...the current prices reflect a 10.3% discount on Willis relative to the price implied by the offer, a figure often referred to as the merger arbitrage spread (arb spread).
What this means is if you buy Willis stock and short Aon at these prices, should the deal close you will make 10.3% in absolute return excluding trading expenses, other things being equal.
However, merger arbitrage is not really “arbitrage”. In principle, arbitrage is a risk-free trade, but merger arbitrages are associated with some risk. Sometimes, the risk can be substantial.
In the same way as higher return potential is generally associated with higher risk, higher arb spreads are associated with a (higher) probability of a (higher) loss. With mergers, the risk typically involves a potential of a price cut, deal extension or deal termination.
As we discussed back in March, double-digit arb spreads are usually run around deals with increased public and regulator attention over antitrust issues.
For example, the Charles Schwab-TD Ameritrade 2020 merger saga that received a lot of objections from peers/market observers and elevated scrutiny from regulators had an 11% arb spread at its peak level. The deal eventually closed upon satisfying the DOJ’s second request.
In a more extreme example, the two-year blockbuster merger between Sprint and T-Mobile that was sued by more than a dozen attorney generals had an average arb spread of 16% during the period between the deal announcement and ultimate DOJ approval.
Now, the Aon-Willis arb spread is currently the second-largest in the sample of 16 pending transactions involving target companies with at least $5bn market value (see table below).
For perspective, the pending S&P Global-IHS Markit merger – last year’s largest M&A deal – has an arb spread of 3.5% and is considered a smooth transaction from an antitrust perspective. That said, it is still expected to receive scrutiny from regulators.
The second largest transaction of 2020 – between semiconductor manufacturers AMD and Xilinx – has the highest arb spread of 10.5% in the sample as the merger may potentially face a challenge from Chinese regulators. Notably, the merger’s 30-day waiting period has expired in the US, which technically means the US regulators have no objections in relation to the transaction. The agencies are reportedly facing an “unprecedented volume” of merger filings with operations further disrupted due to the administration change.
In another related example, the Salesforce-Slack transaction offers a 6.1% arb spread. The merger was issued a second request by the DOJ and is likely being checked on competitive grounds, despite the fact that big tech mergers tend to draw attention over privacy and misinformation issues.
As a reminder, following a period of high volatility post the deal announcement, which coincided with the massive market sell-off in March last year, the Aon-Willis arbitrage spread bottomed at around 4% in May. This falls within the range where M&A transactions typically close, albeit for deals with potential challenges from regulators.
However, the spread has gradually been widening since and sharply increased over the past two weeks.
Now, there are reasons for the market to be rightfully concerned about the Aon-Willis merger. The announcements and actions of the regulators from the brokers’ key revenue markets – EU, US and more recently Australia and New Zealand – all suggested they scan the horizontal merger as potentially reducing competition in their respective markets.
Statements from the regulators point to areas of likely concern within broking. The Australian antitrust agency, for example, pointed to reinsurance as "an already concentrated market" where the deal would further narrow choice. Willis Re has been a major in-market focus of speculation around divestitures, owing to the high market share in geographies including Continental Europe, Japan and Australia, and partially reflecting the relative simplicity of spinning out the entity.
The Australian regulator further pointed to the potential for the deal to hamper competition in the commercial insurance market in areas including complex or high value insurance. The EU also identified large account business as an area that it would look at.
One can only speculate about the outcomes of the regulatory reviews as it is challenging to accurately identify the points of concentrated market share based on publicly available information. Regulators rely on thousands of pages’ worth of confidential and market-sensitive information and lengthy discussions with the market participants when making their decisions. After all, the industry does not frequently have mergers of such scale.
However, what’s certain is that there is a strong impetus from Aon and Willis to get the deal done. The strategic and financial prospects of the deal are appealing. Both parties received overwhelming support from shareholders. Aon approached the deal with high internal efficiencies, a lot of currency in its stock and good practical experience of driving costs out of the business. Meanwhile, Willis was objectively less operationally efficient than its Big Three peers and was facing a succession problem, which ironically is exactly the reason why many smaller broker-agents end up being bought out in the industry nowadays.
In their latest public appearances, both parties emphasised that they were fully committed to getting the deal done. Willis has already incurred $45mn in pre-tax integration expenses in relation to the tie-up and Aon remains pumped up about the revenue and cost synergies from the combination, as well as its strategic benefits. Both have also stressed their continued expectation of a close during H1.
In addition, it remains the perspective of multiple senior industry sources including at rival brokerages that the deal will close.
In summary, the current wide arb gap is suggestive of a market expectation of antitrust complications and the possibility the merger approval will be conditional on some requirements, such as divestiture of certain assets.
However, the circumstances surrounding Aon and Willis that prevailed leading up to the deal suggest that the brokers have plenty of fire in the belly to co-operate with the regulators in a way that should allow bringing the deal across the finish line.
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