Ask any banker interested in hedge funds about their favorite strategies, and they will certainly mention merger arbitrage—a type of trading that involves speculating on the outcome of corporate mergers and acquisitions.
In this article, we’ll discuss the basics of M&A arbitrage, its types, advantages, and disadvantages. There are also tips on how to conduct merger arbitrage to maximize returns.
What is merger arbitrage?
Merger arbitrage, also known as risk arbitrage, is an investment strategy that involves investing in shares or derivatives of the target company to benefit from the anticipated change in the company’s share price when the merger or acquisition is completed. In such a way, a merger arbitrage investor capitalizes on the differences between the current market price and the post-merger price.
Through this approach, savvy investors can capture the difference between the present market value and the future value of the target company’s shares after the merger is finalized. By engaging in merger arbitrage, investors can turn uncertainty into opportunity and potentially yield substantial returns.
However, there are certain risks that may affect the merger arbitrage returns:
- The uncertainty of whether the merger will be completed
- The possibility that the buyer will provide a lower-than-anticipated acquisition price
- The probability of some event disrupting the announced deals
- Unforeseen litigation or regulatory fines that could reduce the target company’s stock and value
- Possible changes in the structure of transactions
Thus, it’s critical to understand all merger arbitrage opportunities, as well the risks and challenges associated with this type of investing, and have an exit strategy if the deal doesn’t go the way it was expected.
Note: If you’re considering a career in a merger arbitrage hedge fund, explore the investment banking questions and answers to prepare for the interview.
Merger arbitrage is an event-driven investing strategy that focuses on the merger event rather than the overall performance of the stock market.
How does merger arbitrage work?
When one company wants to buy the other, the target company’s stock price typically increases as an acquirer pays a risk premium of 10-30% more than the current value of the target’s shares. This is because the target’s shareholders wouldn’t agree to sell their shares at the same price they could sell on the open market.
Here’s a hypothetical example to see how it all works:
Company X’s stock is trading at $40 per share. Then, Company Y announces its plan to acquire Company X and offers $75 per share. The target’s stock doesn’t reach $75 because of the deal’s uncertainties. But it grows to $55.
Here’s a real-life merger arbitrage example:
In 2022, Microsoft announced its plans to acquire Activision Blizzard, which was trading at about $65 per share. Microsoft offered $95 and, in response to this offer, Activision-Blizzard’s stock prices rose to around $80-$85.
As you see, there is usually a difference between the current stock price and what the stock will trade for when a merger deal takes place. This difference is the arbitrageur’s opportunity. Depending on the deal’s success, there are two possible outcomes for investors:
- If a merger is successful, the arbitrageur receives profits from the difference between the stock’s current and expected price.
- If a merger is not successful, the arbitrageur loses a part of their investments.
Note: To learn what is M&A in investment banking, read our dedicated article.
Types of merger arbitrage
There are two main types:
- Merger arbitrage in cash mergers
- Merger arbitrage in stock mergers
Let’s take a closer look at each.
Merger arbitrage in cash mergers
In a cash merger, the acquirer offers to purchase the target company’s shares for cash. Let’s consider an example:
Company B is currently trading at $130/share. On January 1, Company A announces its plan to buy Company B’s shares at $200 in an all-cash deal. It leads to an increase in the target company’s share price and on the announcement date it closes at $185 per share. The deal is completed on November 1.
If an arbitrageur purchases the shares of Company B at $100 on January 1 and waits for ten months, he would have made an annualized profit of:
9.7% = ($200 – $185) / $185* 12 / 10
or $15 per share = ($200-$185).
However, if the deal fails, an investor will lose $55 per share = $185 – $130.
Merger arbitrage in stock mergers
In a stock-for-stock merger, an arbitrageur buys shares of the target company’s stock while shorting shares of the acquiring company’s stock.
Then, if the deal is successfully finalized and the target company’s stock is converted into the acquiring company’s stock, an arbitrageur uses the converted stock to cover the short position.
An investor can also follow this merger arbitrage strategy using options, buying shares of the target company’s stock and put options on the acquiring company’s stock.
How to conduct merger arbitrage?
Here’s a 6-step algorithm of how to conduct the process:
- Research the target company
Learn the target company’s strengths, weaknesses, and growth prospects to accurately assess the potential success of the merger deal.
- Understand the merger agreement
Read the merger agreement to understand its terms. Pay particular attention to the merger timeline and the conditions of the merger.
- Analyze the risk/reward ratio
Analyze the expected return on the merger to be able to decide whether it’s worth investing at all. Consider market uncertainty and the potential of the merger failing.
- Buy the target stock
Invest in the target company’s stock once you have identified a suitable merger.
- Monitor the merger process
Be sure to monitor the updates and events that may affect the deal’s outcome as the merger progresses. If any of the conditions or terms of the merger change, adjust your strategy accordingly.
- Sell your shares
Sell your shares of the target company at the new stock price, once the merger has come to its successful completion. Collect the expected return.
Merger arbitrage hedge funds
Often, lists of merger arbitrage funds and event-driven hedge funds are published on paid subscription services. But to help traders and anyone interested in investment banking learn more about the arbitrage industry, Merger Arbitrage Limited has created the following list:
- Laffitte Risk Arbitrage
The fund focuses on five topics: competition, financing, shareholders’ approval, regulatory approval, and a review of the merger agreement.
- HGC Investment Management
The fund’s strategies are special purpose acquisition companies(SPACs), traditional merger arbitrage, and subscription receipts.
- KL Event Driven UCITS Fund
The fund mainly benefits from risk arbitrage and special event-driven situations.
- Mason Capital Management
The fund has three event-driven investment banking strategies: merger arbitrage, distressed securities, and special situations.
- Alpine Merger Arbitrage Fund
The fund capitalizes on bidding wars, hostile bids, recapitalizations, partial tenders, and restructurings.
Note: To learn more about quantitative investment fund, read our dedicated article.
Key takeaways
Here are the main points to remember from the article:
- Merger arbitrage is an investment strategy that seeks to capitalize on buying the target company’s stock at a price lower than the expected value of that company after the successful completion of a merger
- Risks associated with this investment include the uncertainty of whether the merger will be completed, unforeseen litigation or regulatory fines, and the possibility that the buyer will provide a lower-than-anticipated acquisition price
- There are two main types of merger arbitrage: cash mergers and in-stock mergers
- The main recommendations on the conduction of merger arbitrage are to research the target company, understand the merger agreement, analyze the risk/reward ratio, and monitor the merger process
- The list of merger arbitrage funds includes Allianz Merger Arbitrage Strategy, HGC Investment Management, KL Event Driven UCITS Fund, Mason Capital Management, and Alpine Merger Arbitrage Fund.
