Merger Arbitrage

Merger Arbitrage, also known as risk arbitrage, is an event-driven investment strategy that aims to exploit uncertainties between the period when the M&A is announced and when it is completed. This strategy, mainly undertaken by hedge funds, involves buying and selling stocks of two merging companies to create risk-free profit.

The merger 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 arbitrage transaction needs to be executed quickly before the pricing inefficiencies disappear as rational investors may bring the stock prices to their actual levels.

Merger arbitrage or otherwise known as risk arbitrage is an investment strategy where a company decides to make profits from a successful merger or acquisition. It is a strategy where the difference in market price of the company’s stock before and after the acquisition is taken bet upon to make significant profits.

It is generally considered a high-turnover investment with low risk and moderate returns. Therefore, merger arbitrage funds invest heavily in these companies.

It mainly takes two forms:

1. Pure Arbitrage: It involves buying the target and shorting the acquirer to differentiate between the acquisition price and the market price of the target.
2. 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.

The above three components decide the profit potential and the merger arbitrage strategy that might be implied. The formula below is used to determine the profitability:

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.

Let us understand the different strategies used by merger arbitrage funds to make significant profits from these deals with the help of a couple of examples.

Example #1

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, they should purchase Company X’s stock at $65 and enjoy the profit of $20, or else if they believe that the deal will not make it through. They 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, they may also choose to avoid investing in this deal.

Example #2

Intercontinental Exchange Inc. (ICE) offered to buy out Black Knight Inc. for a whopping $13 billion. However, in March 2023, The Federal Trade Commission sued ICE to block the trade due to irregularities.

The share prices dropped 2.6% to $59 after this news broke out. Regardless of the price drop, traders in the market believe that the prices would rise because the ICE’s team would survive the scrutiny from the court and as a result, the share price might climb to $75 per share, which was also ICE’s offered price for Black Knight’s company.

Traders and analysts forecasted that there was still a 40% chance that this deal would make it through.

Let us understand the pros of merger arbitrage funds investing in these companies despite the fluctuations in the open market. The discussion below will help us gain a clearer picture.

• Most of the strategies are market neutral, and hence these strategies generate profits in most market condition scenarios. These strategies focus on limiting the downside risk while 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.

Despite the pros or advantages as discussed above, there are a couple of cons of these investments. Let us understand them through the discussion below.

• 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 strategies with strong financial muscles, their actions affect the market by a considerable margin as they operate through bulk transactions

This article has been a guide to what is Merger Arbitrage. Here we explain how it works, its examples, formula, pros, and cons in detail. You can learn more about Investment Banking from the following articles –

• Vertical Merger
• Examples on Horizontal Merger
• Compare Mergers vs. Acquisitions
• Horizontal Merger