Merger arbitrageurs love nothing more than new stock-market playthings. Dell, which agreed on Monday to acquire EMC, has given them a peculiar one: a tracking security pegged to the shares of EMC’s separately listed VMware software division. Investors don’t seem to love the idea.
In most M&A transactions, arbs have two shares to play with – one for the buyer, one for the seller. Not so in Dell-EMC, as the PC maker doing the buying is private. That’s where the tracking stock in VMware comes in. Getting to the $64 billion that Dell is offering by its own calculation (down from a headline price of $67 billion on Monday) depends on how the market values this not-quite-ordinary form of equity.
EMC’s fully diluted market cap stands at about $56 billion based on Tuesday’s closing share price, or some $8 billion shy of Dell’s number. That means the market isn’t giving full value to the VMware package, or else investors are concerned the deal won’t go through – or both. (See calculator.)
Dell says the transaction was originally worth just over $33 per EMC share. That figure combines the cash on offer with the value of 0.111 shares of VMware at last Wednesday’s average trading price. But the prospect of a wedge of tracking stock two-and-a-half times as big as VMware’s roughly 20 percent free float has lopped 15 percent off the network and server virtualization group’s worth.
Dell-EMC may also eventually sell some of its 80 percent stake in VMware to raise cash and reduce the nearly $50 billion debt pile accompanying the deal. This double overhang gives arbs plenty to think about with VMware stock alone.
What’s more Dell’s math, which as of Tuesday pegs its offer at $31.74 per EMC share, assumes a VMware tracker will be worth the same as an actual share. A lower value is likely because a contractually synthesized economic interest is much fuzzier than the real security it’s designed to mimic.
So it’s simplistic to suggest that EMC’s trading price means the merger has less than a 50 percent chance of success, assuming the share price would fall back to about $24 if the deal collapsed. It’s equally possible that investors are attaching a 100 percent probability but discounting the tracker stock by about half.
Tuesday’s closing prices offer mathematical middle ground, too – 75 percent certainty the deal will happen, with the tracker worth an implied 30 percent or so less than VMware stock. Now that’s a plausible starting point for a game of arbitrage.