Woodside and Santos scrip-based merger proposal is a classic hedge fund arbitrage play

About the merger proposal

Santos Limited (Santos) and Woodside Energy Group (Woodside) on 7 December, in response to press speculation, were forced to announce that both companies had commenced preliminary discussion regarding a potential merger. The consideration of any merger is at an early stage and there is presently no agreement between the parties.

Merger arbitrage opportunity being played out

The scrip-based merger proposal put forward by Woodside directors to the Santos board is fertile ground for hedge funds and other institutional investors to profit from the arbitrage opportunity often seen in scrip-based mergers involving deeply liquid, high market capitalisation stocks. A scrip-based merger is where the merger consideration is paid in shares (scrip) rather than cash, where an agreed number of shares in the ‘target’ entity (in this case Santos) is exchanged for an agreed number of shares in the acquiring entity, in this case Woodside.

Immediately prior to the ASX release by both companies on 7 December confirming they have engaged in preliminary discussions regarding a potential scrip-based merger, Santos shares were trading at $6.78. This compares to $7.55 today, an eleven percent increase, implying that Santos shareholders expect to be appropriately rewarded, particularly in the short-term, with a higher (post-merger) share value in the larger Woodside entity compared to the Santos share price prior to the merger proposal announcement. Woodside shareholders are also set to ultimately benefit in that the proposed merger sees Woodside becoming one of the world’s largest oil and natural gas producers, with an estimated post-merger market capitalisation of $84 billion. A combined Woodside/Santos merger should see Woodside shareholders benefit from owning equity in a larger combined company considered by some analysts to be a LNG behemoth capable of producing more than 270 million barrels of oil equivalent annually.

The Woodside share price today is $31.24, about four percent higher compared to its price on the day prior to the announcement of its desire to merge with the smaller Santos. This share price action   reflects the typical market behaviour of hedge funds seeking to extract an arbitrage profit on the potential merger transaction by short-selling Woodside shares and placing downward pressure on the Woodside share price. The same hedge funds simultaneously use the cash proceeds of the Woodside shares short sale to buy shares in the takeover target, Santos. This means that the hedge fund has effectively not outlaid any cash to open the ‘long Santos’ position or the ‘short’ Woodside’ position. This simultaneous buy and sell share transactions are executed by computer generated algorithmic trading orders, as an automated response to the merger proposal announcement and explain the significantly higher trading volume in both stocks on the day of release on the ASX of the merger proposal.

The scrip-based merger arbitrage profit strategy is based on the notion that buying shares in the smaller ‘target’ entity (Santos) enables the hedge fund to acquire Santos shares at a value below the exit final value of the trade, post-merger. The profitable exit arises in the months ahead when the agreed number of Santos shares are exchanged for the agreed number Woodside shares, based on the pre-determined share exchange merger terms. The number of Santos shares to be exchanged for Woodside shares is generally based on the relative share price differential at the time of the merger implementation date. Hedge funds, by buying shares in the ‘target’ company, Santos, funded by proceeds from short-selling shares in the ‘acquiring’ entity, Woodside, are able to influence the share exchange ratio between the two companies. This is achieved by forcing the acquiring entity, Woodside, to offer a greater number of Woodside shares for Santos shares because the short-selling pressure on Woodside shares has exerted downward pressure on the Woodside share price, requiring Woodside to offer a higher number of lower-priced Woodside shares to Santos shareholders as purchase consideration for their Santos stock. Conversely, the buying support for Santos shares has increased it’s share price, which also requires Woodside to offer more Woodside shares as Santos purchase consideration, in line with the higher-priced Santos shares.

Once the merger transaction is settled with the exchange of shares at a future date based on the previously agreed share exchange formula, the acquirer’s share price (Woodside) typically displays price strength in response to the merger benefits such as cost synergies and significantly higher market capitalisation which encourages index buying. Woodside’s estimated market capitalisation post-merger is estimated to be $84 billion, compared to $59 billion today. This higher Woodside share price, when combined with the greater number of Woodside shares received in exchange for Santos shares purchased several months previously by the hedge fund, immediately following the initial merger discussions market release, represents the profit earned by the hedge fund successfully executing the merger arbitrage strategy. Merger arbitrage is generally considered a low to moderate risk strategy that requires minimal capital outlay, and so on a risk-adjusted basis, the returns are excellent.

Merger share price premium contention

Santos shareholders are likely to demand a control premium of around fifteen percent for handing voting control over to Woodside under the terms of the merger proposal launched by Woodside. This is especially the case since Santos’ corporate advisors are likely to argue that Santos shares were already under-valued prior to the initiation of merger talks by Woodside. On the other hand, Woodside shareholders want to ensure that Woodside directors don’t over-pay for Santos and dilute Woodside shareholder value.

Merger hurdles that must be addressed

The preliminary discussions between Santos and Woodside must address several regulatory, political and valuation hurdles before a merger transaction can eventuate. This is not unusual for a merger transaction of this scale and so shareholders can anticipate a lengthy and potentially drawn-out negotiation process before a merger, if any, can proceed. Santos is the largest company in South Australia and derives its name from the letters that stand for the words ‘South Australia Northern Territory Oil Search’. This suggests that the South Australian government may seek to require the merged entity to maintain a strong presence in Adelaide, despite Woodside’s head office being based in Perth.

These hurdles indicate that it may be several months before a merger can proceed, if this does eventuate.