Education

How does merger arbitrage work?

After a company announces an intent to acquire another, the price of the target company's stock predictably goes up, although usually not to the full offering price. Instead, because of the risk of the deal not closing on time or at all, the target company's stock will sell at a discount to its value at the merger's closing, this discount increasing with the expected length of time until closing and the perceived risk of the deal. The merger arbitrageur seeks to lock in this spread. When the offer is a cash offer, the arbitrageur merely has to buy the stock of the target in order to do this. However, when the offer is a trade of securities, the investor must also hedge against the possibility of the acquirer's stock falling. He does this by selling the acquirer's stock short.

Show me an example

Consider a stock-for-stock transaction in which Company A, with stock trading at $105, offers one share of its stock for each share of Company B stock, currently trading at $80. An investor looking to create an arbitrage profit would buy Company B stock at, say, $100, the price to which it climbed immediately after the merger announcement, and sell short Company A stock at $105 in an amount equal to the exchange ratio - in this case 1-to-1. (Actually, in some instances, particularly in megamergers, the acquirer's stock price usually drops somewhat immediately after the announcement, as shorting pressure pulls down the price; but for this example we'll keep it at $105.) As the merger date draws nearer, this $5 spread will narrow as the prices of Company B and Company A stocks converge. When the spread narrows, the investor's returns grow - for example, if Company B stock rises to $101 and Company A falls to $104, the investor earns $1 on the long investment and $1 on the short.

Once the merger is consummated and Company B stock is converted to Company A shares, the investor locks in the $5 gain regardless of the current price of Company A stock. (His Company B shares are converted into Company A shares, which he delivers to cover his short sale of Company A shares at $105.) If during the interim the market has tumbled, sending Company A stock down to $80, the investor makes $25 on the short sale of Company A stock at $105 minus the loss of $20 on the Company B shares for which he paid $100. (Though if a market downturn causes Company A stock to fall significantly before the merger closes, Company B might back out of the deal; as a cover against a market downturn, some fund managers supplement their merger arbitrage investments with put options on the S&P Index, which enable the manager to lock in a sell price in the event the index craters.) In this way, the investment is buffered from violent market swings.

How do I make more?

One word - Leverage. With the average merger and acquisition transaction taking four months to complete from announcement, a 5 percent profit as illustrated above would translate into a 15 percent annualized gain. And with the use of leverage or borrowing, the returns can be much higher.

Where's the risk?

The main risk is that the merger will fall through. In this case the stock price of the targeted Company B is likely to return to its original price of $80 or even lower if it was assumed by the market that the deal fell through because of some inherent problems at Company B. The result would be a loss of $20 or more on the purchase of Company B stock at $100 after the deal was announced. Furthermore, had Company A stock dropped after the initial announcement, its share price would likely to return to its former price of $105 after the transaction is called off as all the short sellers cover their shorts; any investor who shorted the stock at less than $105, then, would incur a loss on the short investment on top of the loss he would incur on the Company B shares.

How risky is it?

Historically, the vast majority of friendly acquisition offers that have been announced are completed. Only about 3 percent of "good" transactions "break." In addition, through diversification across many such deals, fund managers are able to minimize the impact of one deal falling through. Still, as a hedge against collapsed deals, some fund managers supplement their long positions in the target company with puts on the company's stock - but only when the spread is such that the potential profit well offsets the cost of the buying the put.

What if i feel that the merger will fall through?

Those who anticipate failed deals usually short the target's stock. For example, Paulson Partners shorted the stock of AEL Industries Inc., a supplier of electronic systems and subsystems, after acquisition plans by another company were reported to be on shaky ground. Fund manager John Paulson predicted the deal would either be revised downward or called off (it was later revised downward) based on the fact that AEL had posted a recent quarterly loss and that the buyer was borrowing heavily for a deal while already steeped in debt.

How does this compare with normal investing?

As compared to the uncertainty of playing the currently volatile equity markets, arbitrage investments such as those described above in companies undergoing mergers or acquisitions can result in relatively consistent returns. The risk of a merger or acquisition falling through is one that a good fund manager can be expected to foresee through strong due diligence. Even hostile takeovers have a fair amount of predictability, as careful analysis can determine the strength of a takeover target's legal or strategic defenses, the ability of the hostile bidder to finance the deal, the possibility of regulatory bodies such as the FTC or the SEC disallowing the deal, or the likelihood of a white knight making a competing bid.

I am already invested in the market. Is merger arbitrage still relevant to me?

Merger arbitrage returns are largely uncorrelated to the overall movement of the stock market. And the risks are much more managed because we're talking about anticipating probable outcomes of specific transactions versus predicting what are often far more random variables when making directional investments. Merger arbitrage, also referred to as risk arbitrage, is a relatively new hedging strategy. Sometimes categorized as one of the market-neutral hedging strategies that have emerged in recent years, merger arbitrage, though little correlated to the market, is not truly market neutral, as we've seen that market downturns can sometimes disrupt the outcome of agreed deals.