However, as is often the case in such merger transactions – especially one of this size – a lot can happen between the timing of a deal’s announcement and that of the merger’s close.
With that in mind, the share price activity of the two brokers since the deal was announced appears to reflect the expectation that the deal will attract increased regulatory and shareholder scrutiny, and increasingly suggests a likelihood that the tie-up may hit a roadblock or require a renegotiated price.
That said, we’d be remiss if we didn’t point out that the trading period following the deal’s announcement has been anything but normal, marked by a sharp spike in volatility in which hedge funds have been forced to de-lever and limited in their normal market function of trading away arbitrages and anomalies.
That, to some extent, may explain some of the deviations in the stock prices of Aon and Willis in the past two weeks, though it is our view that the market will continue to price for the variety of hurdles the deal needs to clear in the time between when volatility recedes and the transaction is closed.
Usually, in all-stock mergers, when a deal is close to certain, the target’s and acquirer’s shares trade at a known spread justified by an exchange ratio negotiated at the outset, defined as the number of acquirer shares per target share.
However, ahead of closing there is normally a gap between the buyer’s and the seller’s shares beyond what would be explained simply by the exchange ratio, often reflecting the potential likelihood of changes to a deal’s terms, the possible cancellation of the deal, or even the market inefficiencies we noted above.
In the case of Aon-Willis, if the deal was certain, Willis’ stock should trade at an 8.1% premium to Aon’s shares, reflecting a 1.08x exchange ratio, plus the difference in a year’s worth of dividends between the two firms, which we estimate at 0.1%.
This compares with the stocks trading at parity (no gap) at yesterday’s close, and an average gap of 1.2% for the 14 prior daily closes since the announcement.
Put another way, had investors been pricing for deal certainty, Willis’ stock should be trading ~8% higher than it is now, a gap we would refer to as the “divergence”.
For comparison, in the relatively smooth merger between SunTrust Banks and BB&T Corp the divergence stood at ~1% following the announcement.
Alternatively, the pending merger deal between investment brokers TD Ameritrade and Charles Schwab had a divergence of 3.5% following the announcement in November last year, and is now at 5.3% after the US Department of Justice initiated a review of the merger for potential antitrust issues, for the first time in that industry’s history.
Another recent blockbuster merger between telecoms providers Sprint and T-Mobile had a divergence of 10% following that deal’s announcement. The companies were subsequently sued by more than a dozen attorneys general across the US over antitrust issues. This was then further complicated by a disagreement between shareholders over deal terms.
In the table below, we summarize the statistics from the past three years from a sample of 23 all-stock mergers involving firms of comparable size and market capitalization of more than $1bn each.
The current 7.6% price divergence of the Aon-Willis deal – higher than that of comparable transactions – appears to indicate that investors expect complications in closing the deal, if one operates under the assumption that current markets are efficient.
What are investors expecting to go wrong? We believe there are two primary impediments to the transaction being closed as announced, split between regulatory (antitrust) issues and shareholder (Willis and Aon) disapproval.
As we noted in “A strategic coup, but an unfair price”, contrary to the popular perception that it would be Willis shareholders who challenged the deal, we see the potential for shareholder dissent over deal terms to come from Aon’s side.
Since then, we’d highlight one more obstacle that may threaten the Aon-Willis deal – the increased probability of a recession.
Recessions typically lead to steep declines in M&A activity as businesses put unforced strategic decisions on hold in an environment of elevated uncertainty. Given the long gestation period of the Aon-Willis merger (estimated at around one year by management), a recessionary environment could erode the operating results on either side of the deal and potentially make the existing terms obsolete.
As an example, Sprint had to improve the deal terms for T-Mobile shareholders following a deterioration in operating performance during the two-year approval process.
We wouldn’t emphasize this factor too strongly, since the transaction is not subject to increased financial stress (= no debt financing) and insurance brokerage revenues are relatively immune to a recessionary environment.
A recessionary environment could also favor the deal in certain respects, such as a reduced risk of losing key staff in an exposed labor market and limited alternative costs.
Ultimately, we see the deal as highly likely to-close, given the strategic and financial opportunities it affords. However, the transaction has the potential to undergo a challenging approval process involving both regulators and shareholders, as well as a wild card in the form of a potential recession – risks it appears the stock market is taking into consideration.
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