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What is Merger Arbitrage?

You might have read about Hedge funds in our previous series. If not, click here

Today, let’s discuss some of the hedge fund strategies which are used by investors to make a gain. One of it being Merger Arbitrage.

What is Merger Arbitrage?

As the name suggests, it is a hedge fund strategy adopted to take benefits from the inefficiencies around mergers and acquisitions. It is an investment strategy involving simultaneous purchase and selling of the stock of merging companies. Typically, the price of the target company is set below the acquisition price due to the uncertainty of the acquisition being taken place. This leads to investors buying the stock before the acquisition and selling it after the event, to make gains.

It is an event driven investing. A merger arbitrageur review the probability of the deal being taken place while a portfolio manager is just concerned about the profitability of the M&A deal.

Once the deal takes place, the difference between the purchase price and price after acquisition leads to potential gains. However, this is a risky business and something that only professionals tend to play with. It is a successful strategy for making returns but requires a lot of expertise.

Let’s say Chop Chop shares are trading at $50 per share and Finance ventures come in to bid the price at $57 per share. The Chop Chop’s share price will immediately jump and reach a price between $50 and $57, take it $54. Now, seizing the opportunity risk arbitrageur will purchase the stock at $54 and sell it for $57 as soon as the event takes place, making a gain of $3.

However, it’s not as easy as it seems to. Things always don’t go as predicted and sometimes stock prices tend to move in the opposite direction. The biggest risk factor is the possibility of a deal falling through. If the deal collapses with no alternative bidders, it might fall back to its initial value, leading to a significant loss to the investor.

Apart from the most simple way of investing in M&A, there are more investment opportunities during the event. There is also a probability of the acquiring company’s shares falling due to the risk of excess debt taken for acquisition. So, the arbitrager short sells the shares of the acquiring company by borrowing shares. A failed deal, on the other hand, might also be seen as a failure of the acquiring company and its share price might fall too. Short selling the same, might act as a hedge against buying the shares of the company being acquired.

If a merger arbitrager expects the deal to fall off, it will then short sell the shares of the target company making a gain if the deal eventually does not take place. These investments are made by specialist arbitrage and hedge funds.

Types of Merger Arbitrage

There are generally two types of mergers, mainly, cash and stock mergers. A cash merger involves acquiring the target company’s shares for cash whereas in stock mergers it is done through exchange of acquiring company’s stock with target company’s stock.

In a stock to stock merger, the investor purchases the stock of the target company and short sells acquiring company’s stock. After the merger takes place, the share of the target company gets converted to the shares of the acquiring company and hence the converted shares can be used to cover the short sell position.

Liquidation arbitrage is also a kind of risk arbitrage involving the strategy of finding out an undervalued company to be liquidated. Prior to liquidation, its liquidation value will be greater than its market value. The differences in the prices before and after the event can lead to gains.

Another strategy is Pair trading where the prices of two similar companies in the same industry with similar valuation and trading patterns tend to behave differently. Investors sell the stock of a highly priced company and buy the shares of a lower priced company to make gains.

Speculation vs Arbitrage

Here it is important to note that the two terms, Speculation and Arbitrage differ from each other. While Arbitrage involves buying in one market and then selling in another to make a gain, speculation is based on assumptions and does not require a sizable investment base. Speculation is more riskier than arbitrage with a greater risk reward strategy. Anyone can engage in speculation by arbitrage strategy adopted by institutional investors and hedge funds.

If all goes planned, Merger Arbitrage can provide significant returns. The only problem lies in the uncertainty of the Mergers and Acquisition deals. To know and take advantage of such deals, it is important to stay updated about the M&A deals taking place.

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