Merger Arbitrage Explained: Strategy, Risks, and Special Considerations

What Is Merger Arbitrage?

Merger arbitrage is an investing strategy used by hedge funds to make money from corporate mergers. This strategy involves buying the stock of a takeover target while accounting for the risk that the deal might not go through. Investors, called merger arbitrageurs, look for market inefficiencies and profit opportunities during mergers. This approach focuses on big corporate events like mergers, acquisitions, or reorganizations.

How Merger Arbitrage Works in Practice

Merger arbitrage, also known as risk arbitrage, is a subset of event-driven investing or trading, which involves exploiting market inefficiencies before or after a merger or acquisition. A regular portfolio manager often focuses on the profitability of the merged entity.

By contrast, merger arbitrageurs focus on the probability of the deal being approved and how long it will take to finalize the deal. Since there is a probability the deal may not be approved, merger arbitrage carries some risk.

Critical Factors Impacting Merger Arbitrage

When a corporation announces its intent to acquire another corporation, the acquiring company's stock price typically decreases, and the target company's stock price increases. To secure the shares of the target company, the acquiring firm must offer more than the current value of the shares. The acquiring firm's stock price declines because of market speculation about the target firm or the price offered for the target firm.

However, the target company's stock price typically remains below the announced acquisition price, which is reflective of the deal's uncertainty. In an all-cash merger, investors generally take a long position in the target firm.

If a merger arbitrageur expects a merger deal to break, the arbitrageur may short shares of the target company's stock. If a merger deal breaks, the target company's share price typically falls to its share price prior to the deal announcement. Mergers may break due to a multitude of reasons, such as regulations, financial instability, or unfavorable tax implications.

Exploring Different Types of Merger Arbitrage

There are two main types of corporate mergers—cash and stock mergers. In a cash merger, the acquiring company purchases the target company's shares for cash. Alternatively, a stock-for-stock merger involves the exchange of the acquiring company's stock for the target company's stock.

In a stock-for-stock merger, a merger arbitrageur typically buys shares of the target company's stock while shorting shares of the acquiring company's stock. If the deal is thus completed and the target company’s stock is converted into the acquiring company’s stock, the merger arbitrageur could use the converted stock to cover the short position.

A merger arbitrageur could also replicate this strategy using options, such as purchasing shares of the target company's stock while purchasing put options on the acquiring company's stock.

The Bottom Line

Merger arbitrage is an investing strategy that tries to profit from mergers by buying and selling the stocks of the target companies. The goal is to take advantage of price differences that occur during the merger process, though there is always some risk if the deal doesn’t close. Unlike general stock investing, this strategy focuses only on the merger itself, using methods like going long on the target’s stock or shorting the acquirer’s stock. The approach can vary depending on the type of merger, whether it’s an all-cash or an all-stock deal. Merger arbitrage is event-driven, which means it looks at specific events like mergers and acquisitions rather than overall market trends.