Definition
Merger arbitrage is an investment strategy that capitalizes on the price gaps between a company’s current market price and its price once the acquisition is complete. It involves buying the stocks of a company being acquired and, if appropriate, short selling the stocks of the acquiring company. The strategy relies on the assumption that the announced deal will close and the stocks will move to the announced acquisition prices.
Key Takeaways
- Merger Arbitrage is a sophisticated investment strategy often used by hedge funds, which involves buying and selling the stocks of two merging companies to create riskless profit.
- This strategy capitalizes on the price spread between the current market price of a target company’s stock and the price that the acquiring company has agreed to pay for it. Investors stand to earn the difference in price if the merger successfully goes through.
- While the strategy can be profitable, it is also associated with various risks. For instance, if the announced merger fails to materialize, the investor could incur significant losses. Therefore, careful and thorough analysis of the potential merger deal is crucial.
Importance
Merger arbitrage is an important finance term because it refers to a crucial investment strategy that involves buying and selling the stocks of two merging companies. This strategy capitalizes on the fact that shares of the target company typically trade below the price offered by the acquiring company, exploiting the “spread” for financial gain.
When successful, it could lead to significant returns. Additionally, it is considered to be a market-neutral strategy, meaning it can provide returns even in sideways or bear markets; thus, offering investors an interesting means of risk diversification.
Understanding merger arbitrage can therefore be valuable for both investors attempting to maximize returns and companies seeking to effectively manage their financial transactions during mergers and acquisitions.
Explanation
Merger arbitrage is a specialized strategy primarily used by hedge funds and institutional investors to capitalize on the price discrepancies that exist when a company announces a merger or acquisition. The purpose of this strategy is to profit from the price spread between the market price of the target company’s shares post-announcement and the price offered by the acquiring company.
Typically, once a merger is announced, the share price of the target company jumps, but it doesn’t usually reach the offer price, due to the inherent risk that the deal might fall apart. In merger arbitrage, a trader will go long (buy the shares) on the stock of the company being purchased, and may also short sell the stock of the acquiring company, effectively locking in the price spread.
The deal could take several months to complete, during which both macro and deal-specific risks are present. As such, this strategy is typically left to those with complex models to assess risk and the financial means to stomach potential losses.
The strategy, while potentially profitable, involves significant risk and requires sophisticated risk management to execute successfully.
Examples of Merger Arbitrage
A famous example of merger arbitrage is the AOL and Time Warner merger in
AOL, an internet service provider, proposed a merger with Time Warner, a mass media conglomerate. The merger was thought to create a company with great synergy, combining Internet service with media content. As news of the merger became public, arbitrages purchased Time Warner shares, anticipating their value would rise to meet AOL’s share price.
In 2015, pharmaceutical companies Pfizer and Allergan announced a $160 billion merger. Investors who speculated that the merger would go through bought shares of Allergan and short sold shares of Pfizer, expecting that Allergan’s share price would increase and Pfizer’s would decrease to balance out the transaction. Nevertheless, it provides a classic example of a scenario where merger arbitrage could take place.
One more recent example is the merger between Walt Disney Company and 21st Century Fox, announced in 2017 and completed in
Using merger arbitrage, investors would have bought shares in 21st Century Fox while concurrently short selling shares in Disney in the expectation that the shares of the acquisition target (21st Century Fox) would rise while those of the acquiring firm (Disney) would fall.
FAQs on Merger Arbitrage
What is Merger Arbitrage?
Merger Arbitrage, also known as risk arbitrage, involves investing in securities of companies that are subject to some form of extraordinary corporate event, such as amalgamation, merger, or acquisition. The goal of the arbitrageur is to profit from the difference in stock market price discrepancies between the companies.
How does Merger Arbitrage work?
Merger Arbitrage works by purchasing the stock of a company that is expected to be acquired and shorting the stock of the acquiring company. If the acquisition goes through, the price of the acquired company’s stock typically rises while the acquiring company’s falls. This creates a profit for the arbitrageur.
Is Merger Arbitrage risky?
Like any investment strategy, Merger Arbitrage comes with its inherent risk. The main risk occurs when the merger or acquisition falls through. If an announced deal does not close as expected, the price of the acquired company’s stock may dramatically decrease, incurring hefty losses for investors. Therefore, successful merger arbitrage requires significant research and risk assessment.
Why do traders use Merger Arbitrage?
Traders use Merger Arbitrage as it can often offer consistent, low-risk returns. Although profit margins per trade can be relatively low, the strategy can provide reliable returns when executed successfully over multiple trades. Additionally, these returns tend to be less correlated with overall market trends, offering portfolio diversification.
Can individual investors do Merger Arbitrage?
While Merger Arbitrage is typically more common amongst hedge funds and institutional investors due to the complex analysis and large capital required, individual investors with a strong understanding of the strategy can also participate. It involves a fair amount of risk and research, so individual investors should proceed with caution and thoroughly understand the details of each potential deal.
Related Entrepreneurship Terms
- Acquisition Premium
- Deal-Risk Arbitrage
- Spread
- Arbitrageur
- Takeover Bid
Sources for More Information
- Investopedia: This website provides a broad overview of various financial and investment terms and strategies, including merger arbitrage.
- Wall Street Mojo: This site offers more in-depth explanations of financial topics, with a specialty in investment banking and private equity.
- Corporate Finance Institute: A professional development organization offering online courses and resources in finance and related subjects including merger arbitrage.
- Financial Times: A major financial newspaper that may discuss merger arbitrage in their news articles or opinion pieces.
