Merger Arbitrage Strategies
– Part 1 of a 2 Part Series
Merger arbitrage, otherwise known as “risk arbitrage,” is an investment strategy that primarily focuses on mergers and acquisitions (M&A) and capturing the spreads on announced deals.
This strategy falls within the category of event-driven investing, which exploits inefficiencies that can occur before or after events including mergers, spinoffs, and bankruptcies. Merger arbitrage is an alternative investment strategy whose risk and returns are not dependent on the direction of the stock market and therefore seeks to reduce overall portfolio volatility with non-correlated superior returns.
Merger arbitrage strategies are designed to profit from M&A transactions and they come in various forms:
1. Pure Merger Arbitrage – arbitrageurs buy the target and short the acquirer in order to profit from the difference between the acquisition price (in either cash or stock) and the market price assigned to the target.
2. Speculative Merger Arbitrage – arbitrageurs buy potential targets in order to profit from an upcoming merger announcement without knowing for certain that such an announcement will ever materialize.
When a company signals its intent to buy a public company, the per-share price that the acquiring company must agree to pay for the target company is typically greater than the prevailing per-share stock price on the public exchange. This price difference is known as the “takeover premium.”
After the takeover terms are announced, the share price of the target company rises, but typically continues to hover below the price specified in the takeover terms. The discount to the offer price reflects the market’s uncertainty about whether the merger will occur. The greater the risks to the deal closing, the wider this discount to the offer price. As a result, most deals will trade at a spread. This is where merger arbitrageurs enter the picture. To understand how merger arbitrage is profitable, it is important to understand that corporate mergers are typically divided into two categories: cash mergers and stock-for-stock mergers.
Cash Mergers
In a cash merger, the acquirer offers to purchase the shares of the target for a certain price in cash. The target’s stock price will most likely increase when the acquirer makes the offer, but the stock price will remain below the offer value. In some cases, the target’s stock price will increase to a level above the offer price. This would indicate that investors expect that a higher bid could be coming for the target, either from the acquirer or from a third party. To initiate a position, the arbitrageur will buy the target’s stock. The arbitrageur makes a profit when the target’s stock price approaches the offer price, which will occur when the likelihood of deal consummation increases. The target’s stock price will be equal to the offer price upon deal completion.
Stock Mergers
In a stock merger, the acquirer offers to purchase the target by exchanging its own stock for the target’s stock at a specified ratio. To initiate a position, the arbitrageur will buy the target’s stock and short sell the acquirer’s stock. This process is called “setting a spread”. The size of the spread positively correlates to the perceived risk that the deal will not be consummated at its original terms. The arbitrageur makes a profit when the spread narrows, which occurs when deal consummation appears more likely. Upon deal completion, the target’s stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. At this point in time, the spread will close. The arbitrageur delivers the converted stock into his short position to close his position. A merger arbitrageur could also replicate this strategy using options, such as purchasing shares of the target company’s stock while purchasing put options on the acquiring company’s stock. The proper spread strategy should take into consideration the following data points:
- The probability of the deal closing
- Hostile or friendly
- Cash tender or vote
- Strategic buyer or private equity
- The time it will take to close the deal
- The downside if the deal breaks
- Any dividends during the pendency of the deal
- The probability of a higher bid
- Tax implications of the deal
For both cash and stock merger deals, the discount on the open market price of the target company tends to shrink as the closing date of the deal approaches and the deal progresses through various milestones such as the successful receipt of financing and shareholder and regulatory approval. Typically any discount largely disappears by the day that the takeover is completed.
There are also mergers that use combinations of stock and cash that require an election by holders of the target company. Such deals will make the relationship between the acquiring company and target company stock prices much more complicated than for standard, plain vanilla “cash” and “stock” takeover deals, and require very specific, intricate strategies.