3 lists the discount for each mandatory offer.

It is interesting that all 7 voluntary public offers occurred in the petroleum and chemicals sector and were launched by two bidders, PetroChina and Sinopec. PetroChina acquired 3 companies and Sinopec acquired 4 companies. Both companies sought to acquire 100% of the target firm. Tab.2 Raw Arbitrage Returns for Voluntary Tender Offer

Return of Merger Arbitrage (7 Voluntary deals only) Return of buy-and-hold

In market portfolio

Mean 0.99% 5.87%

Median 0.95% 7.15%

Std. Dev 0.15% 1.74% Note: the estimation duration for the return is one month Tab.3 Discounted Rate for Closing Price

Stock Code

Announcement Date

Offer Price

Closing Price

Discounted %

000708 2006/11/01 2.62 5.68 53.87%

600575 2006/2/24 5.98 6.81 12.19%

000062 2006/2/10 3.81 4.71 19.11%

600828 2005/12/15 2.91 3.82 23.82%

600397 2005/7/4 3.90 4.05 3.70%

600586 2004/12/8 8.93 10.81 17.39%

600327 2004/11/4 5.09 6.10 16.56%

600162 2004/9/29 7.31 8.57 14.70%

600297 2004/9/1 7.34 8.48 13.41%

600393 2004/6/2 6.67 7.28 8.38%

600496 2004/3/9 8.18 12.26 33.28%

600213 2004/3/8 5.01 7.43 32.57%

600828 2003/8/4 7.04 7.35 4.22%

000816 2003/7/24 6.05 6.14 1.47%

600282 2003/6/13 5.86 8.71 32.72%

Average Discounted Rate 19.16% Note: The target firm, 600828, has been merged twice and we regard the two mergers as two independent deals in our data.

Although the average raw return on a monthly base is positive, if we compare it with the return on the market portfolio over the same sample period, the market portfolio strategy appears to deliver superior returns (Tab.2). The return on the market portfolio is listed in the right column of Tab.2. This simple comparison captures relative strategy performance, but it ignores the risk exposures from investing in these target companies. We properly risk adjust the merger arbitrage return in Tab.4.

In addition to examining the CAR for voluntary offers, we also use the CAR to compare the pattern of the merger arbitrage returns between voluntary and mandatory tender offer. Tab.4 and Tab.5 reveal descriptive statistics on the cumulative abnormal returns (CAR) for voluntary and mandatory tender offer bids, respectively. The mean CAR for voluntary offer from day -30 to the announcement day 0 is significantly positive at 17.77% with a t-stat of 3.027. On the contrary, the mean CAR from day 0 to the resolution day is borderline significantly negative at -4.14% with a t-stat of -1.88. This suggests that there are no abnormal profits for investors from engaging in the post-announcement merger arbitrage. In addition, the return patterns associated with the pre- and post-announcement period suggest insider trading in the target firm stock.

For mandatory offers, both the mean CAR (2.24%) from day -30 to the announcement day 0 and the mean CAR (1.78%) from day 0 to the resolution day are not statistically significant, which indicates that the mandatory tender offer event do not have significant effect on the market price of the target firm. Tab.4 Description Statistics & T-test for Cumulative Abnormal Returns of Voluntary Tender Offer Over The Estimated Period

Voluntary Tender Offer (7 deals)

Period Mean Median Max Min Std Dev. t-

value CAR(-30,tr) 12.98% 9.87% 50.4% -10.6% 20.02% 1.72

CAR(-30,0) 17.77% 18.2% 45.1% -2.3% 15.53% 3.03*

CAR(0, tr) -4.14% -3.84% 6.19% -13.2% 5.82% -1.88**

Note: tr: resolution date of tender offer; * indicates significance at the 0.025% level for right tailed test: 0:,0: 10 >≤ μμ HH ; ** indicates significance at the 0.1% level for left tailed test:

0:,0: 10 <≥ μμ HH

Tab.5 Description Statistics & T-test for Cumulative Abnormal Returns of Mandatory Tender Offer Over The Estimated Period

Mandatory Tender Offer (15 deals)

Period Mean Median Max Min Std t-

Dev. value

CAR(-30,tr) 3.95% 3.41% 35.5% -20.2% 12.04% 1.27

CAR(-30,0) 2.24% 0.03% 15% -8.13% 7.03% 1.23

CAR(0, tr) 1.78% 1.56% 20.7% -15.5% 7.54% 0.92

Note: tr: resolution date of tender offer.

-5%

0%

5%

10%

15%

20%

-3 0

-2 6

-2 2

-1 8

-1 4

-1 0 -6 -2 2 6 10 14 18

Trading Date Realted to Tender Offer

A v

er ag

e C

u m

u la

ti v

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b n

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al R

et u

rn

Voluntary Mandatory Total Fig.2 Average Cumulative Abnormal Returns to Target Firms’ Stocks from Trading Day -30 to Day +21 Relative to The Announcement

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

Trading Date After Announcement

A v

er ag

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u m

u la

ti v

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b n

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Total Voluntary Mandatory Fig.3 Average Cumulative Abnormal Returns to Target Firms’ Stocks from Trading Day 0 to Day +21

Fig.2 and Fig.3 show the plots of the average cumulative abnormal returns (CAR) for the periods, (-30, +21) and (0, +21), respectively, for all 22 tender offers in our sample. It also breaks down the target returns by mandatory and voluntary tender offers. All of the offers in our sample were either accepted or rejected within 21 trading days. Tab.6 shows the distribution for voluntary and mandatory tender offer by duration. Tab.6 Distribution for Tender Offer Deals by Trading Period

Trading Period

Number of Mandatory offer

Number of Voluntary offer Sub-Total

21 days 11 6 17

20 days 3 0 3

17 days 0 1 1

16 days 1 0 1

Total 15 7 22

The CAR for voluntary offers (in Fig.2) starts to

rise around day -14 with the largest pre-bid rise

occurring before the announcement day 0. The cumulative pre-announcement returns, which the arbitrageur would not accrue, average around 17% percent. The CAR for voluntary offers (in Fig.3) drifts downward after the announcement day 0. The merger arbitrage strategy appears unprofitable. Schwert shows that although the CAR to target firm’s stocks (in US) starts to rise around day -41 (representing some degree of information leakage); however, it jumps dramatically on the announcement day 0[20]. On the contrary, in our findings, there is no jump in the CAR for voluntary offer on the announcement day 0; however, the CAR shows a seriously information leakage before the announcement of the tender offer. We may infer the existence of insider trading associated with merger and acquisition deals in China; empirically, we observe that the price fully reflects the tender offer price prior to the merger announcement.

The pattern of the CAR for voluntary offers is much different from that for mandatory offers. The CAR for mandatory offer (in Fig.3) is rather flat over the whole estimated period from day -30 to day +21 and the share price of target firm in mandatory offer deals does not appear to be affected by the mandatory tender offer event.

We also break down the target returns by the different stock exchange. In 13 deals, the target firm was listed on the SSE, while in 9 deals, the target firm was listed on the SZSE. Fig.4 shows the plots of the two CAR. The behavior of the CAR for the SSE listed target firm acts in a similar way to the one for voluntary offer. It starts to rise around day -14 with the largest pre-announcement rise (around 10%) occurring before the announcement day 0 and then goes downward. The CAR for the SSE listed target firms is similar to the CAR for the mandatory offer. This phenomenon raises an interesting question: does there exist more inside trading in the SZSE listed target firms prior to tender offer announcements? This is an empirical question that we would like to explore in our future research.

-5%

0%

5%

10%

15%

-3 0

-2 6

-2 2

-1 8

-1 4

-1 0 -6 -2 2 6 10 14 18

Trading Date Related to Tender Offer

A v

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Firms listed in SSE Firms listed in SZSE Fig.4 Average Cumulative Abnormal Returns Classified by SSE and SZSE from trading day -30 to day +21 relative to the announcement 4 Conclusion

Although most merger and acquisition studies show that merger arbitrage is a profitable investment strategy

in developed markets, the evidence from this study shows that there is no opportunity to earn extra return from investing in the target firm post-announcement in China. In addition, we demonstrate that there is a significantly positive cumulative abnormal return (CAR) in the pre-announcement period followed by a borderline negative CAR in post-announcement period, which suggest the existence of insider trading prior to announcement. Finally, the pattern of CAR for mandatory tender offer is different from that of for voluntary offer and the mandatory tender offer events have no impact on the price of the circulating shares of the target firm.

The near zero return for the post-announcement merger arbitrage strategy in China is rather surprising, since merger arbitrage strategies are very profitable in the developed financial markets. The result indicates the efficiency of the Chinese stock market to properly assess the target firm value post announcement. The pre-announcement drift coupled with no price jump on event day, suggest that the Chinese market is strong form efficient; that is prices reflect insider information. We will re-examine this pattern in the future when more M&A deals are transacted as the M&A market continues to blossom in China Reference

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