Why Hedge Funds Lost in Pfizer-Allergan

Many traders and large hedge funds trade strictly in merger arbitrage. These traders look at deals that have already been announced, and examine the deal terms and the levels the stocks are trading. If they think the chances of the merger going through are great, but the stock being acquired is trading below where it “should,” they see opportunity and will often buy shares (or call options or take some other bullish position). In the case of Pfizer-Allergan, there was plenty of “opportunity.”

Two weeks ago, extreme pain in my lower back woke me from a sound sleep. As the night progressed, the pain became so intense, that I spent the night in the emergency room. I had kidney stones. As I lay in that hospital bed waiting for the pain medicine to work, I vowed, “NEVER AGAIN!”

Hedge funds that suffered huge losses due to the breakup of the Pfizer-Allergan merger must have felt similar pain.

The U.S. Treasury Department recently announced new rules that would limit companies’ ability to participate in inversions. The new rules put the Pfizer (PFE) and Allergan (AGN) merger in peril.

I took an interest in this because I had an open position in PFE, owning call options (a bullish position) since January.

In the case of PFE/AGN, there was plenty of “opportunity.” The day before the Treasury’s rule changes, AGN closed at 278. Based on the details of the deal, if PFE and AGN merged, the stock would be priced around 340—that’s $62 of potential gains!

The opportunity was so large that, as of the December 31 filing, AGN was the top holding of hedge funds, with 80 funds holding AGN among their 10 largest positions.

Hedge Funds Took the Bait

So why did the ruling play such havoc with the PFE/AGN merger? It was a case of Fool’s Gold and many hedge funds took the bait.

Here’s what I mean.

Hedge funds, of course, like to hedge, and they did so in this case: they hedged their huge long exposure to AGN by shorting huge amounts of PFE. That probably explained the rising short interest in PFE stock over the prior few weeks and why the stock had been so weak.

Fast forward to the day the new rules were announced. With so many funds caught on the wrong side of the trade, AGN plunged $41, and has fallen further since. Clearly, many hedge funds sold their AGN—and also closed the rest of the trade, which meant covering their shorts on PFE. Sure enough, PFE surged about 10% in the three days since the rules came out and the deal was called off.

Last year, something similar happened when the AbbVie (ABBV)-Shire (SHPG) merger fell apart. Like the PFE/AGN arbitrage, the ABBV/SHPG arbitrage resulted in a very large hit for many hedge funds. Despite their losses when the ABBV/SHPG merger fell apart, the hedge funds saw a great opportunity with PFE/AGN and couldn’t resist trying again.

Similar to the hedge funds, I too had not learned my lesson. About four years ago, I had a similar experience with kidney stones, and just like my recent incident, I vowed NEVER AGAIN. So in the weeks that followed my first experience, I followed the doctor’s recommendations, drinking plenty of water and cutting down on salt. But as time passed, I went back to drinking one glass of water a day and found my hand at the bottom of a bag of potato chips.

Three Important Concepts to Remember

I hope my medical experience and these hedge fund losses will remind you of three important concepts:

First of all, there is no free lunch. When you see something in the market that’s too good to be true, it usually is.

Second, there is always the risk of a bad outcome. In the case of PFE/AGN, many of Wall Street’s smartest minds forgot that, and lost big money as a result.

Third, if you keep an open mind, there can be opportunities to benefit from “crowded” trades when signs point against them. That’s part of the reason I was long PFE calls, which snapped back nicely on the news after a rough prior few weeks. In case you’re holding AGN long and wondering what to do now, here’s Cabot Benjamin Graham Value Investor analyst Roy Ward’s recent analysis on AGN:

Allergan plc (AGN) announced that its merger agreement with Pfizer (PFE) has been terminated by mutual agreement. Per their agreement, Pfizer will pay Allergan $150 million for the reimbursement of expenses associated with the transaction. Pfizer had sought to merge with Allergan and relocate to Ireland to take advantage of lower corporate tax rates in Ireland, where Allergan is headquartered. The resulting tax inversion could have saved Pfizer billions of dollars, and deprived the U.S. Treasury of future income taxes from the company. Pfizer and Allergan will continue to develop and sell drugs, and merge with smaller partners. Pfizer will likely join a campaign calling for an overhaul of the tax code for U.S. corporations. High U.S. taxes place corporations at a disadvantage when competing with foreign businesses. Hold.

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Sincerely,

Jacob Mintz
Chief Analyst of Cabot Options Trader and Cabot Options Trader Pro

Jacob Mintz

Jacob Mintz is a professional options trader and editor of Cabot Options Trader. Using his proprietary options scans, Jacob creates and manages positions in equities based on unusual option activity and risk/reward.