What is Merger Arbitrage?

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 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.

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Merger Arbitrage Formula

So the above three components decide the profit potential of a merger arbitrage:

Merger Arbitrage Spread (i.e Profit Potential) = Risk Premium + Risk Free Rate

To analyze the probability of a deal-breaker, 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. However, 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 for $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 there is a 60% probability that the deal will materialize and 40% that it will not be executed.

Based on the available information, if the arbitrageur believes that the deal will materialize, 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 decide the deal probability, he may also choose to avoid investing in this deal.

Pros

  • 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.read more, 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. read more while 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.read more nature of the strategy.

Cons

  • Sometimes trades exploit the market using these strategies. Many strategies are purely speculative and are a form of gambling and hence may take the stock prices to a level that the company’s fundamentals cannot explain.As hedge funds mainly use these strategiesHedge Funds Mainly Use These StrategiesHedge 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.read more with strong financial muscles, their actions affect the market by a considerable margin as they operate through bulk transactions

Conclusion

The mergerMergerMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm.read more arbitrage can be purely speculative or based on pricing inefficiency among different markets. In addition, 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.read more transaction needs to be executed quickly before the pricing inefficiencies disappear as rational investors may bring the stock prices to their actual levels.

This article has been a guide to merger arbitrage and its definition. Here we discuss the formula of merger arbitrage spread and examples, advantages & disadvantages. You can learn more about Investment Banking from the following articles –

  • Vertical MergerExamples on Horizontal MergerCompare Mergers vs. AcquisitionsHorizontal Merger