Rupert Murdoch and Masayoshi Son triggered M&A shockwave

When Rupert Murdoch and Masayoshi Son walked away from their deals last week, the moguls created a shock wave on Wall Street as investors sold stocks across a variety of sectors to cut their risk exposure.

Early last week, Murdoch's 21st Century Fox said it had given up on trying to buy rival Time Warner. The news sent Time Warner shares down 13 percent the following day, punishing investors who had bet on Murdoch paying a big premium to get the deal done.

Within hours of the Murdoch news, press reports indicated that Sprint and its parent, SoftBank, had given up a chase for T-Mobile US. Many investors had been convinced that SoftBank CEO Son was determined to capture T-Mobile and had bid the stock higher in anticipation of a deal. T-Mobile tumbled 8 percent the next day.

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Rupert Murdoch
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The collapse of the two high-profile deals was excruciating for some so-called event-driven funds that wager on the success of mergers by purchasing shares of target companies before deals finalize. While neither deal had been signed, some of those funds had a strong belief that mergers would happen in the end.

But the pain didn't stop there. When funds incur losses, they often trigger risk-control measures designed to limit damage. One result can be that funds are forced to sell other stocks that are completely unrelated to the deals-gone-bad.

That appeared to be the case last week, when other potential acquisition targets saw unusually large price declines in the absence of major company-specific news. According to traders at event-driven funds, the first stocks to be sold are often those that carry a high level of risk—or are involved in deals with a relatively high chance of falling apart.

One victim was Botox maker Allergan, whose shares fell 6 percent during the week. Canadian drug maker Valeant and Bill Ackman's hedge fund Pershing Square Capital Management have made a tender offer to purchase Allergan, but the target company has been resistant and refused to enter negotiations.

Even companies that have formal deals felt an impact, possibly revealing which transactions investors consider to be at risk of collapse. Shares of casino equipment maker Bally Technologies, for instance, fell 5 percent last week. Scientific Games, controlled by Ronald Perelman, announced on Aug. 1 that it would acquire Bally.

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Why would investors consider the Bally deal risky? If completed, the deal will pile a large amount of debt onto a combined company with exposure to the struggling regional casino industry.

Indeed, the deal has some of the hallmarks of those done before the financial crisis that wound up in bankruptcy. Scientific Games has a market capitalization of just $600 million and has agreed to pay a whopping $3.3 billion for Bally. The companies declined to comment for this article.

To pay such a price, Scientific Games has secured a large debt package that the combined company would need to service in the years ahead. According to its own investor presentation, Scientific Games will have debt equal to 6.3 times earnings before interest, taxes, depreciation and amortization. That's much higher than the typical leverage for companies in the gaming industry.

What's more, the companies are having a tough time weathering the downturn in the gaming industry. Both stocks had fallen sharply in the previous months and were trading around 52-week lows when the deal was announced.

As in many deals, there is a "material adverse effect" clause that could cause the financing to fall through if the business deteriorated very seriously.

—By's John Jannarone.