November 3, 2022 – “The bird is freed,” Elon Musk tweeted the day he closed the $44 billion Twitter buyout.
It was a bittersweet ending to the M&A story of the year.
On April 25, 2022, Musk announced the friendly acquisition of the company at $54.20 cash per share, representing a 37.9% premium and $44 billion enterprise value. The consideration was influenced by the meme-worthiness of 4.20 as a weed joke.
Nonetheless, this friendly acquisition came after Musk established a nearly 10% toehold in the company’s stock, requested to join the board of directors, declined to join the board of directors once they had agreed, and then threatened to commence a hostile takeover if his initial offer was not accepted. Then, Musk submitted a go-private proposal for Twitter with little if any due diligence (aside from meaningful use of the service).
At $44 billion, the largest leveraged buyout in history got off to a bizarre start.
Source: Accelerate
The issue with jumbo-sized deals is that a multitude of things can go wrong. Whether it be antitrust approvals, foreign investment approvals, or financing, the larger the deal, the more moving parts. With more moving parts comes greater risk.
While historically, 5.5% of M&A deals break, this risk is lower for smaller-than-average deals and higher for larger-than-average deals. For example, small-cap deals have a 4.6% deal break rate while large-cap deals have a 15.8% failure rate.
Source: Accelerate
This quantitative data point provides an excellent macro starting point for the probability analysis of the likelihood of deal completion. However, from a micro perspective, judging the probability of a deal closing requires significant expertise and due diligence.
The key document governing an acquisition is the definitive merger agreement. This document details all conditions for closing the transaction. In addition, it outlines all actions that the target and acquiror shall, and shall not, do.
At the most fundamental level, a deal cannot complete if the conditions for closing have not been satisfied (unless they are waived).
As applied to the Twitter / Musk transaction specifically, the following were the substantive conditions detailed in the merger agreement:
- Shareholder approval
- Antitrust and foreign investment approval
- No Material Adverse Effect (“MAE”) has occurred
- Target and acquiror performing their obligations required under the agreement
Shareholders were rewarded with a 37.9% premium in a shaky market, so the shareholder vote was highly likely to be successful. In addition, Musk already owned nearly 10% of the shares outstanding, and he agreed to vote those shares in favour of the deal.
Antitrust approval would be no issue since the transaction had no anticompetitive effects. In addition, foreign investment approval was not required, given the buyer was American.
Note that under the merger agreement, financing was not a condition to closing. Musk had secured financing prior to entering the definitive agreement. Moreover, it is rare for a target to agree to a buyout if the acquiror does not have committed financing.
However, that is not to say that financing was not a risk to closing, manifested through the fourth condition outlined above (the acquiror performing its obligations).
Concurrently with the merger agreement, Musk secured $25.5 billion of fully committed debt and margin loan financing while also providing a $21.0 billion equity commitment – sufficient equity and debt capital to close the deal successfully. Banks that stepped up and committed the required debt financing included Morgan Stanley, Bank of America, Barclays, MUFG, BNP Paribas, Mizuho, and SocGen. These are some of the largest, most reputable, and most well-capitalized banks in the world. They would be good for the money.
Musk is well-known as the world’s wealthiest person, with an estimated net worth of more than $200 billion. In this context, the $21.0 billion equity commitment did not seem like a stretch. However, the equity commitment contained some critical details that potentially placed the funding on shaky grounds.
More than half of the initial $21.0 billion equity commitment was to be funded by a $12.5 billion margin loan to Musk. This $12.5 billion was lent against Musk’s unencumbered Tesla stock. With this detail, the equity commitment was suddenly dependent on Tesla stock not crashing. Effectively, those betting on the success of the buyout transaction were short a put option on Tesla stock (granted an option that was well out of the money at the time).
While the deal was not conditioned on financing, the financing was the most significant risk when the deal was first announced given the large margin loan was contingent upon volatile Tesla stock.
During the month after the deal was announced, a few key events occurred with respect to the equity financing. First, on May 5, Musk received $7.139 billion of third-party equity commitments, increasing his equity commitment to $27.25 billion and reducing the Tesla stock-backed margin loan to $6.25 billion. These third-party equity commitments came from Larry Ellison, Sequoia Capital, Qatar Holding, and others. In addition, Saudi Prince Alwaleed bin Talal, a major Twitter shareholder who initially opposed the deal, agreed to roll his equity into the privatization of Twitter, reducing Musk’s required equity cheque.
Then, on May 25, Musk allowed the margin loan to expire while boosting the equity commitment to $33.5 billion. Over the deal cycle, Musk sold more than $15 billion of Tesla stock over almost 340 separate transactions to fund taxes payable and the Twitter commitment. In addition, he sold $16 billion of Tesla shares in 2021. These transactions, along with third-party equity commitments, were enough to eliminate the margin loan, removing the most significant risk in the buyout.
While the margin loan reduction significantly reduced the deal risk, other issues quickly emerged.
By the summer, the macro situation had worsened, stocks were falling, and shares of social media companies were plunging. Under this backdrop, Musk realized he was significantly overpaying for Twitter at $54.20 and wanted out.
On July 8, Musk dropped a bomb that he was purportedly terminating the merger agreement. Initially, he used the excuse that Twitter’s disclosure of bots as a percentage of monetizable daily active users (“mDAUs”) was materially misstated or perhaps even fraudulent, which would allegedly lead to a Material Adverse Effect (“MAE”). Proving that an MAE had occurred was likely the only mechanism that would allow Musk to get out of the deal.
The issue with MAEs is that they are nearly impossible to prove. Specifically, in the history of modern M&A, a target has successfully relied on an MAE to terminate a deal just once (see Akorn, Inc. v. Fresenius). In the case in which the buyer successfully got out of a merger based on a purported MAE, the target’s business had fallen off a cliff and had suffered materially. Not only did the target’s financial performance decline dramatically, but regulatory issues also came to the forefront.
In Twitter’s case, nothing fundamentally detrimental had occurred to the company. It had clearly not suffered an MAE, and its disclosure of its estimate of bots as a percentage of mDAUs was impossible to prove false. On September 1, I told Global Finance, “It’s basically impossible here to claim an MAE.” Many have tried in the past, and nearly all have failed.
Musk’s case was built on quicksand and Twitter knew it.
Therefore, shortly after Musk moved to terminate the deal, Twitter sued to enforce the merger agreement and get the courts to force Musk to buy the company at $54.20 per share.
Specific performance is a clause in merger agreements in which one merging party can sue to get the other party to perform their obligations as set out in the merger agreement. Courts force buyers to follow through with deals in which the would-be acquiror got cold feet. Many market participants did not understand this dynamic.
In addition, there was a significant misunderstanding regarding the $1 billion reverse break fee featured in the transaction. Specifically, many prognosticators believed that Musk could pay the $1 billion reverse break fee and “just walk away”. This is not how break fees work. When a definitive agreement is signed, the parties agree to perform on a best-efforts basis their obligations outlined in the agreement. Just walking away was never an option. Neither was conducting additional due diligence, which is performed prior to signing a definitive agreement.
Modern definitive merger agreements are notoriously difficult for buyers to wriggle out of. They evidently assign the market risk to the buyer. These contracts have been designed over decades to vaccinate against cold-footed would-be acquirors.
While much drama ensued in discovery leading up to the Musk v. Twitter trial, it did not go Musk’s way. He was losing badly and likely did not want to face the embarrassment of a trial. Meanwhile, by September 14, all conditions of the deal had been satisfied. Twitter was ready and willing to close the deal, however, Musk continued to throw whatever he could at the wall to see what would stick to facilitate wriggling out of the deal. The issue was, nothing worked in discovery, and the odds were heavily tilted in Twitter’s favour leading up to the trial.
Consequently, on October 4, Musk’s legal team announced that he intended to proceed to close the buyout at $54.20 per share on October 28.
This was huge.
To execute a successful merger arbitrage investment, a deal requires several attributes:
- Attainable conditions, including regulatory, foreign investment and shareholder approvals
- A credible buyer with the means to close the deal
- Confidence in the consideration paid
- Certainty around deal timing
The conditions to satisfy the Twitter buyout were always the easiest part. Shareholders overwhelmingly approved the deal. It breezed through antitrust approval and did not require foreign investment approval. These conditions were satisfied within the first four months of the deal announcement.
Musk has a net worth of over $200 billion, so theoretically, he could honour his financial obligation. While there briefly was financing risk given the margin loan, it was eliminated relatively quickly.
As for the deal terms, typically merger litigation is settled via a price cut.
During the 2020 Covid bear market, five M&A transactions hit turbulence but were completed with an average -9.3% downward price adjustment:
- Forescout / Advent: -12.1%
- Delphi / BorgWarner: -5.0%
- Advanced Disposal / Waste Management: -8.6%
- Taubman / Simon: -18%
- Tiffany / LVMH: -2.6%
I publicly stated that a negotiated price cut to $50.00 would be the most probable scenario for Twitter and Musk to settle the litigation. In the throes of their drama, it was reported that Musk and Twitter did in fact nearly settle the battle at $50.00 per share.
Nonetheless, $54.20 cash per share was on the table, with Twitter stock trading at a significant discount.
The one major hurdle in allocating to the Twitter merger arbitrage was the uncertainty around the timing of closing.
Litigation can be an extremely lengthy process.
The recent deal litigation regarding Change Healthcare and UnitedHealth Group exemplifies the difficulty of investing in a merger target mired in litigation.
On January 6, 2021, UnitedHealth announced the friendly acquisition of Change Healthcare for $25.75 per share, a 41.2% to the target’s unaffected price of $18.24. The parties indicated that they expected the merger to close in the second half of 2021, implying an approximately nine-month deal timeline. On announcement day, Change’s stock rallied to $24.00, representing a 7.3% gross spread and an expected 9.7% annualized yield (7.3% x 12 months / 9 months).
The Change/ UnitedHealth deal became embroiled in antitrust risk, with the U.S. Department of Justice (DoJ”) initially delaying the deal well past the initial expected closing date and then, on February 24, 2022, suing to block the deal.
The merging parties disagreed with the DoJ and went to court. After nearly seven months, the federal judge ruled against the Justice Department’s antitrust challenge. The corporations won and closed the merger on October 3, 2022.
This closing date was a year later than they initially expected the transaction to be completed, a significant delay caused by the litigation. As a result, for investors, the initial 9.7% annualized yield was whittled down to just 4.2% annualized (7.3% x 12 months / 21 months).
The initial 9.7% yield was attractive. The resulting 4.2% yield, which decreased dramatically due to lengthy litigation, was not. In merger arbitrage, duration matters.
Therefore, the final piece to the puzzle in allocating to the Twitter merger arbitrage came into place when on October 4, Musk shocked the market by seemingly giving up opposing the deal and agreeing to close the buyout at $54.20 per share on October 28.
On October 5, I told Yahoo Finance, “Musk just indicated he will close on the terms at $54.20. All conditions have been satisfied and debt financing is committed. It’s looking like this is a done deal.”
So that’s that, right?
Turns out, there was a great deal of misinformation and fear priced into Twitter stock, and it hovered around a 7% discount to the consideration, despite having a reasonable certainty of closing.
With less than a month to closing, the Twitter merger arbitrage offered an approximately 100% arbitrage yield (7% gross return over a few weeks) with all conditions satisfied and closing timing disclosed. This was an extremely attractive arbitrage situation, and at this time the Accelerate Arbitrage Fund (TSX: ARB) acquired Twitter shares, making the arbitrage investment one of the Fund’s largest positions.
Source: Bloomberg, Accelerate
In addition, on October 21, just seven days before the deal was to close, a journalist wrote a rumour that the Twitter / Musk buyout may require foreign investment approval from a Government agency called the Committee on Foreign Investment in the United States (“CFIUS”).
Any rational arbitrageur knew this rumour was completely false, as CFIUS approval only applied to international investors (not to U.S. citizens). As such, the Twitter buyout was not conditional upon CFIUS clearance.
Nonetheless, this false rumour caused Twitter’s stock to trade down to around $50.00, offering an approximate 8% gross return to the expected October 28 closing one week later. An 8% return in one week is like 400% annualized, which is pretty good when bond yields are 5%. ARB capitalized on the volatility and increased its position in the Twitter arbitrage. I went on BloombergTV, calling the rumour “noise” and reaffirming my confidence in closing.
Accelerate waited patiently through the drama and price volatility, looking for more clarity on the certainty of closing before entering the arbitrage opportunity once we believed that the risk/reward was heavily in our favour.
How attractive was the risk/reward? ARB was able to generate a 6.5% weighted average gross yield on its Twitter share acquisitions starting on October 5 and again on October 21. With the deal closing on October 28, this equated to a 170% annualized return.
Ultimately, the Twitter / Musk merger arbitrage was a good case study of the risks and opportunities in merger arbitrage.
What was revealed is that there’s a widespread misunderstanding of several important issues affecting M&A, including how merger agreements actually work, MAEs, CFIUS, break fees, and merger litigation, amongst others.
In addition, the deal showcased the modern definitive merger agreement’s strength while also highlighting how expertise in M&A can give an investor a significant advantage over the market.
By capitalizing on our nearly 15 years of experience professionally running arbitrage hedge funds and using it to successfully navigate the Twitter / Musk buyout, we were able to generate an attractive yield for ARB clients with high certainty and do so in an uncorrelated fashion.
Consistent and uncorrelated returns are the crux of a successful merger arbitrage strategy.
Happy investing,
-Julian
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