Merger Arbitrage Strategies
– Part 2 of a 2 Part Series

 

Active or Passive Strategies

The arbitrageur can generate returns either actively or passively.  Active arbitrageurs purchase enough stock in the target to control the outcome of the merger.  These activist investors initiate sales processes or hold back support from ongoing mergers in attempts to solicit a higher bid.

On the other end of the spectrum, passive arbitrageurs do not influence the outcome of the merger. One set of passive arbitrageurs invests in deals that the market expects to succeed and increases holdings if the probability of success improves. The other set of passive arbitrageurs is more involved, but passive nonetheless: these arbitrageurs are more selective with their investments, meticulously testing assumptions on the risk-reward profile of individual deals. This set of arbitrageurs will invest in deals in which they conclude that the probability of success is greater than what the spread implies.  Passive arbitrageurs have more freedom in very liquid stocks:  the more liquid the target stock, the better risk arbitrageurs can hide their investment.  In this case, using the assumption that a higher arbitrageur presence increases the probability of consummation, the share price will not fully reflect the increased probability of success and the risk arbitrageur can buy shares and make a profit. The arbitrageur must decide whether an active role or a passive role in the merger is the more attractive option in a given situation.

Deal Considerations

If a merger arbitrageur expects a merger deal to break, the arbitrageur may short shares of the target company’s stock. If a merger deal breaks, the target company’s share price typically falls to its share price prior to the announcement of the deal. Mergers may break due to a multitude of reasons, such as regulations, financial instability, or unfavorable tax implications.

When screening for merger arbitrage opportunities, arbitrageurs typically try to avoid: agreements in principle, deals subject to financing, deals subject to due diligence, targets with poor earnings trends, targets with poor earnings, deals in cyclical sectors, and deals in highly regulated industries such as telecom.  Arbitrageurs focus instead on:  definitive agreements, strategic rationale of the acquisition, whether it is a large acquirer, no financing conditions, no due diligence conditions, a strong performing target, a fair valuation, and an acquisition with little to no regulatory risk such as the software industry. Additionally, smaller-capitalization companies make attractive opportunities as the regulatory and anti-trust hurdles are lower and spreads may be wider because of less competition.

Benefits

Merger arbitrage strategies have a number of unique benefits compared to traditional investment strategies.  In particular, investors can use the strategy in nearly any market condition, which makes it a nice alternative to have on-hand.  The strategy’s unique risk-reward profile may also make it compelling for investors looking to balance out their portfolio risk levels.

The core benefits of merger arbitrage include:

• Low-Risk.  Pure merger arbitrage involves relatively low risk since an acquisition
  .00has already been consummated, although the potential profit is limited to the
  .00difference between the market and acquisition price.

• High-Reward.  Speculative merger arbitrage involves significant potential upside
  .00if an M&A announcement is made, although there’s no guarantee that such an
  .00announcement will ever be made.

• Market Neutral.  Merger arbitrage strategies are market neutral since they involve
  .00a long and short position, which means that an arbitrageur’s exposure to the overall
  .00market is relatively limited compared to other strategies.

Risks

Merger arbitrage strategies are designed to mitigate many types of risks; however, there are some important risks to consider include:

• Event Risk. The largest risk for pure merger arbitrage is the merger falling through
  .00and becoming unsuccessful, which can result in rapid steep losses.

• Inverse Risk.  Merger arbitrage removes macro risk factors, but some dynamics
  .00could lead to a buyer’s stock appreciating and hurting a short position.

• Liquidity Risk. Mergers tend to reduce trading in a stock once the price rises, which
  .00means that it could be difficult to enter or exit a position.

Because of these risks, merger arbitrageurs must have the knowledge and skill to accurately assess a number of factors.  A merger arbitrageur will analyze the potential merger—looking at the reason for the merger, the terms of the merger, any regulatory issues that may hinder the merger, and determine the likelihood of the merger actually occurring and how.  Because this requires expertise, institutional investors—such as hedge funds, private equity firms, and investment banks are the major users of merger arbitrage.  This investment strategy is best used by sophisticated investors who have the expertise to evaluate the merger and are willing to accept the risk of it not going through.