Merger arbitrage sometimes referred to as risk arbitrage is acquiring and selling the shares of two merging companies in order to generate risk-free gains. Merger arbitrage is a subset of event-driven trading strategies that try to profit from Merger and Acquisitions (M&A) activity.
Due to the uncertainty surrounding the transaction's completion, the target company's stock price generally trades at a discount to the purchase price. A merger arbitrage will assess the likelihood of a merger failing to close on time or at all and will therefore acquire stock before the acquisition. Anticipating a profit after the merger or acquisition is finalized.
Understanding merger arbitrage
Merger arbitrageurs or risk arbitrage is a type of event-driven trading based on exploiting market inefficiencies before or during a merger or acquisition. Since acquisitions and mergers are uncertain until they are concluded there will be a risk premium for both companies. For example, if company A is buying company B for $10 a share, the shares will trade slightly under $10. Reflecting the possibility of the deal falling through. This risk premium is commonly denominated as merger arbitrage spread.
Merger arbitrageurs will evaluate the probability of the deal being completed. They will then place several trades, to try and profit from the merger arbitrage spread. If the deal closes, they will earn the risk premium.
Merger arbitrageurs are concerned with the likelihood that the transaction will be authorized and the time required to complete it. Due to the possibility that the transaction may be denied, merger arbitrage entails considerable risk. Merger arbitrage is a trading strategy that is focused on the event of the merger rather than the company’s fundamentals.
What is merger arbitrage spread?
When a business announces its intention to buy another, the acquiring company's stock price generally declines. While the target company's stock price climbs. To acquire the target company's shares, the purchasing business must make an offer that is more than the shares' current price. Stock prices of the acquiring firm fall as a result of market speculation about the target firm or the price given for the target firm.
The target company's stock price, on the other hand, generally remains lower than the reported purchase price. Thereby reflecting the deal's uncertainty. The difference between the announced acquisition price and the current stock price is commonly referred to as merger arbitrage spread. Investors often take a long position in the target company in an all-cash transaction.
If a merger arbitrageur believes that a merger will fail, he or she may sell short shares of the target company's stock. Therefore profiting it the deal is not completed. When a merger agreement fails, the target company's stock generally reverts to its pre-merger price. Mergers can fail for a variety of reasons, including regulatory requirements, financial instability, and adverse tax consequences.
Types of merger arbitrage
Corporate mergers may be classified into two types: cash mergers and equity mergers. Although both types end up combining two companies, the mechanics of each one are entirely different.
The acquiring firm pays cash for the target company's shares in a cash merger. These are usually the most attractive opportunities for merger arbitrageurs since they entail a price per share that is higher than the current price.
Alternatively, a stock-for-stock merger requires the acquiring firm to swap its shares for that of the target company. This is common among companies that are consolidating. It is also common if the acquirer does not have enough funds to complete the transaction. It may also happen if the company in question wants to avoid excessive debt to complete the acquisition.
The most common merger arbitrage strategies
Merger arbitrage usually entails the purchasing shares of the target company's stock while shorting the acquiring company's stock in a stock-for-stock merger. If the transaction is completed in this manner and the target company's stock is converted to the acquiring company's shares, the merger arbitrageur can use the converted stock to cover the short position.
A merger arbitrageur may potentially mimic this approach when it comes to cash mergers. By purchasing shares of the target company's stock while simultaneously obtaining put options on the acquiring company's stock.
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