Merger arbitrage is the business of trading stocks in companies that are subject to takeovers or mergers. Arbitrage exploits the fact that takeovers normally involve a big price premium for the company. As long as there is a price gap, there is potential for sizable rewards. But betting on mergers can be risky business. As a general rule, it's a tool that's exclusively for professionals, and probably not something you want to try at home. In this article, we'll take you on a tour of the high-risk world of merger arbitrage.

What is Merger Arbitrage?

Arbitrage involves purchasing an asset at one price for an immediate sale at a higher price. Thus, an arbitrageur - a fancy term for the person who buys the stock at the lower price - tries to profit from the price discrepancy. It is fairly rare to find potential opportunities for arbitrage in an efficient market, but once in a while, these opportunities do pop up.

Merger arbitrage (also known as "merge-arb") calls for trading the stocks of companies engaged in mergers and takeovers. When the terms of a potential merger become public, an arbitrageur will go long, or buy shares of the target company, which in most cases trade below the acquisition price. At the same time, the arbitrageur will short sell the acquiring company by borrowing shares with the hope of repaying them later with lower cost shares.

If all goes as planned, the target company's stock price should eventually rise to reflect the agreed per-share acquisition price, and the acquirer's price should fall to reflect what it is paying for the deal. 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 an example of 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. However, if it trades at a higher price, the market is betting that a higher bidder will emerge.

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.

At the same time, the arbitrageur will probably short sell Hungry stock in anticipation that its share price will fall in value. Of course, the value of Hungry may not change. But, oftentimes, an acquirer's stock does fall in value. If Hungry shares do fall in price from $100 to $95, for example, the short sale would net the arbitrageur another $5 per share, or 5% (15% annualized if the deal took four months to complete).

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.

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%).

On the other hand, the behavior of the acquirer's stock is less predictable in the event of a scuttled takeover. The market might interpret the blown deal as a big loss for Hungry, and its shares might fall in value, say 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.

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.

Even worse, growing numbers of specialist funds moving into this part of the market has caused, paradoxically, greater market efficiency and subsequently fewer chances for profit. For instance, only so many investors can pile into a merge-arb trade before the price of the target company's shares will jump to the agreed per-share acquisition, which completely eliminates the price spread opportunity.

This changing situation forces arbitragers to be more creative. For instance, to bulk up returns, some traders leverage their bets, but also increase their risk, by using borrowed funds. Some merger investors make bets on potential acquisition targets before any deal is announced. Others step in as activists, pressuring a target's board of directors to reject bids in favor of higher prices.

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.