What Is Merger Arbitrage?

What Is Merger Arbitrage?

Let me explain merger arbitrage to you directly—it's often seen as a hedge fund strategy where you simultaneously buy and sell the stocks of two companies that are merging to lock in what could be 'riskless' profits. The catch is the uncertainty around whether the deal will actually close, so the target company's stock usually trades below the acquisition price. As a merger arbitrageur, you'd assess the chances of the deal falling through or delaying, then buy the stock ahead of time, aiming to profit when the merger goes through.

Understanding Merger Arbitrage

You should know that merger arbitrage, or risk arbitrage, falls under event-driven investing or trading, where the goal is to exploit market inefficiencies around mergers or acquisitions. While a typical portfolio manager might look at how profitable the merged company will be, that's not what we're focusing on here.

Instead, as a merger arbitrageur, you'd zero in on the likelihood of the deal getting approved and how long it might take to close. Keep in mind, there's always a risk because the deal might not get approved at all.

Important Note

Here's something crucial: merger arbitrage is all about the merger event itself, not the broader stock market performance.

Special Considerations

When a company announces it's acquiring another, the acquirer's stock price usually drops, while the target's rises. To get those target shares, the acquirer has to offer more than their current value, and the drop in the acquirer's stock comes from market speculation about the target or the offer price.

That said, the target's stock price often stays below the announced acquisition price due to the deal's uncertainty. In a straight cash merger, investors typically go long on the target firm.

If you, as an arbitrageur, think the deal might break, you could short the target's shares. If it does break, the target's price usually drops back to pre-announcement levels. Deals can fail for reasons like regulations, financial issues, or tax problems.

Types of Merger Arbitrage

There are two primary types of corporate mergers for arbitrage: cash and stock mergers. In a cash merger, the acquirer buys the target's shares outright with cash. In a stock-for-stock merger, it's an exchange of the acquirer's stock for the target's.

For a stock-for-stock deal, you'd typically buy the target's shares and short the acquirer's. If the deal closes and the target's stock converts to the acquirer's, you can use that to cover your short.

You could also mimic this with options—buy the target's shares and get put options on the acquirer's stock.