Comcast boasts more Internet subscribers than those who have signed up for cable TV packages from the company.
Photograph by Joe Raedle — Getty Images
By Jen Wieczner
April 25, 2015

For investors like Roy Behren who bet on corporate acquisitions, the worst case scenario is for a proposed deal to fail. The takeover target’s shares usually plummet after a merger collapses, decimating the investor’s portfolio like a bad day at the blackjack tables.

But a funny thing happened this week after Comcast withdrew from its blockbuster merger with Time Warner Cable because of antitrust concerns. Instead of taking a hit, Time Warner Cable’s shares (TWC) shot up 4.4%.

“It’s ironic that the day that Comcast comes out and says it’s pulling out of the deal, Time Warner Cable is up $6.50,” says Westchester Capital Management’s Behren, who oversees the $5.4 billion Merger Fund, a mutual fund that invests in takeover targets while shorting their acquirers.

The reason? The market, he says, believes that there’s a dark horse getting ready to swoop in with its own bid for Time Warner Cable, likely Charter Communications (CHTR)—the same company that lost out to Comcast in the original scramble for Time Warner Cable last year.

Charter declined to comment on whether it would make a new offer for Time Warner Cable, but its shares rose by a little more than 1% on Friday. Then again, Comcast’s shares (CMCSA) rose nearly that much as well. Given the uncertainty, deciding which telecom stocks are best to buy now is tricky.

Behren, however, correctly predicted the unraveling of the Comcast merger, and gave Fortune a peek at how a pro merger arbitrage investor would play the situation.

Up until the end of 2014, Behren’s Merger Fund held a $262 million stake in Time Warner Cable–making it the fund’s largest holding. Taking such a big position reflected his confidence that the takeover by Comcast would be successfully completed, he explained. “We would not invest in a deal that’s a coin flip.”

But over the past few months, Behren and his team started to notice an unnerving pattern in Time Warner Cable’s stock price: It was trading far below Comcast’s offer of about $159 per share. Since shares of Time Warner Cable would be worth that much if the deal went through, the fact that they were so much cheaper—as low as $136 on January 30—meant that people were starting to doubt that the merger would actually happen.

Behren began talking to the companies, as well as their competitors in the industry, to glean intelligence about how regulators were likely to view the merger. The companies, of course, never disclose any confidential information, nor do they give any signs that a deal is going south. So it’s Behren’s job to read between the lines (and inevitably relentless corporate optimism), with the help of antitrust experts and lawyers who advise Westchester Capital’s portfolio managers. “They’re not going to say to us, ‘We just had a really crappy meeting with the F.C.C. and we’re worried that they’re going to block the deal,” he says. “We draw our own conclusions.”

As Behren and his co-managers gathered information and watched as the government put new regulations on Internet service providers, they started losing hope for the merger. Considering the risks of having a long position in Time Warner Cable when the deal collapsed, they began selling their stake. “Going into this week, it was a fraction of where it was back in [December],” Behren says.

It was a tough call: Because Time Warner Cable shares were trading below what Comcast was willing to pay for them (a differential known as the deal’s “spread”), selling them now—or not buying more—would mean leaving money on the table if the deal ended up actually happening. “It’s pretty difficult. When you see a deal spread widening out, it means that there’s more money to make, so it’s not easy to have the discipline to unwind the position,” Behren says. “But our job is to invest in deals that have a high likelihood of being completed.”

(Because merger arbitrage involves shorting the acquiring company in proportion to the investment in the acquisition target in order to hedge risk, Behren simultaneously bought back shares of Comcast which he had sold short.)

Though he’d anticipated that the deal could fail well in advance of the reports this week that government bigwigs opposed it, the last few days were a whirlwind as Behren and his team followed the developments, many of which were just rumors, and weighed how to adjust their stock positions. “We usually don’t see this much action,” he says.

While he won’t talk about his trading over the past couple of days because of compliance reasons, he described what a merger arbitrage strategy might have looked like. Since Comcast has officially put away its M&A pocketbook for the time being, it’s no longer appealing to merger arbitrage funds. So investors who were shorting it to balance out their Time Warner Cable bets would want to get out of that position. They would cover their shorts by buying back Comcast shares, which is probably why Comcast stock actually went up as the deal failed, Behren says.

But they wouldn’t necessarily cut bait on Time Warner Cable just yet. That’s because Charter may still be circling, and while pros like Behren wouldn’t just invest on speculation alone, Charter already made a very public run at Time Warner Cable last year. Indeed, Charter’s consolation merger with Bright House Networks, made after losing out on Time Warner Cable the first time, was contingent upon the Comcast deal happening. Presumably, Charter wanted to make sure that it was still able to buy Time Warner Cable should the Comcast deal fall through.

“If the investor thought that there was the legitimate possibility of Charter entering a deal with Time Warner Cable, it would be perfectly appropriate for an arbitrageur to have a position in Time Warner,” says Behren.

On the flip side, investors who really wanted to wager on Charter acquiring Time Warner Cable might even take the extra step of shorting Charter proportionately to their Time Warner Cable stake. But that is not something most people should try at home.

In the meantime, Behren noticed that shares in another pending deal — AT&T’s proposed acquisition of DirecTV (DTV) — are behaving strangely. On Friday, DirecTV’s shares dipped to more than $5 below the price at which AT&T (T) has agreed to buy them, “because of the negative PR from the Time Warner-Comcast deal,” Behren says. “It has people worried.”

But for investors who think that the AT&T deal has a better chance than Comcast’s, now might be the time to scoop up DirecTV for a near-guaranteed profit of at least $5 per share.

For more about the Comcast-Time Warner Cable deal collapse, watch this Fortune video:

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