Reflecting on the Tilray and Aphria Merger

The merger between Tilray (TLRY) and Aphria (formerly APHA) closed back in May 2021. I think it serves as an interesting case study for how the meme-ification of markets can create really strange situations.

A little background, Tilray and Aphria were Canadian cannabis producers. Now it's just Tilray. I don't have a ton to say on the actual business prospects of this merger, as I don't really follow the cannabis industry closely enough to say anything useful. However, the headline is that there will be (and has been) margin compression in the cultivation of marijuana. It's basically a commodity where the margin is captured further down the chain through branding and unique products. So it makes sense that we're seeing more aggressive M&A from the sector.

The basics of the deal was that Tilray would absorb Aphria. Aphria shareholders would get 0.8381 shares of TLRY for every one share of APHA they owned. So you'd expect APHA shares to trade at a slight discount to that 0.8381 multiple reflecting the risk of the deal blowing up.

But then the Reddit short squeeze madness happened and the entire stock market went crazy for a few weeks (and it went crazy again in June too!). The weed stocks were getting squeezed and the spread between the two stocks blew out. What should have been a healthy low two-digits percentage spread, became a high two-digits, and even three-digit spread .

Unfortunately I don't have the APHA data to recreate the spread chart by hand so I'll have to dig that up on the net. But to start, here's what TLRY looked like in February 2021, a few months before the merger closed. As you can see, after the initial pain subsided, it was a relatively painless trade going forward. Those "diamond hands" who had the gall to put this trade on at the heights were rewarded handsomely for taking on the risk of catastrophe.

Now here's a ratio chart from February 22, reflecting how wide this got. Credit to this finance writer for the chart.

How did this happen?

  • The same funds who had on this spread were caught in short squeezes
  • Reddit/WSB was pushing cannabis stocks, and Tilray was more of a household name than Aphria
  • A complete reluctance to short any speculative names

A core tenet of merger arbitrage trading is that it's supposed to be market neutral; that you're not really taking a direct view on the direction of a stock or the market itself. However, in this case, the dominant population trading these stocks were not analyzing the probabilities of the merger going through successfully, or Tilray raising their bid. They were buying momentum, and Tilray had the hottest momentum. So you were in effect doing what is a popular Fintwit day trading strategy; shorting parabolic speculative stocks, with Aphria serving as a volatility dampener.

Doubtless, there were some hero prop traders who put this trade on and added into the pain. They won big. But there were many who started too early and blew up or got a tap on the shoulder from their risk managers.

In these types of trades (i.e., not buying and holding compounders, or doing technical analysis type trading), you get paid for providing a service to the market. And you're paid based on the supply and demand of that service. In a quiet market, you don't get rich putting on simple merger arb trades, because plenty of traders are willing to provide the liquidity to the folks who want to get rid of that risk. The same way that you don't get rich putting on a vanilla pairs trade between two utilities that have diverged 2 standard deviations.

But in this trade, there were very few traders willing to take the risk of shorting Tilray, and hence, they got paid huge because the market correctly estimated how substantial the risk was.

This is my first post and it's pretty much just a stream of consciousness. Nothing profound at all, just felt like reflecting how in these types of "longer-term market making" style trades like merger arb or pairs trading, your payday is linked to the demand for your services. The same way that if everybody in your city is a realtor, you can afford to be really tough in negotiating a sales commission when listing your house.

Graham

Graham

I made this site because I already write privately. But its easy to excuse lazy work when its just for you. Hopefully publishing it incentivizes me to dig harder when writing about trading.
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