Merger arbitrage is an investment strategy that concurrently buys and sells the stocks of two merging companies.
Let’s review the concept of arbitrage before getting into merger arbitrage. In its simplest form, it entails buying securities on one market to immediately resell on another market with a goal to make a profit from the discrepancy in price.
However, in the hedge fund world, arbitrage generally refers to the concurrent purchase and sale of two securities that are similar, but whose prices, in the trader’s opinion, are not in sync with their true value. Acting on the hypothesis that over time prices will revert to true value, the trader will sell short the overpriced security and buy the underpriced security.
How is merger arbitrage different?
Merger arbitrage is an event-driven investing − this is an investing strategy that looks to take advantage of pricing inefficiencies that can occur before/after a corporate event, like a merger, bankruptcy, spinoff, or acquisition.
For example, think about what happens with a potential merger. When a company signals that it intends to purchase another company, typically the stock price of the target company goes up, and the stock price of the acquiring company goes down. But, the stock price of the target company generally stays below the acquisition price, which is a discount reflecting the uncertainty of the market about whether the merger will actually happen.
This is where merger arbitrageurs come in.
Corporate mergers types
To comprehend how a merger arbitrage is profitable, you must comprehend that corporate mergers are generally divided in two categories: stock-for-stock mergers and cash mergers.
With a stock-for-stock merger, the company that is acquiring exchanges its stock for the target company stock. During a stock for stock merger, a merger arbitrageur buys the target company’s stock while shorting the stock of the company acquiring. When the merger is finished, and the stock of the target company is converted into the acquiring company’s stock, the merger arbitrageur uses the converted stock to cover his/her short position.
With cash mergers, the company acquiring purchases the target company’s shares for cash. Until the acquisition is finished, the target company’s stocks generally trade below the acquisition price. So, one can purchase the target company’s stock prior to the acquisition, and then make a profit when the acquisition goes through. This is not arbitrage, it is a speculation on an event occurring.
While it may seem simple, there are some risks. For example, the merger might fail to happen for a number of reasons. Perhaps one of the companies is not able to meet the conditions of the merger, perhaps shareholder won’t obtain approval, or regulatory issues could prevent the merger.
As a result of these risks, merger arbitrageurs need to have the necessary knowledge and skill to assess a number of factors accurately. A merger arbitrageur will examine the potential merger, look at the reason for the merger, the merger terms, and regulatory issues that could interfere with the merger, and decide the likelihood of the merger actually happening and how it might happen.
In a nut shell, while merger arbitrage sounds like a good investment strategy, it is better used by the sophisticated investors with the necessary expertise to evaluate the merger and accept the risk that it may not go through.
Need more advice? Don’t hesitate to check out our complete guide to investing into stocks and bonds and learn how to anticipate market movements and navigate the trading field.