Merger arbitrage is the business of trading stocks in companies that are involved in takeovers or mergers. The most basic of these trades involves buying shares in the targeted company at a discount to the takeover price, with the goal of selling them at a higher price when the deal goes through.

But betting on mergers is a risky business. As a rule, it's a tool that's exclusively for professionals, and probably not something you want to try at home.

Key Takeaways

  • Merger arbitrage is trading in the stocks of companies that are involved in proposed takeovers or mergers.
  • The simplest type of merger arbitrage involves buying of a company targeted for takeover at a discount from the acquisition price, betting the deal will go through.
  • Merger arbitrage has proven a successful strategy for many funds, but it requires expertise to accurately assess the risks.

Understanding Basic Merger Arbitrage

Merger arbitrage (also known as "merge-arb") involves trading the stocks of companies engaged in mergers and takeovers. When the terms of a proposed merger become public, an arbitrageur will go long, or buy shares of the target company, which in most cases trade below the acquisition price.

Those investors who already own shares in the target company when the takeover is announced likely have seen big gains already, given that most acquisition prices are well above the market price. And those investors may not want to wait around until the deal goes through, which could take many months, before realizing their gains. This is where the merger arbitrage trader steps in, buying the shares at a discount in exchange for assuming the risk that the deal may fail.

If the deal does go through, the target company's stock price will rise to the agreed acquisition price. The wider the gap, or spread, between the current trading prices and their prices valued by the acquisition terms, the better the arbitrageur's potential returns. (For related reading, see Trading The Odds With Arbitrage.)

A Successful Merger Example

Let's look at how a successful merger arbitrage deal works in practice.

Suppose Delicious Co. is trading at $40 per share when Hungry Co. comes along and bids $50 per share—a 25% premium. The stock of Delicious will immediately jump, but will likely soon settle at some price higher than $40 and less than $50 until the takeover deal is approved and closed.

Let's say that the deal is expected to close at $50 and Delicious stock is trading at $47. Seizing the price-gap opportunity, a risk arbitrageur would purchase Delicious at $48, pay a commission, hold on to the shares, and eventually sell them for the agreed $50 acquisition price once the merger is closed. From that part of the deal, the arbitrageur pockets a profit of $2 per share, or a 4% gain, less trading fees.

From the time that they are announced, mergers and acquisitions take about four months to complete. So, that 4% gain would translate into a 12% annualized return.

Know the Risks to Avoid the Losses

While this all sounds fairly straightforward, it is assuredly not that simple. In real life, things don't always go as predicted. The entire merger arbitrage business is a risky one in which takeover deals can fizzle and prices can move in unexpected directions, resulting in sizable losses for the arbitrageur.

Merger arbitrage is a risky, complicated business and could result in significant losses.

The biggest factor that increases the risk of participating in merger arbitrage is the possibility of a deal falling through. Takeovers can get scrapped for all kinds of reasons ,including financing problems, due diligence outcomes, personality clashes, regulatory objections, or other factors that might cause the buyers or seller to pull out. Hostile bids are also more likely to fail than friendly ones. The longer a deal takes to close, the more things can go wrong to scuttle it.

Consider the consequences of the Hungry-Delicious deal falling through. Another company might make a bid for Delicious, in which case its share value may not fall by much. However, if the deal collapses with no alternative bids being offered, the arbitrageur's position in the target company would probably fall in value, back to the original $40 price. In that case, the arbitrageur loses $8 per share (or roughly 16%).

More Complicated Merger Arbitrage Scenarios

There are other ways to trade a takeover or merger. Many times, the share price of the acquiring company falls, perhaps because investors express skepticism about the wisdom of the deal or the company taking on too much debt. So an arbitrageur will often short sell the acquiring company by borrowing shares with the hope of repaying them later with lower cost shares.

In another case, if the deal falls through the market might interpret the blown deal as a big loss for the acquiring company, and its shares might fall in value. Consider the case of a failed Hungry-Delicious deal, mentioned above. A failed deal might mean that Hungry's stock falls from $100 to $95. In this case, the arbitrager would gain $5 per share from short selling Hungry's stock. Here, short selling the acquirer's stock would act as a hedge, offering some shelter from the $8-per-share loss suffered on the target's stock. (For more insight, see A Beginner's Guide To Hedging.)

A failed deal—especially one where the acquirer has bid an excessively high price—might be cheered by the market. Hungry's share price might return to $100 or it may go even higher, to $105, for example. In this case, the arbitrager loses $8 per share on the long trade and $5 per share on the short trade, for a combined loss of $13.

Risk and Merger Arbitrage

With short positions offsetting long positions, merge-arb deals are supposed to be fairly safe from broader stock market volatility, but in practice, that's not always the case. A bull market can push up the share value of the target company, making it too pricey for the acquirer, and push up the price of the acquirer, creating losses on the short selling end of the arbitrage deal.

A bear market can always create problems. During the 2000-2001 market crash, arbitrageurs suffered hefty losses. If Delicious and Hungry had been engaged in a takeover deal during that time, the stock prices of both would have dropped. It is likely that Delicious would have fallen more than Hungry, because Hungry would have withdrawn its offer as market optimism dried up. If arbitrageurs had not hedged by short selling Hungry stock, their losses would have been even greater.

To offset some of the risk, arbitrageurs mix up traditional moves, sometimes shorting acquisition targets and going long the acquirer, then selling calls on the target's shares. If the merger falls apart and the price falls, the seller profits from the price paid for the call; if the merger closes successfully, the call reflects much of the difference between the current price and the closing price.

Expert Business

Small investors thinking they might try a bit of merge-arb should probably think again. Veteran arbitrageur Joel Greenblatt, in his book "You Can Be a Stock Market Genius" (1985), recommends that individual investors steer clear of the highly risky merger-arbitrage arena.

The merge-arb business is largely the domain of specialist arbitrage firms and hedge funds. The real job for these firms lies in predicting which proposed takeovers will succeed and avoiding those that will fail. This means that they must have experienced lawyers at their disposal to evaluate deals and securities analysts with a real understanding of the real worth of the companies involved.

A diversified collection of bets on announced deals can make steady returns for these firms. That said, a stream of gains is still sometimes punctuated by the occasional loss when a "sure-fire" deal falls apart. Even with high-priced professionals to back them up with information, these specialist firms can sometimes still get deals wrong.

The Bottom Line

If all goes as planned, merger arbitrage potentially can deliver decent returns. The problem is that the world of mergers and acquisitions is rife with uncertainty. Betting on price movements around takeovers is a very risky business where profits are harder to come by.

For related reading, check out The Merger - What To Do When Companies Converge and The Basics Of Mergers And Acquisitions.