Merger Arb
Why Twitter and Activision should be on the radar
I’ve tried to stay away for stock ideas for some time, but I think these two merger arb deals are too good to overlook.
Currently both trade at around a 20% discount to their agreed upon purchase price. This is a substantial discount that I suspect represents both the higher cost of leverage and increased uncertainty around both deals. In the case of Twitter, the FUD is the buyer. In the case of Activision, it’s the FTC.
A quick look at both cases, and why I think both deserve a look.
The lower risk — Activision
Unlike Twitter, in Activision you have a willing and reliable buyer. You also have a solid business with good IP, and long term cash flows. The issue here is the FTC. Right now the market suggests the odds are 50/50 that this deal goes through, whereas historically only 10% of all M/A deals fall through. (Source: McKinsey)
So the market is betting against historical odds. The reason is FTC Chair Lina Kahn is known to be in favor of antitrust and antimonopoly. I think it’s worth reading some of what she wrote in her 2018 piece “The New Brandeis Movement: America’s Antimonopoly Debate”
Antimonopoly does not mean ‘big is bad.' The New Brandeisians—like Justice Brandeis—recognise that certain industries tend naturally towards monopoly. This is especially true of networks. In such cases, the answer is not to break these firms up, but to design a system of public regulation that prevents the executives who manage this monopoly from exploiting their power. A second goal is to ensure that executives face the right incentives to provide the best service possible to everyone who relies on the monopoly to sell or to buy a particular product or service. In the past Americans have used both direct government regulation, and various forms of antimonopoly law and policy, to achieve these ends.
So the key questions from Ms. Kahn’s own work….does this merger give Microsoft executives the ability to exploit the power gained from the acquisition?
While certainly this would strengthen the offering of Microsoft’s gaming subscription service, consumers would have another option in the form of Sony PlayStation. So in that respect a system does exist which checks the pricing power Microsoft has. Because gaming is such a distributed industry across PC, Mobile and Console, Microsoft is highly incentivized to make it’s games available to all systems, as it’s the in-game purchases which really drive the LT value.
The fact that large makers such as Take Two and EA still exist, suggests that competition in the industry won’t be harmed by this acquisition. This was the key argument in her paper Amazon's Antitrust Paradox. The ability of companies like Amazon to starve out it’s competition was the crux of her concern. This concern will not be on the table for this acquisition.
Adding to the bullish thesis is the fact that the workers union at Activision is in support of this merger. That alleviates another potential pressure point, the effect of this transaction on employees. Support from the union makes it very difficult for the FTC to argue in court that this transaction would hurt employee competition.
Even if the transaction were to fall through, Activision would still be a good company at a reasonable price which hopefully has used this time to clean up it’s culture. A stronger culture would likely justify the stock trading close to the acquisition price and allow it’s developers to focus on delivering the next big hit. The down side is limited, the up side is attractive.
The higher risk — Twitter
Twitter’s situation doesn’t have the same antitrust cloud hanging over it….but it does have a buyer that’s trying to back out.
Here’s a quick timeline of the acquisition and share price:
April 14 (45.08) — Elon offers 54.20 for Twitter
April 25 (51.70) — Twitter accepts Musk’s offer
April 28 (49.11) — Twitter issues Q1 earnings, restates MDAUs for 2019-2021
May 11 (46.09) — SEC and FTC open inquiry’s into the transaction
May 13 (40.72) — Elon says the deal is on hold due to bot accounts
June 3 (40.11) — Antitrust review is cleared
July 8 (36.81) — Elon announces he is terminating the acquisition
July 12 (34.06) — Twitter sues Elon Musk
As this has all played out very publicly, I will gloss over the details to get to the heart of the arguments and key points as stated in the merger agreement.
The $1 billion termination fee is not a factor:
“Parent will be required to pay Twitter a termination fee of $1.0 billion. Specifically, this termination fee is payable by Parent to Twitter if the Merger Agreement is terminated by Twitter because (1) the conditions to Parent’s and Acquisition Sub’s obligations to consummate the Merger are satisfied and the Parent fails to consummate the Merger as required pursuant to, and in the circumstances specified in, the Merger Agreement; or (2) Parent or Acquisition Sub’s breaches of its representations, warranties or covenants in a manner that would cause the related closing conditions to not be satisfied. Mr. Musk has provided Twitter with a limited guarantee in favor of Twitter (the “Limited Guarantee”). The Limited Guarantee guarantees, among other things, the payment of the termination fee payable by Parent to Twitter, subject to the conditions set forth in the Limited Guarantee.”
Since Twitter has not terminated the agreement, this will not be settled for $1 Billion unless Twitter’s board decides to terminate the agreement, something they have not shown any inclination of doing. Mr. Musk can only terminate for $1 Billion if Twitter were to sell to another buy, or shareholders don’t approve the merger.
Therefore, it’s worth looking at the allowable reasons for termination as set in the merger agreement:
ARTICLE VIII
TERMINATION, AMENDMENT AND WAIVER
Section 8.1 Termination. Notwithstanding anything contained in this Agreement to the contrary, this Agreement may be terminated at any time prior to the Effective Time, whether before or after the Company Stockholder Approval is obtained (except as otherwise expressly noted), as follows…
(i) if the Company shall have breached or failed to perform any of its representations, warranties, covenants or other agreements set forth in this Agreement, which breach or failure to perform
(A) would give rise to the failure of any condition set forth in Section 7.2(a) or Section 7.2(b), and
(B) is not capable of being cured, or is not cured, by the Company on or before the earlier of (x) the Termination Date and (y) the date that is thirty (30) calendar days following Parent’s delivery of written notice to the Company of such breach;
So to summarize, Elon can terminate the merger if Twitter has breached or failed to perform any of its representations set forth in the agreement PROVIDED that these breaches would give rise to a failure to conditions set forth in 7.2 sections (a) Or (b). These sections state that Twitter will have performed it’s obligations set out in the agreement AND that
Each of the representations and warranties of the Company contained in this Agreement without giving effect to any materiality or “Company Material Adverse Effect” qualifications therein, shall be true and correct as of the Closing Date (except to the extent such representations and warranties are expressly made as of a specific date, in which case such representations and warranties shall be so true and correct as of such specific date only), except for such failures to be true and correct as would not have a Company Material Adverse Effect…
But here is the kicker….returning to the above Termination Clauses,
provided, however, that Parent shall not have the right to terminate this Agreement pursuant to this Section 8.1(d)(i) if Parent, Acquisition Sub or the Equity Investor is then in material breach of any of its representations, warranties, covenants or agreements hereunder; or
(ii) prior to the receipt of the Company Stockholder Approval, if the Company Board shall have made an Adverse Board Recommendation Change.
Is Elon Musk already in material breach of any representations, such as…
Notwithstanding the foregoing, the Equity Investor shall be permitted to issue Tweets about the Merger or the transactions contemplated hereby so long as such Tweets do not disparage the Company or any of its Representatives.
…disparaging the company in his tweets.
Thus Elon will have to prove that Twitter made misrepresentations that were Material to the acquisition AND that he is not in breach of the agreement already by disparaging the company.
Notice that the argument can not solely rest upon the existence of bots or spam accounts. Nor is it simply enough to prove that more than 5% of the accounts are bots and/or spam accounts. Elon will have to prove that Twitter breached the agreement by it’s representations. In other words he will have to prove that either Twitter gave intentionally misleading mDAU numbers, fudged the numbers altogether, or knew that the mDAU metric was materially inaccurate. This is a very high bar of proof. In other words he will have to prove that Twitter has been committing fraud.
Given that if they were committing fraud, Twitter would have to be either exceptionally dumb or desperate to allow for discovery by initiating a lawsuit, it seems highly unlikely that they were fragrantly defrauding shareholders.
At the same time, all Twitter has to prove is that Elon intentionally disparaged the company in an attempt to exit the deal. A bar which won’t be very difficult to meet. If they do so, then Elon is on the hook, even if Twitter did misstate the bot and spam accounts.
Because of this, it seems highly unlikely that any Judge will find that Twitter misstated material facts in an attempt to dupe Elon AND that Elon has in no way breached the contract by disparaging Twitter.
Given the above, I think a speculative position in both Activision and Twitter seems to make sense. If you think, like I do, that both have a greater than 50% probability of closing, you can allocate a larger percentage to the one you feel more confident in (in my case Activision) and allocate a smaller percentage to the on you feel has more risk (Twitter). Since both cases are completely uncorrelated to one another, you hedge the risk of putting all your eggs into one basket.