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 differentiate 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 analyze the probability of a deal break, the arbitrageur must study several 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 there is a 60% probability that the 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. 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 avoid investing in this deal.
- Most of the strategies are market neutralMarket NeutralMarket neutral is an investment strategy or portfolio management technique where an investor seeks to negate some form of market risk or volatility by taking long and short positions in various stocks to increase ROI achieved by gaining from increasing and decreasing prices from one or more than one market., and hence these strategies generate profits in most market condition scenarios. These strategies focus on limiting the downside riskDownside RiskDownside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. 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 returnThe Absolute ReturnAbsolute return refers to the percentage of value appreciation or depreciation of an asset or fund over a certain period. Such assets include mutual funds, stocks and fixed deposits. 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 fundsStrategies Are Mainly Used By Hedge FundsHedge fund strategies are a set of principles or instructions followed by a hedge fund in order to protect themselves against the movements of stocks or securities in the market and to make a profit on a very small working capital without risking the entire budget. that have strong financial muscles, their actions affect the market by a considerable margin as they operate through bulk transactions.
The mergerMergerA merger is a voluntary fusion of two existing entities equal in size, operations, and customers deciding to amalgamate to form a new entity, expand its reach into new territories, lower operational costs, increase revenues, and earn greater control over market share. arbitrage can be purely speculative or based on pricing inefficiency among different markets. The non-equilibrium state may not exist for a long time. Hence, the arbitrageArbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security's price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left. 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 article 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 –