Farallon Capital Management: Risk Arbitrage (A) Harvard Case Solution & Analysis


Farallon Capital Management is a risk arbitrageur or merger arbitrageur. The proposed merger announcement of British Telecom and MCI communication attracted many of the risk arbitrageurs to capitalize of the opportunity (Economic Policy Institute, 1998). Like every other merger deal, a risk of failure of merger existed which was to be borne by the risk takers that invested in the purchasing of MCI shares and shortly sold the BT shares. Farallon Capital Management was one of those risk arbitrageurs that invested in this deal to earn the profit through arbitrage.

Overview: The Issues / Business Case; the Parties Involved

The issue arose when MCI Communication announced its difficulties about the merger; sending a signal that the company might back off the merger deal and the potential risk faced by the arbitrageurs and other investors would come true as the share price would fall down drastically resulting in a loss for the equity holders.

The market was full of opinions and views that differed significantly from each other. Some parties were in favor of the deal and still wanted to continue with the investment; while others opposed this deal with full force. At this point of time, Farallon Capital Management needed to decide whether it should stay in the position where it existed or it should call off the deal to avoid the further potential losses.

Strength Analysis

The founders of Farallon Capital Management had a unique blend of experience that would lead them to the sky of success. Their experience in private equity and distressed property along with the expertise in public market helped them to establish a firm through which; they could unleash the untapped opportunities in the public market investment in risk arbitrage and distressed property. Moreover, other people with diverse experience and set of skills related to this field joined Farallon Capital Management to enhance its strengths.

In the past, the company’s strengths have facilitated the company’s performance through proper allocation of funds within and among the segments. When the market for risk arbitrage in mergers was low, the company shifted the capital to other segments in order to keep the returns stable. This strategic allocation of capital increased the profitability and return levels of the company.

Another major strength of the company was the maintenance of the low risk. Farallon Capital Management gave priority to capital preservation to protect its investors from heavy losses. The beta of the fund, that measures risk of the company and is a major source of fluctuation in the expected return from the company, was below 0.2 in the last three years. The returns averaged 11.6% in the last decade and the volatility of those returns was also very low and leverage was kept far below the maximum level allowed by Federal Reserve Board’s regulations. All these facts represented the strengths of the company. Above all, Farallon Capital Management also used stock index futures when it was required in order to keep the risk under control which further added to the strength of the company.

Potential risks involved in this credit derivative deal

Although Farallon Capital Management was a hedge fund but shared the characteristics of a mutual fund (Weithers, 2007). It had the authority to choose a particular investment strategy and to involve in risk management to attain a higher return. However, Farallon Capital Management did not use leverage to provide higher return on equity by compromising on its high return on assets.

The BT – MCI merger showed upcoming positive potential for the risk arbitrageurs as it was termed as the largest international merger ever (CNET, 1996). However, this huge opportunity did not come without heavy risks. The potential risks for Farallon Capital Management involved in this credit derivative deal were the risk of failure that might result from the undisclosed terms of mergers or the fact that BT can back off the merger if the core business of MCI had materially declined. This was seemed to be happening by the announcement of difficulties faced by MCI.

Along with that, other potential risks were the involvement of international parties in the merger. There are different political and legal barriers when foreign countries are involved in any deal. The actual spread from the deal was far below from the expected returns for Farallon Capital Management. It claimed that the risks were not being assessed properly by the market; hence this resulted in increased interest of the general public and other hedge funds in the deal. Thus, the market forces were reducing the likely spread for the risk takers or arbitrageurs because the huge influx of the mergers in this time period and the potentially high returns from this type of investment had been giving a wrong perception to the market about the level of risk involved in the deal.

The biggest risk for Farallon Capital Management was that it had already invested approximately 9% of asset under management in this deal. Thus, any upside or downside potential would........................

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Farallon Capital Management, an investment company that specializes in risk arbitrage, has made significant long and short positions at MCI Communications and British Telecommunications, respectively, in the hope that the proposed merger of these companies will be successfully completed. Raises questions facing Farallon both positive and negative experiences of becoming unfold. Provides a rich understanding of some of the institutional investment strategies involving short-selling, as well as for understanding the merger arbitrage and its function in the capital markets. "Hide
by Andre F. Perold, Robert Howard Source: Harvard Business School 27 pages. Publication Date: 06 Oct 1998. Prod. #: 299020-PDF-ENG

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