Merger arbitrage, otherwise known as risk arbitrage, is an investment strategy that aims to generate profits from successfully completed mergers and/or takeovers. It is a type of event-driven investing that aims to capitalize on differences between stock prices before and after mergers. Investors who employ merger arbitrage strategies are known as arbitrageurs.
How Merger Arbitrage Works
In a typical merger, the acquirer is often required to pay a premium. i.e., offer to purchase the target company’s shares at a higher-than-market price.
The announcement of the merger at a higher price tends to drive up the price of the target’s shares, allowing investors to profit from the difference.
Investors can either benefit from the announcement or the successful completion of the merger, depending on the time of investment.
If the investor already owns shares prior to the announcement, he/she can benefit from the increase in prices on the day of the announcement. If the investor chooses to purchase the target’s shares after the announcement, his/her gains depend on the “arbitrage spread.”
The arbitrage spread refers to the difference between the acquisition price of the shares and the market price at the time of investment. The larger the spread, the higher the potential reward for the investor (it will be the largest if investments are made prior to the announcement).
Merger Arbitrage in Cash Mergers
Cash mergers are mergers where the acquirer offers to pay a certain amount of cash (at a premium) for shares of the target company. In such a case, the acquirer typically announces the price at which it will acquire the target’s shares if the merger were to be completed successfully. The investor/arbitrageur relies on the successful completion of the merger and benefits from the difference between the price at which he/she purchases the share and the acquisition price.
Consider an example – Company B is currently trading at $80/share. On June 11, Company A announces that it will buy the majority of Company B’s shares at a premium of $200 in an all-cash deal due to the value that they see in the merger. It leads to a sudden increase in the stock price on the announcement date, and the stock price closes at $110/share.
Jane is an experienced arbitrageur and purchases the shares of Company B at $110 based on her confidence in the success of the deal. As the deal comes to a close, the share price of Company B increases steadily until it reaches the acquisition price on the specified acquisition date.
Here, the arbitrage spread for Jane was $90 ($200 – $110) per share, which is how much she would make on each share if the acquisition is closed. It is also known as “going long” on the target company’s stock, based on the expectation that the share price will rise as the merger comes to a close.
Merger Arbitrage in Stock Mergers
In stock-for-stock mergers, the acquirer offers to purchase the shares of the target company by offering some of its own shares to the target company’s shareholders. In such a case, the arbitrageur benefits by purchasing shares of the target company, while short-selling the acquirer’s shares. The investor short sells the acquirer’s shares to create a “spread.”
As the deal comes to a successful close, the spread narrows, and the investor makes a profit. The acquirer’s equity gets diluted, and the value of each share gets diluted as well, as there are now more outstanding shares, allowing the investor to make money from short-selling.
On the other hand, the investor takes a long position in the target company in order to reap the benefit of the increase in share price after the announcement.
How Do Investors Predict the Outcome of Mergers?
The single-best (until date) predictor of merger outcomes is the degree of hostility. Simply put, if the target company is willing to be acquired/merged, the process is likely to be easier than if they were unwilling to do so, and the acquisition was more of a hostile takeover.
Arbitrageurs also play an important role in shaping the outcome of a merger; they often make large financial investments based on the speculation that the merger will be successfully completed. Once they are financially invested, they will do everything in their power to ensure that the merger goes through.
In their study, Risk Arbitrage in Takeovers, Francesca Cornelli and David Li find that the arbitrage industry typically holds as much as 40% of the target company’s stock during a merger.
Active Arbitrage vs. Passive Arbitrage
Active arbitrage refers to a situation where the arbitrageur holds enough stock in the target company to influence the outcome of the merger.
Passive arbitrage is when arbitrageurs are not in the position to influence the merger – they make investments based on the probability of success (and the degree of hostility), and size up their investments when this probability increases.
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