Risky business, arbitrage, but that's the point

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Sir Iain Vallance and his chief executive at BT, Sir Peter Bonfield, are not the only ones praying that MCI's profits warning late last week does not prove a deal breaker. It transpires that the investment banking community's various arbitrage departments stand to lose at least $1bn if the merger fails - probably the biggest arbitrage hit of any deal in recent memory. Risk arbitrage may be a cleaner business than it was when Ivan Boesky ruled the roost, but at least he was well informed.

This was a merger that looked like an arbitrageur's dream. Both MCI and BT are big and very liquid stocks, but the possibility (always more apparent than real) that the Federal Communications Commission might eventually block the deal meant that the value of the deal has never been fully reflected in the MCI share price. As a consequence the arbs have been going massively long of MCI while at the same time "shorting" BT, a spread of approximately 10 per cent should the deal eventually go through.

Paradoxically, the very attractiveness and apparently near-certain rewards of the spread have led some arbs to adopt a more cautious approach. The panic that would set in should the bet go wrong has led some to steer clear of the situation. But most have piled in like there's no tomorrow.

What this probably means is that MCI will get taken over whether or not the merger with BT goes through. With so many powerful investment banks - Goldman Sachs, Salomon Brothers and Merrill Lynch among them - facing losses, they have an even bigger incentive than usual to find an alternative bidder.

Harder to gauge is what effect the arbitrage positions will have on BT's attempt to renegotiate the terms of the deal. Some of MCI's new-found shareholders will be pushing hard for no change in the terms on the grounds that this will destroy their profit. Others will take the view that anything that saves the deal, and heads off calamitous losses, is worth a try.

On this front, however, there seems to be some hardening of attitudes round at MCI itself. MCI directors have already proved their independence and determination of mind by voting through the extra investment in local telecommunications, regardless of anything BT might have to say on the matter. Now there are mutterings from the MCI camp that nothing justifies a renegotiation of the terms since BT has had its own share of unanticipated costs since the deal was first struck.

These include the windfall profits tax and the double-whammy effect of the abolition of tax credits on dividends. The first effect is to increase the costs of servicing the pension fund by up to pounds 200m a year. The second is either to reduce the yield on the stock or increase the cost to the company of servicing the dividend. Either way, some MCI insiders believe that the unexpected damage at BT since the deal was announced is rather greater than the unexpected damage at MCI.

The dangers of standoff can readily be seen. If the only way that BT can re-sell this deal to its shareholders is by renegotiating the terms and MCI refuses to do so, then the whole thing is going to collapse. It will come as little consolation to the top brass at BT that the monetary damage to the investment banking community of such an outcome is going to be rather greater than their own loss of face.

Stock market may have lost touch

There's no better contrary indicator, it would seem, than a survey of fund managers' intentions. On the day that Merrill Lynch flagged a shift in asset allocation from equities into gilts, the stock market reached another all-time high and gilts fell.

Bad timing aside, the broker's monthly survey made interesting reading. According to the study, pension funds have not been so keen on gilts since December 1994, when the yield on government bonds was a rather more attractive 8.5 per cent. Net sellers of UK equities now outnumber net buyers by 18 per cent, the biggest gap for a year.

One of the reasons for this is more onerous solvency conditions for pension funds. However, it's not all technical. The outlook for interest rates has deteriorated sharply since Gordon Brown ducked the consumer boom two weeks ago, while the resultant soaraway pound means earnings forecasts for exporters have been reined in this year and next. And the abolition of the tax credit has reduced the dividend stream from shares. Many institutions are just fundamentally more bearish about equities than they were.

So why is the stock market riding high? In part it shows what an inadequate measure of the overall stock market the utility and financials-dominated FTSE 100 has now become. The stock market is also being dragged up by the strength of overseas equities, particularly Wall Street, against which London looks cheap. But it might also suggests the market has lost touch with reality.

ICI's balance sheet ready to bubble

Charles Miller Smith, ICI's quiet and slightly nervy chief executive, was in an audacious mood yesterday. He deserved to be. In just two months Mr Miller Smith has pulled off the transformation of ICI from a dull, bulk chemicals giant, battered by sterling and mood swings in the chemicals cycle, to a higher-margin, more predictable and hopefully better valued beast.

With the disposal yesterday of half ICI's bulk chemicals businesses - titanium dioxide, polyester polymers and polyester films - to DuPont for pounds 1.8bn, he has achieved a fantastically good price given that these were barely profitable concerns. Having paid pounds 5bn for Unilever's highly rated, speciality chemicals businesses in May, Mr Miller Smith was under pressure to cut debt and find buyers for the commodity businesses. Though he promised to take no more than three years to dispose of pounds 3bn of businesses, doubters saw ICI as a forced seller bound to realise poor prices.

Not so. Mr Miller Smith proved he was a fast mover, selling ICI's stake in ICI Australia for pounds 1bn just two months after the Unilever deal. He has also shown that in the chemicals industry a handicap to one company can be a prize to another. That DuPont's share price held up even though it had paid ICI a princely sum shows not only the quality of ICI's Tioxide technology and the geographic fit, but that in very tough markets, it is worth coughing up the cash to get a leading market position. ICI demonstrated just that when it shelled out for the Unilever businesses.

The wife-swapping atmosphere in the chemicals industry suggests that ICI will get a decent price for its remaining bulk chemicals assets such as ethylene, chlorine, chemical quarrying and the North American Tioxide businesses that DuPont chose not to buy. That will improve ICI's balance sheet even further.

Having sold off almost pounds 2.9bn of businesses in just two months, borrowings will be around half pre-disposal levels and interest cover will be very acceptable at over three times. Even if he struggles to sell the rest, the pressure is now off Mr Miller Smith. And having spent 11 of his 30 years at Unilever managing precisely those businesses he is now left with, investors can feel reassured that the new look ICI is in safe hands. The argument for re-rating ICI is compelling.