Elon Musk’s Twitter drama is encouraging arbitrage. Perhaps we should resist

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There is a lot of money sitting between Elon Musk’s high takeover price for Twitter Inc. and the lower price at which the stock is currently trading – and investors have taken notice of the opportunity here.

Welcome to the world of merger arbitrage, where investors bet on deals closing or falling apart.

Though once the domain of sophisticated investors, the strategy has gone mainstream with Mr. Musk’s agreement to buy Twitter for US$44-billion, or US$54.20 a share.

That’s partly because of Mr. Musk’s profile as chief executive officer at Tesla Inc., and popularity among retail investors. It’s also because Twitter’s current share price, US$38.99 on Friday, implies that investors can score gains of 39 per cent if the takeover goes through.

Anyone who makes this bet has become an arbitrageur, and it appears that their ranks are swelling.

According to the TD Direct Investing Index, which tracks investor sentiment and trades through Toronto-Dominion Bank’s online brokerage, Twitter was the fourth most popular stock purchase among younger investors in April, when Mr. Musk announced his intentions through a regulatory filing.

That’s up from the 443rd spot in March, and may reflect rising interest in this particular deal.

“The amount of media coverage I’ve seen, including requests to comment about it, has been greater than any deal I can remember in my career,” Aaron Glick, merger arbitrage specialist at Cowen & Co. in New York, said in an interview.

“It’s clear that this deal has penetrated the public discourse,” Mr. Glick added.

The interest in Twitter comes amid a sharp rise in the number of takeovers globally. The number of megadeals valued at more than US$5-billion each rose to 130 last year, up 57 per cent from 2020, according to the consultancy PwC.

Two recent Canadian deals have grabbed considerable attention for their twists and turns, and shone a light on what can be a tempting opportunity for investors.

One that didn’t work: Britain-based Cineworld Group PLC offered to buy Canada’s Cineplex Inc. in 2019 for $34 a share. Cineworld walked away from the deal soon after the start of the pandemic, though, and now Cineplex shares trade at just $11.65.

One that is still in the works: Rogers Communications Inc. agreed last year to buy Shaw Communications Inc. for $40.50 a share. But regulatory setbacks related to Shaw’s Freedom Mobile wireless assets have caused delays that have rattled confidence in the deal.

Shaw shares currently trade at $35.29, or 13 per cent below the takeover price.

In the case of Twitter, the social-media company has agreed to be acquired by Mr. Musk. However, the share price reflects concerns that the mercurial Mr. Musk could walk away from the deal he initiated or demand a lower price.

In recent weeks, he has threatened to terminate the deal over his concerns about the number of fake Twitter accounts. He is also likely aware that technology stocks have fallen substantially over the past month, making his current offer look comparatively rich.

Given this backdrop, should small investors be dabbling in merger arbitrage?

Julian Klymochko, chief executive officer at Calgary-based Accelerate Financial Technologies, an alternative exchange-traded fund provider, said that 94 per cent of U.S. mergers and acquisitions over the past decade have closed while just 6 per cent have been terminated.

That sounds encouraging. However, the average spread between a stock price and a takeover price is much higher than normal right now because of increased regulatory scrutiny, stock market volatility and rising interest rates, he added, suggesting heightened risks.

“Arbitrage requires a highly specialized skill set and significant experience to become proficient,” Mr. Klymochko said in an e-mail.

An alternative, then, is to let an expert do the driving. Mr. Klymochko manages the Accelerate Arbitrage Fund ETF (ARB). Shaw and Rogers are among the fund’s top holdings.

Still, Twitter may beckon with Mr. Musk’s star power and the potential for strong returns over a relatively short period of time.

But Mr. Glick said that an important consideration in any arbitrage bet is the theoretical downside should the deal fall apart. Professionals will then compare this risk-and-reward to their own estimates of the deal closing, based on experience, due diligence and conversations.

Some observers peg Twitter’s intrinsic value at about US$30 without Mr. Musk’s deal, implying a downside of 45 per cent. The current share price is about halfway between this intrinsic value and the takeover price, suggesting the market sees a 50-per-cent probability that the takeover will succeed.

Those odds are no better than a coin toss.

Editor’s note: An earlier version of this article incorrectly attributed the US$30 estimated intrinsic value of Twitter shares to a firm which has not quoted a downside price. Hindenburg Research published an estimate of US$31.40 in May, based on the decline of the Nasdaq Composite Index.

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