Lessons in Merger Arbitrage: The J & J/Guidant Deal

Yesterday's news included the revised deal by Johnson & Johnson for Guidant, the medical device maker.

PHILADELPHIA -- Johnson & Johnson will acquire medical device maker Guidant Corp. for 15 per cent less than previously agreed, rescuing a deal that nearly collapsed in the wake of safety concerns and litigation over Guidant's heart products.

The November 15 announcement with revised deal terms came at a particularly advantageous time for me, as I am teaching an alternative investments course at a local university and how various relative value arbitrage strategies work was a topic for discussion.

The J & J/Guidant merger is a particular good case study, as it illustrates several elements of the merger arbitrage strategy and the factors a merger arbitrageur weighs: the terms of the deal, the likelihood of regulatory approval, and the risk of unanticipated events on the deal completion. It gives an understanding of the return profile for merger arbitrage, with large kurtosis and negative skewness.

Though the original definitive agreement announced December 15, 2004 called for J & J to acquire Guidant for a cash and stock package valued at $76, revelations by Guidant beginning in mid-June, 2005 led to warnings or recalls affecting about 88,000 heart defibrillators and almost 200,000 pacemakers.Not surprisingly, this left the completion of the deal in doubt (and caused the premium to blow out-see above), with The Deal reporting October 28 that “arbs are scurrying to review law on “material adverse effect”, a clause which might allow J & J to get out of the deal without paying the break-up fee. Speculation in early November had the parties negotiating with different valuations in mind, Guidant at $67-68 and JNJ at $61.

The revised deal value of $63.08 ($33.25 cash and .493 JNJ)averted a court battle about whether the defibrilator and pacemaker recalls and warnings amounted to a "material adverse effect".

link: J&J to buy Guidant at a 15% discount