Farallon Capital Management: Risk Arbitrage Harvard Case Solution & Analysis

Proposed Alternatives and Solution

Ultimately, Farallon Capital Management is left with three options. These are given below:

  • The first is to continue to hedge market risk by short selling BT shares. If it chooses to hold the position, then there would be potential losses in the case of failure of merger and negotiation as well.
  • The second option is to gradually reduce the position of short selling. This would allow the fund to diversify the investment and reduce the percentage of investment of asset under management in this deal.
  • The third and last one is to abandon the position completely so that no risk from BT – MCI deal remains in the umbrella of fund.

Seemingly, there is a high probability of at least a re-negotiation, if not termination. The low share price of BT reflects the possibility of merger whereas; it also reflects the dilution of BT. Most of the prospects indicate that the deal will be negotiated. In these circumstances, it is best for Farallon Capital Management to use multiple strategies to reduce the losses and find possible ways to maintain its past performance.  If the deal is terminated, then the market speculates other potential mergers for MCI, so the anticipated market value of MCI would not fall down to that level from where it initiated before the merger announcement.

Critique / evaluate on the proposed “talk points” to clients.

Sometimes, the companies try to involve in poison pills to avoid a hostile takeover. Thus, the companies deliberately try to devalue the price of its shares to protect itself from any hostility. However, the fact that MCI was consistently denying the probability of termination of deal whereas a constant pressure from BT to re-negotiate the deal remained was an alert for the investors and the risk arbitrageurs to look for ways to take their hands out of the deal.

At this point, if the Farallon Capital Management suddenly pulls out its hand from the deal then it would send a wrong signal to the market and the ultimate results would bring hap hazards in the market, even if they were not destined to happen in normal situation. The selling of huge equity would also result in subsequent losses for Farallon Capital Management.

Thus, Farallon Capital Management should choose the second option for the time being and start to give up its position gradually unless it finds a potential buyer at a right price that suits the funds. In the meanwhile, other opportunities should be spotted and tapped that could help the company survive its profits. The freed up cash should be utilized in the deals that have a strong negative correlation with the current deal so that the risk of the portfolio could be diversified (Bettis& Hall, 1982). Various sources of information should be used for this purpose as the company has been practicing it in the past.

Historical Risk Return Analysis

From the Exhibit 1 of the case, this fact is clear that Farallon Capital Management has managed to keep the returns fairly high because of its expertise in the field and thoughtful selection of the portfolio. According to the theory, the risk and return have a positive relation and are directly related to each other. A higher risk would mean a higher standard deviation (Amit&Livnat, 1988);however, Farallon Capital Management has managed to keep the average annual compound return high with an unusual feature of keeping the annualized standard deviation low which no other company has achieved.

Concluding remarks

The strength of the company, that it is not heavily leveraged will result in a favorable position for Farallon Capital Management. In the worst case scenario by the chosen option to dilute the investment gradually, Farallon Capital Management would be able to absorb the losses because of this strength. Even if the company is not able to give up its position entirely; it would not be kicked out of the market like other hedge funds that are heavily leveraged. Since Farallon Capital Management has gone long in MCI shares and short in BT shares, hence the risk would be leveraged out.

In the best case scenario, the company would end up in profit by investing and diversifying in different securities. This step is important for Farallon Capital Management because a sudden decline after three years would question the ability of the funds and investors would deeply investigate this unusual behavior. The efforts of Farallon Capital Management to keep the standard deviation and beta quite low will no longer benefit the company at least in the near future...................................

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