Farallon Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

Potential risks involved in credit derivative deal

Farallon always tried to get high returns on assets but resisted opportunities to leverage low returns on assets into high returns on equity. The risk arbitrage market had seen many pitfalls such as the period following the guilty plea of Ivan Boesky on illegal stock parking charges in October 1986 and the collapse of the United Airlines leveraged buyout in October 1989. Arbitrageurs who were highly levered when they entered into these markets as they were put out of the business.

In Risk arbitrage, the outcome following the announcement of a proposed merger can be uncertain. One possibility is that the proposed acquisition will fail due to resistance by the target company. In addition, the management of the target company may appeal to its shareholders to vote against a proposed acquisition. Alternatively, the target company may decide to sell the company to another bidder. Even if the target company agrees to a merger, still a deal can face complications from regulatory agencies. Lastly, even if a deal will eventually be completed, still the closing date remains uncertain and the final terms may be revised, which pose exposure to risk arbitrage market.

Proposed Alternatives and Solution

Throughout BT/MCI deal, Farallon hedged its purchase of MCI shares through the short sale of either BT ordinary shares or BT AmericanDepositary Receipts (ADRs). In addition, Farallon also hedged the currency exposure in BT’sdividends. Since, the shocking announcement of MCI, Farallon has been exposed to various potential risks that can be dealt by continuing short sell BT shares to hedge market risk, which will reduce the short selling position or withdraw from the position entirely.

If Farallon withdrew from its position, then it would result in huge losses that have to beared, and Farallon being a low leveraged firm can sustain that position. If Farallon chose to continue short sell BT shares to hedge market risk , then there would be a 50% chance to either succeed or fail. In case of success, Farallon would be able to generate high gains from this deal; however, in case of failure, it would still have to bear all the losses arising due to cancellation of the deal between BT and MCI. The last option for Farallon was to reduce its short selling position, which would help to reduce the current 9% of investment of asset under management and would allow the firm to avail other opportunities.

Among the leading Wall Street equity research analysts, Grubman was in support of the deal, stating that there was no chance of renegotiating this deal and that MCI was a unique and valuable asset, and, even if the deal got terminated, still there would be other buyers ready to acquire MCI. Reingold, another equity research analyst believed that MCI’s shares were worth only $20, which was not the current price of $35; therefore, BT would take benefit of this opportunity to walk away from the deal or, at least, adjust the price that it wants to pay for MCI. In these highly uncertain situation, Farallon should use a combination of these strategies to mitigate the risks and losses, and should find possible ways and take necessary steps so as to sustain its past performance.

Evaluation on the proposed “talk points”

On July 9, 1997, MCI called an unscheduled teleconference in which it announced that it would meet the market’s second quarter earnings expectation, but the costs associated with entering local telephone markets would be significantly higher than expected. MCI’s future earnings expectations went down to almost 50% due to losses inexcess of $800 million associated with local entry. MCI also said that competitive pressures would lead to lower earnings thanexpected in the long run. Moreover, there’s a $150 million termination fee if companies don’t complete the sale (Exhibit 9)..............................

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