by TMFDeeJ aka Jason Knapp

I Hate Merger Arb, But This One Sure Is Interesting

Normally I do not engage in the investing strategy called merger arb. For those who are not familiar with it, merger arb involves purchasing the shares of companies that are in the midst of being taken over in an attempt to profit from the gap between the stock is currently trading for and the amount that the acquiring company will pay when the deal closes. In days of yore, when trading was more difficult for individual investors and there wasn't millions of Hedge Funds wringing every single penny out of arb opportunities, one could make decent money using this strategy. However, in today's market the spreads that are available for merger arb situations are usually so narrow that many, including myself, now equate the strategy to picking up nickels in front of a steamroller. Sure, you can grab a few of them, but eventually you're going to get squashed by a deal falling apart and potentially lose all of your previous merger arb profits and then some.

Now that I've completely bashed this investing technique, I am going to share the first interesting merger arb opportunity that I have come across in some time. Word broke earlier today that Energy Transfer Equity (ETE) has made an unsolicited takeover offer for fellow pipeline operator Williams Companies (WMB), sending the latter's stock soaring over 25%.

Williams promptly rejected the ETE takeover bid and retained Barclays PLC and Lazard to investigate selling itself to another company at a higher price, merging with a different company or continuing down its current path. The offer rejection is not all that surprising, many analysts viewed it as being too low. The uncertainty that now surrounds WMB has an impact upon another stock, Williams Partners L.P.

The general partner WMB is in the midst of taking over its limited partner WPZ, mirroring a similar recent move by Kinder Morgan Inc (NYSE:KMI), Inc.

Investors are speculating that should WMB be taken over, the deal to purchase the limited partner would fall apart. Indications are that the ETE bid requires the cancellation of the merger of the Williams General and Limited partners. Shares of WMZ are down nearly 8% as I type this. For merger arb in today's market, the spread between the takeover offer for WMZ and its current price is now pretty large. WMB's takeover offer for WMZ was an all-stock deal that provided 1.115 ratio of Williams common shares per unit of Williams Partners. At the time the deal to buyout WMZ was announced, that amounted to $55.80/share. Now that shares of WMB have skyrocketed following the unsolicited takeover target, the offer to takeover $WMZ amounts to a whopping $69/share. That represents a range of 13.8% to 40.8% upside in WPZ stock should the deal close.

Of course, in order for the WPZ deal to close, any potential WMB deal might have to fall apart. Should that happen, you'd be looking at upside in WMZ likely at the lower end of the above range. Even a spread of say 15% would be huge though, if the WPZ transaction closes as scheduled in Q3 2015. We're talking about an annualized gain of 30% should the deal close around year-end, with the potential to increase dramatically should it close before then.

There's always downside in merger arb situations. So what's the downside here? If WMB is eventually taken over by ETE or someone else and the offer to purchase WMZ is torpedoed, its stock would likely drop to the level that they were trading around before it accepted the takeover by WMB, around $47.50/share. That represents only 3% downside on a stock that yields a massive 6.4%.

The reason why I don't normally engage in merger arb is the profits are normally very small and the downside is normally very large. However, using my rough back-of-the-envelope numbers, it looks like investing in Williams Partners L.P. at the current level offers 15% to 40% upside in exchange for 3% downside. I like those odds. I normally do not engage in merger arb, but this one certainly is interesting. I may initiate a position Williams Partners in the near future.

I'd love to hear others' thoughts on how this situation might unfold and the potential to profit on Williams Partners' stock.