What is Merger Arbitrage?
Merger Arbitrage, also known as risk arbitrage, is an event-driven investment strategy that aims to exploit uncertainties that exist between the period when the M&A is announced and when it is successfully completed. This strategy, mainly undertaken by hedge funds, involves buying and selling stocks of two merging companies to create riskfree profit.
It mainly takes two forms:
- Pure Arbitrage: It involves buying the target and shorting the acquirer to make the difference between the acquisition price and the market price of the target.
- Speculative Arbitrage: It involves buying the target in speculation that the prices will go higher after the completion of the deal with no certain information or evidence that the deal will ever materialize.
Merger Arbitrage Formula
So the above three components decide the profit potential of a merger arbitrage:
To analyse the probability of a deal break, the arbitrageur must study a number of factors including the risks associated with the votes of the shareholders, the finance available to companies, the probability of competing bids, the probability of some event disrupting the deal with a bid for the acquirer, and the existing trends in the industry.
However, with the increasing level of connectivity of the economies across the globe, the most challenging task is to successfully sail through the review processes of the regulatory authorities in jurisdictions throughout the world.
Example of Merger Arbitrage
Let us assume that a hypothetical Company X’s stock is trading at $50 per share. Now, Company Y announces its plan to buy Company X, such that holders of Company X’s stock get $85 in cash. As a result, Company X’s stock jumps to $65. It does not reach $85 as there may be chances that the deal will not be successful.
The arbitrageur can either buy the stock of Company X at a price of $65. A profit of $20 per share will be there if the deal materializes or a loss of $15 per share will be there if the deal does not materialize and the stock falls back to $50, which may or may not occur. Assuming, that the there is a 60% probability that deal will materialize and 40% that it will not be executed.
Now based on the available information, if the arbitrageur believes that the deal will materialize, then he should purchase Company X’s stock at $65 and enjoy the profit of $20 or else if he believes that the deal will not make through then he should short-sell Company X’s stock at $65 and pocket the profit of $15 per share. Since there is not enough information available to make an informed decision regarding the deal probability, he may also choose to stay away from investing in this deal.
- Most of the strategies are market neutral and hence these strategies generate profits in most of the market condition scenarios. These strategies focus on limiting the downside risk at the same time making informed speculations or decisions to make a profit from the market condition.
- The aggressive approach of the strategy favors the absolute return nature of the strategy.
- Sometimes trades exploit the market using these strategies. Many strategies are purely speculative in nature and is a form of gambling and hence may take the stock prices to a level that cannot be explained by the fundamentals of the company.
- As these strategies are mainly used by hedge funds that have strong financial muscles, their actions affect the market by a huge margin as they operate through bulk transactions.
The merger arbitrage can be purely speculative or based on pricing inefficiency among different markets. The non-equilibrium state may not exist for a long time so the arbitrage transaction needs to be executed fast enough before the pricing inefficiencies disappear as rational investors may bring the stock prices to their actual levels.
This has been a guide to what is Merger Arbitrage and its definition. Here we discuss the formula of merger arbitrage spread along with examples, advantages & disadvantages. You can learn more about Investment Banking from the following articles –