BHP/Rio Tinto

In November, the huge Australian mining company BHP Billiton announced a bid to acquire a rival company, the Rio Tinto Group, with a 3-to-1 share swap. In other words, it wanted Rio stockholders to turn in each of their shares for three shares of the new, larger, combined company.

The offer was sweetened a bit in February (3.4 to 1) and in that form is still on the table. Oddly, the prices of the two companies haven't really been trading as if the market finds this offer credible.

If there were a significant amount of arb activity, and a general expectation that the deal would go through, one would expect that the price of a share of Rio stock on the market would be, roughly, 3.4 times the value of a share of BHP stock. So if (just choosing my numbers to make the math easy here) BHP is trading for Aus$40 on a given day, you'd expect to see Rio shares trading for Aus$136.

Why? Because there's a good deal of speculative activity out there that is specifically in the merger arb business. (Sometimes, much less fittingly, called "risk arb," a usage I'll ignore). If the two company's market valuation got out of line, you'd expect the people and institutions in the merger arb business to act on it. Suppose, in may example, BHP is at $40 and Rio is a good deal lower than the valuation implicit in the 3.4 to 1 ratio. Suppose Rio went to $80, which implies a 2:1 ratio. What would happen?

The merger arbs would move in and buy Rio shares like mad. They'd do so in the expectation of being able to trade in each one for their 3.4 shares of BHP -- getting a return of $136 for each investment of $80, an easy $56 if ever there was one. The very fact of their moving in to do this would constitute an increase of demand for the stock of course, increasing its price -- forcing its price up to the level dictated by that 3.4 offer.

To repeat, that's what would happen IF two conditions obtained: there was a general expectation the deal would close, and there was a lot of arb activity.

Apparently one or both of those conditions is missing. Rio is trading at a discount of more than 8% to where it "should" be on such reasoning. Why? I'm guessing the market believes regulators in one or another of the many affected jusridictions will intervene and stop or complicate the deal.

Glass Lewis

One of the frequent complaints of good-governance activists is that many corporations today, especially those headquartered in the United States, combine the roles of quarterback and coach -- or, to drop the metaphor, they combine the roles of chief executive and chairman of the board.

Activist shareholders of Exxon Mobil -- where Rex W. Tillerson bears both titles -- have brought this issue to a head -- it will be voted on as "Proxy Item 5" at the company's annual meeting May 28.

They did likewise last year, and garnered 40% of the vote. The task this year will be to build on that figure. They have an ally in Glass Lewis, an independent proxy advisory firm, which is recommending that shareholders support the call for an independent chairman.

In a statement yesterday, Glass Lewis said that such a separation is "almost always a positive move."

I wonder whether there is any arb fund out there that makes use of such good-governance principles by pairing companies. One might find two companies that are in the same industry and otherwise similar operationally, BUT FOR one of these "takle your vitamins" type rules the folks at Glass Lewis like to tell us about.

Oil company A has two people in these two roles, oil company B combines them.

So (on my imagined scenario) an arb fund would be long on A and short on B.

Is anybody doing that? And how well?

If anyone reading this knows the answer to that question: get in touch. Thanks.