Merger Arbitrage: Definition, How it Works

How do you make money from acquisitions when you’re neither on the buyer or seller side?

The answer is ‘merger arbitrage’, an alternative investment strategy focused on M&A transactions.

This is the DealRoom guide to merger arbitrage.

Merger arbitrage emerged as a favourite strategy of hedge funds looking to capitalize on the spreads  that emerge between companies’ stock pricing over the course of a deal, beginning at the announcement of a deal, at which point a premium has been offered for the stock so it begins ticking upward, right to the deal’s closing (or otherwise), when the price should tend toward the price being offered by the sell-side.

A good proportion of deals don’t end up closing, however, meaning that there is always an inherent risk in the strategy.

_{Why not check out: 4 Ways Which Mergers and Acquisitions Affect Stock Prices}

How does Merger Arbitrage Work?

In short, merger arbitrage works by trading on the spread that exists between the stock price after the announcement of an M&A transaction, and the price that the buyer has offered to buy the seller’s stock at.

In the example below, the ‘spread’ is the difference between the price that the stock reaches on the announcement of the deal ($20.50), and the ultimate amount offered by the buyer in the announcement ($21.50). This spread exists because of the risk  that always exists that a deal won’t close.It is called ‘the arbitrage spread.’

This arbitrage spread always exists in deals involving publicly-listed companies, meaning there are ample opportunities for merger arbitrageurs (or spread traders) to attempt to profit from deals when they’re announced. The size of the spread is a combination of the risk premium of the stock being acquired, the risk-free rate in the market at that point, and the time to close premium - with more time to accept or refuse a deal seen as a bigger risk to the arbitrage opportunity (as the money could be invested elsewhere).

Merger Arbitrage Funds

The vast number of acquisitions involving publicly-listed companies every year creates opportunities that hedge funds are inevitably eager to exploit.

In the second half of the 1990s, an explosion in the number of hedge funds trading on M&A deals (merger arbitrage funds) caused the average arbitrage spread on a publicly-listed transaction to fall by 400 bps, significantly reducing the opportunities that previously existed to profit from third party M&A transactions.

Types of Merger Arbitrage

Understanding how stocks typically react to the announcement of a transaction is essential to understanding merger arbitrage.

The buyer approaches the target firm with an offer - usually at a premium of15-20% in excess of the current market price - before publicly announcing the bid. Fast and furious stock market trading pushes up the price of the seller’s stock, and generally (but not always) pushing down the buyer’s stock.

Two movements: upwards in the seller stock, downwards in the buyer stock.

Next, there are two types of deals that merger arbitrage focuses on:

• All-cash acquisitions
• Stock for stock acquisitions

In the all-cash acquisitions, the merger arbitrage play usually involves taking a long position on the seller’s stock through the use of call options, and potentially a short position on the buyer’s stock through the use of put options.

In the case of stock for stock acquisitions, the merger arbitrage fund usually acquires the stock of the seller’s stock, goes short on the buyer’s stock, and then covers his or her positions on the buyer’s stock when the deal closes. It’s not difficult to see how this operation carries complex risks.

Valuation of Merger Arbitrage

In addition to the risk premium, the risk-free rate, and the time-to-close premium, merger arbitrage funds consider a range of other risks that can impact on the deals (typically measured as their contribution to the risk of the transaction not being closed).

Examples or risks iinn merger arbitrage are:

• Shareholder resistance: Arbitrageurs will measure whether shareholders are outright against the deal, or whether they’re just wrangling for a bigger acquisition price.
• Deal background: Arbitrageurs will pay particular attention to the specifics of the deal - what are the idiosyncrasies that could lead to it collapsing?
• Regulatory hurdles: Does this look like a deal that anti-trust regulators will spend two years pondering? If so, it’s one to avoid for arbitrageurs.
• Previous (proposed) transactions: Any deals involving this company and/or its peers should inform the arbitrageur about the deal’s chances of closing.

Related Resources

In the world of companies that pay particularly close attention to the workings of M&A, merger arbitrageurs might be second to M&A Science.

Anybody serious about becoming more informed, aware, and capable in M&A would do well to take a look at the resources that we developed over the past decade for the advancement of the M&A community.