Merger arbitrage is the business of trading stocks in
companies that are subject to takeovers or mergers. Arbitrage exploits the fact
that takeovers normally involve a big price premium for the company. So long as
there is a price gap, there is potential for sizable rewards. But betting on
mergers can be risky business. As a general rule, it's a tool that's
exclusively for professionals, and probably not something you want to try at
home. In this article, we'll take you on a tour of the high-risk world of
merger arbitrage.
What Is Merger Arbitrage?
Arbitrage involves purchasing an asset at one price for an
immediate sale at a higher price. Thus an arbitrageur - a fancy term for the
person who buys the stock at the lower price - tries to profit from the price
discrepancy. It is fairly rare to find potential opportunities for arbitrage in
an efficient market, but once in a while, these opportunities do pop up.
Merger arbitrage (also known as "merge-arb") calls
for trading the stocks of companies engaged in mergers and takeovers. When the
terms of a potential merger become public, an arbitrageur will go long, or buy
shares of the target company, which in most cases trade below the acquisition
price. At the same time, the arbitrageur will short sell the acquiring company
by borrowing shares with the hope of repaying them later with lower cost
shares.
If all goes as planned, the target company's stock price
should eventually rise to reflect the agreed per-share acquisition price, and
the acquirer's price should fall to reflect what it is paying for the deal. The
wider the gap, or spread, between the current trading prices and their prices
valued by the acquisition terms, the better the arbitrageur's potential
returns. (For related reading, see Trading The Odds With Arbitrage.)
A Successful Merger example:
Let's look at an example of how a successful merger
arbitrage deal works in practice.
Suppose Delicious Co. is trading at $40 per share when
Hungry Co. comes along and bids $50 per share - a 25% premium. The stock of
Delicious will immediately jump, but will likely soon settle at some price
higher than $40 and less than $50 until the takeover deal is approved and
closed. However, if it trades at a higher price, the market is betting that a
higher bidder will emerge.
Let's say that the deal is expected to close at $50 and
Delicious stock is trading at $47. Seizing the price-gap opportunity, a risk
arbitrageur would purchase Delicious at $48, pay a commission, hold on to the
shares, and eventually sell them for the agreed $50 acquisition price once the
merger is closed. From that part of the deal, the arbitrageur pockets a profit
of $2 per share, or a 4% gain, less trading fees. From the time that they are
announced, mergers and acquisitions take about four months to complete. So that
4% gain would translate into a 12% annualized return.
At the same time, the arbitrageur will probably short sell
Hungry stock in anticipation that its share price will fall in value. Of
course, the value of Hungry may not change. But, oftentimes, an acquirer's
stock does fall in value. If Hungry shares do fall in price from $100 to $95,
for example, the short sale would net the arbitrageur another $5 per share, or
5%.
From the time that they are announced, mergers and
acquisitions take about four months to complete. So the 4% gain from target's
stock and the 5% gain from the acquirer's stock together would translate into
an impressive annualized return of 27% (less transaction costs) for the
arbitrager.
Know the Risks to Avoid the Losses
While this all sounds fairly straightforward, it is
assuredly not that simple - in real life, things don't always go as predicted.
The entire merger arbitrage business is a risky one in which takeover deals can
fizzle and prices can move in unexpected directions, resulting in sizable
losses for the arbitrageur.
The biggest factor that increases the risk of participating
in merger arbitrage is the possibility of a deal falling through. Takeovers can
get scrapped for all kinds of reasons including financingproblems, due
diligence outcomes, personality clashes, regulatory objections or other factors
that might cause the buyers or seller to pull out. Hostile bids are also more
likely to fail than friendly ones. The longer a deal takes to close, the more
things can go wrong to scuttle it.
Consider the
consequences of the Hungry-Delicious deal falling through. Another company
might make a bid for Delicious, in which case its share value may not fall by
much. However, if the deal collapses with no alternative bids being offered,
the arbitrageur's position in the target company would probably fall in value,
back to the original $40 price. In that case, the arbitrageur loses a whopping
$8 per share (or roughly 16%).
Which penny stocks will rise? We'll tell you, free!
On the other hand, the behavior of the acquirer's stock is
less predictable in the event of a scuttled takeover. The market might
interpret the blown deal as a big loss for Hungry, and its shares might fall in
value, say from $100 to $95. In this case, the arbitrager would gain $5 per share
from short selling Hungry's stock. Here, short selling the acquirer's stock
would act as a hedge, offering some shelter from the $8-per-share loss suffered
on the target's stock. (For more insight, see A Beginner's Guide To Hedging.)
A failed deal - especially one where the acquirer has bid an
excessively high price - might be cheered by the market. Hungry's share price
might return to $100 or it may go even higher, to $105, for example. In this
case, the arbitrager loses $8 per share on the long trade and $5 per share on
the short trade, for a combined loss of $13.
With short positions offsetting long positions, merge-arb
deals are supposed to be fairly safe from broad stock market volatility, but in
practice that's not always the case. A bull market can push up the share value
of the target company, making it too pricey for the acquirer, and push up the
price of the acquirer, creating losses on the short selling end of the
arbitrage deal.
A bear market can always create problems. During the
2000-2001 market crash, arbitrageurs suffered hefty losses. If Delicious and
Hungry had been engaged in a takeover deal during that time, the stock prices
of both would have dropped. It is likely that Delicious would have fallen more
than Hungry, because Hungry would have withdrawn its offer as market optimism
dried up. If arbitrageurs had not hedged by short selling Hungry stock, their
losses would have been even greater.
To offset some of the risk, arbitrageurs mix-up traditional
moves, sometimes shorting acquisition targets and going long the acquirer, then
selling calls on target shares. If the merger falls apart and the price falls,
the seller profits from the price paid for the call; if the merger closes
successfully, the call reflects much of the difference between the current
price and the closing price.
Expert Business
Small investors thinking they might try a bit of merge-arb
at home should probably think again. Veteran arbitrageur Joel Greenblatt, in
his book "You Can Be a Stock Market Genius" (1985), recommends that
individual investors steer clear of the highly risky merger arbitrage arena.
The merge-arb business is largely the domain of specialist
arbitrage firms and hedge funds. The real job for these firms lies in
predicting which proposed takeovers will succeed and avoiding those that will
fail. This means that they must have experienced lawyers at their disposal to
evaluate deals and securities analysts with a real understanding of the real
worth of the companies involved.
A diversified collection of bets on announced deals can make
steady returns for these firms. That said, a stream of gains is still sometimes
punctuated by the occasional loss when a "sure-fire" deal falls
apart. Even with high-priced professionals to back them up with information,
these specialist firms can sometimes still get deals wrong.
Even worse, growing numbers of specialist funds moving into
this part of the market has caused, paradoxically, greater market efficiency
and subsequently fewer chances for profit. For instance, only so many investors
can pile into a merge-arb trade before the price of the target company's shares
will jump to the agreed per-share acquisition, which completely eliminates the
price spread opportunity.
This changing situation forces arbitragers to be more
creative. For instance, to bulk up returns, some traders leverage their bets,
but also increase their risk, by using borrowed funds. Some merger investors
make bets on potential acquisition targets before any deal is announced. Others
step in as activists, pressuring a target's board of directors to reject bids
in favor of higher prices.
Conclusion:
If all goes as planned, merger arbitrage potentially can
deliver decent returns. The problem is that the world of mergers and acquisitions
is rife with uncertainty. Betting on price movements around takeovers is a very
risky business where profits are harder to come by.
by Ben McClure
Ben McClure is a long-time contributor to Investopedia.com.
Ben is the director of Bay of Thermi Limited, an independent
research and consulting firm that specializes in preparing early stage ventures
for new investment and the marketplace. He works with a wide range of clients
in the North America, Europe and Latin America. Ben was a highly-rated European
equities analyst at London-based Old Mutual Securities, and led new venture
development at a major technology commercialization consulting group in Canada.
He started his career as writer/analyst at the Economist Group. Mr. McClure
graduated from the University of Alberta's School of Business with an MBA.
Ben's hard and fast investing philosophy is that the herd is
always wrong, but heck, if it pays, there's nothing wrong with being a sheep.
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