What Is Merger Arbitrage?
Merger arbitrage, often regarded as a hedge fund strategy, involves simultaneously purchasing and selling the respective stock of two merging companies to generate ‘riskless’ profits. Given the uncertainty of deal completion, the stock price of the target company usually trades below the offered acquisition price. A merger arbitrageur assesses the likelihood of the merger not finalizing on time or at all, and strategically purchases stock before the acquisition, anticipating a profit upon successful merger or acquisition completion.
Key Takeaways
- Merger arbitrage is an investment strategy where an investor simultaneously buys shares of two merging companies.
- This strategy exploits market inefficiencies related to mergers and acquisitions (M&A).
- Known as risk arbitrage, this subset of event-driven investing focuses on capitalizing on market conditions before or after a merger or acquisition.
Understanding Merger Arbitrage
Merger arbitrage, also recognized as risk arbitrage, is a branch of event-driven investing that zeroes in on market inefficiencies before or after mergers or acquisitions. While a regular portfolio manager often examines the profitability of the merged entity, merger arbitrageurs prioritize the likelihood of deal approval and the time required to conclude it. Although merger arbitrage carries some risk due to the potential deal denial, it is a strategy centered around merger events rather than total stock market performance.
Special Considerations
Upon announcing an acquisition intent, the acquiring company’s stock price typically drops while the target company’s stock price sees an upsurge. To obtain the target company’s shares, the acquiring firm generally offers a premium over the current stock value. Market speculations over the target firm and the acquisition offer often cause fluctuations in the acquiring firm’s stock price. However, the target company’s stock price remains below the declared acquisition price, reflecting deal uncertainty.
In all-cash mergers, investors usually adopt a long position in the target firm. Conversely, if a merger arbitrageur predicts a deal’s failure, shorting the target company’s stock may be beneficial. Failed mergers commonly cause the target company’s share price to revert to its pre-announcement level, breaking deals due to reasons like regulatory constraints, financial issues, or adverse tax considerations.
Types of Merger Arbitrage
Corporate mergers come in two primary forms: cash and stock mergers. In a cash merger, the acquiring company buys the target company’s shares in exchange for cash. Oppositely, a stock-for-stock merger involves exchanging the acquiring company’s stock for that of the target company’s.
During a stock-for-stock merger, a merger arbitrageur generally purchases the target company’s stock while shorting the acquirer’s stock. Upon deal completion, the target company’s converted stock can cover the arbitrageur’s short position. Alternatively, this strategy may involve using options, purchasing the target company’s stock while buying put options on the acquirer’s stock.
Related Terms: Risk Arbitrage, Event-Driven Investing, Cash Merger, Stock-for-Stock Merger.
