A visionary investor is always on the lookout for opportunities to potentially grow their investments. While there are lots of known investment techniques and strategies available today, not many are aware of the opportunities which can often arise when companies decide to merge or when one company acquires another. One such opportunity is known as merger arbitrage in the financial world.
This article aims to explain in clear terms what merger arbitrage is and how it works. We also discuss how investors can potentially anticipate the outcome of mergers to make informed investment decisions.
What is Merger Arbitrage
Merger arbitrage is a strategy which is applicable during company mergers or acquisitions. In this strategy, investors buy shares or related assets of a company that is about to be taken over. The goal is to realise potential gains from the anticipated rise in the company's stock price once the merger or acquisition is completed. This strategy is also known as ‘risk arbitrage’ because there is a possibility that the deal may not go through.
Working of Merger arbitrage
Merger arbitrage occurs when an official merger or acquisition announcement is made. Typically, when one company plans to acquire another, the share price of the company being bought (called the target company) usually goes up. This happens because the acquiring company often offers a premium (typically 10–30%) above the current market price to convince the target company’s shareholders to sell their shares. After all, no one would want to sell their shares at the same price they could already get in the stock market.
To understand it better, let’s suppose, Company A’s stock is trading at Rs. 400 per share. Then, Company B announces that it plans to acquire Company A and offers Rs. 750 per share (a significant premium). Due to uncertainty around whether the deal will go through, Company A’s share price doesn’t spike straight to Rs. 750. However, it may rise to around Rs. 550, reflecting investor optimism while still pricing in the potential risk.
The Rs. 200 “gap” reflects the potential risk that the deal might not close due to various possible reasons. In such a scenario, an investor practicing merger arbitrage would buy shares of Company A at Rs. 550 in the hope that the deal will go through and they will potentially receive Rs. 750 per share.
*Example for illustrative purposes only.
Read Also: How arbitrage funds leverage market volatility
Merger arbitrage in cash mergers
In cash mergers, the acquiring company offers to buy the shares of the target company for a fixed amount of cash per share. This is considered relatively straightforward because the final amount is pre-determined. Even though this aspect is straightforward, the overall process can still be complex due to factors like due diligence, negotiations, and regulatory approvals.
Now, let’s understand this better through an example. Let’s suppose Company X offers Rs. 150 per share in cash to acquire Company Y. Company Y’s stock trades at Rs. 140 after the announcement. An arbitrageur could buy shares at Rs. 140. If the deal completes successfully, the investor could receive Rs. 150 per share, resulting in a potential gain of Rs. 10 per share.
*Example for illustrative purposes only.
Having said this, there is always a potential risk that the deal may fall apart.
Merger arbitrage in stock mergers
In a stock-for-stock merger, the acquiring company offers its shares instead of cash to buy the shares of the target company. This means shareholders of the target company get shares of the acquirer in exchange for their own.
In this type of deal, a merger arbitrage investor can aim to make potential gains in two ways:
- They buy shares of the target company (expecting the price to go up after the merger).
- At the same time, they short-sell shares of the acquiring company (expecting the price to fall slightly because more shares will be issued, reducing the value of each share).
This difference between the two prices is called the ‘spread’. If the deal goes through smoothly, the spread narrows and the investor potentially makes gains from both sides.
Let’s understand this better with an example. Suppose Company B plans to acquire Company A in a stock-for-stock deal. Company B offers 1 of its shares for every 3 shares of Company A.
Before the announcement:
- Company A is trading at Rs. 300 per share.
- Company B is trading at Rs. 2,400 per share.
Therefore, the implied value of 3 Company A shares is Rs. 2,400 (or Rs. 800 per share).
After the announcement:
- Company A stock jumps to Rs. 750 (since 3 shares would get 1 Company B share worth Rs 2,400), but not all the way to Rs. 800, due to uncertainty.
- A merger arbitrageur buys Company A shares at Rs. 750 and short-sells Company B shares at Rs. 2,400.
Once the deal is approved and finalised, the arbitrageur exchanges Company A shares for Company B shares, closes the short position at a lower price (if Company B shares fall slightly due to share dilution), and realises the potential gains from the price difference.
Predicting the outcome of mergers
An important factor that can predict whether a merger will succeed or fail is the attitude of the company being acquired, whether it is a friendly takeover or a hostile takeover. So, if the company being acquired is open to the deal, the process usually goes smoothly. But if the company doesn’t want to be bought and resists the takeover, the deal can potentially become much more difficult.
Merger arbitrage investors also play a major role in how things turn out. These investors often put a lot of money into the target company, expecting the merger to happen. Once they are invested, they usually do everything they can such as talking to shareholders or influencing decisions by engaging the target company’s board members––all with the aim of helping the deal go through as their potential gains depend on it.
Active arbitrage vs passive arbitrage
Active Arbitrage
This happens when an investor owns a large number of shares in the company that’s being acquired. As a result of this, they can potentially influence the merger decision like by voting on the deal or persuading other shareholders. This is used by hedge funds and institutional investors.
Passive Arbitrage
This happens when investors don’t have much power to affect the outcome of the merger. They invest based on how likely they think the deal is to succeed. If the chances of the merger going through improve (like if both companies seem to agree), they might increase their investment to target higher potential returns. This is more common among individual investors.
Read Also: What is arbitrage trading?
Conclusion
Merger arbitrage may offer an opportunity for investors to potentially benefit from companies’ mergers and acquisitions. It works by identifying price differences between current stock prices and expected merger outcomes.
FAQs:
What is merger arbitrage?
Merger arbitrage is a strategy that seeks to potentially benefit from the price difference between a company’s current market price and its acquisition price after a merger or acquisition is announced.
How do cash and stock merger arbitrage differ?
In cash mergers, the acquiring company pays a fixed amount for each share. In stock mergers, shareholders of the target company receive shares of the acquiring company.
What factors affect merger arbitrage success?
- Approval by regulatory bodies (SEBI).
- Shareholder vote outcomes.
- Legal or financial issues.
- Market sentiment and news developments.
What are the main risks in merger arbitrage?
- Deal cancellation or withdrawal.
- Regulatory rejections.
- Stock price volatility.
- Extended timelines, reducing the potential annualised returns.
- Inaccurate predictions about merger outcomes.
How are returns calculated in merger arbitrage?
Potential returns are calculated as the percentage difference between the target company’s current share price and the offer (deal) price.
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