When it comes to investing, few strategies theoretically have as few risks as arbitrage. This term refers to when financial assets are purchased in one market and immediately resold in another market in order to exploit and benefit from discrepancies between the two prices.
One special form of arbitrage that's used by investors during an M&A deal is a merger arbitrage (also known as a "risk" arbitrage). So how exactly does a merger arbitrage work, and what are the upsides and drawbacks?
How Does a Merger Arbitrage Work?
Mergers most often occur in two formats: cash and stock (as well as a combination of both). The acquiring company either offers to make a cash purchase of the target company's shares in stock, or offers to exchange its own shares for the target company's stock.
Upon the announcement of a planned M&A deal, the acquiring company's stock tends to decline, while the target company's stock tends to rise in order to approach the acquiring company's offer. However, there's still typically a small difference between the target company's stock price and the acquiring company's announced offer.
This is because when two companies make plans to merge, there's usually a minor risk that the deal will fall through. For example, shareholders may not approve the deal, or antitrust regulations may prevent it from happening.
As a result, most M&A deals will trade at a spread, and this risk of failure can be quantified as the size of the spread. When there is a difference between the target company's stock price and the acquiring company's offer, larger differences typically imply greater risks.
Arbitrageurs therefore leverage this spread in order to (hopefully) turn a profit. These investors purchase the target company's stock at the time the deal is announced. Then, they hold onto the stock until the deal goes through and they can resell it for a higher price. On the other hand, if arbitrageurs believe that the deal will fail, they can short the target company's stock, believing that it will fall back to its previous position before the announcement.
When Are Merger Arbitrage Strategies Used?
Although understanding the underlying concept is fairly easy, profiting from merger arbitrages is an entirely different matter. Skilled arbitrageurs need to be able to assess each individual deal and determine the likelihood that it will actually occur. However, because they plan to resell their shares immediately in order to benefit from a temporary price difference, arbitrageurs don't need to worry about the profitability or long-term success of the merged entity.
Because they involve a good deal of in-depth analysis in order to turn a profit, merger arbitrages are a popular strategy among large, sophisticated institutional investors. Hedge funds, investment banks and private equity firms are all frequent arbitrageurs.
Merger arbitrages are one example of what's known as "event-driven investing." Passive investment strategies traditionally involve purchasing and holding a stock because it's undervalued and its value is expected to rise in the future. Meanwhile, event-driven investing consists of strategies that rely on external events that will affect a stock price (such as a merger or bankruptcy).
Final Thoughts
From Amazon and Whole Foods to AT&T and Time Warner, recent history has been full of major M&A deals. Savvy investors know how to use merger arbitrages in order to predict the future and turn a profit.
