What Are Merger Securities?

Merger securities are non-cash assets paid to the shareholders of a corporation that is being acquired by or merged with another company. These securities generally consist of bonds, options, preferred shares, and warrants.

Key Takeaways

  • Merger securities are non-cash assets paid to the shareholders of a corporation that is being acquired by or merged with another company.
  • The main idea behind paying out assets as merger securities is to avoid flooding the market and depressing prices by spreading out sales.
  • Well-informed large investors can benefit from buying shares in companies that have the potential to offer merger securities.
  • Merger securities can be difficult for small investors to sell, and they might not receive the securities at all if their investments are too small.

Understanding Merger Securities

Merger securities can become undervalued when large investment firms are required to sell them, due in part to their requirements for holding and sale. For example, a large mutual fund may receive stock options when another firm purchases a company in its portfolio. However, that same fund may have a policy against holding options. In that case, the fund may need to sell them, which could cause the price of the options to decline. By distributing the options to shareholders as merger securities instead, the fund can maintain its policy without selling at fire-sale prices.

Merging two companies is a complicated process, and one that can cause significant volatility on several different fronts. On the most basic level, the stock prices of the acquiring firm and the target firm can fluctuate dramatically. Shares of the firm making the acquisition tend to decline in the days leading up to the merger. Meanwhile, shares of the firm being acquired generally advance. These price changes can have an even more significant impact on related merger securities, especially derivatives like options and warrants.

The main idea behind paying out assets as merger securities is to spread sales over time and distribute decisions among shareholders. Crucially, shareholders do not need to sell merger securities during the highly volatile merger period when it is easier to make costly errors. They can sell the merger securities right away and take potential losses, wait a respectable time, or even hold them for many years. Investors deal with merger securities based on their own goals and knowledge. Since they are bound to make different decisions, the problem of flooding the market is also eliminated.

Benefits of Merger Securities

Well-informed large investors can benefit from buying shares in companies that have the potential to offer merger securities. There is a lot of press attention when a company announces plans for a merger or acquisition. However, it typically takes months or even years to complete the process. That usually gives investors time to get in and get a share of the merger securities.

The key benefit of getting the merger securities is that they might be undervalued by the market. Smaller investors could consider the merger securities to be an inconvenience to be discarded if they consider them at all. In many cases, investors are only willing to pay what shares in the company are worth. In reality, what they are getting is shares of the company plus the merger securities.

Since many investors do not account for the value of the merger securities, that leaves room for other investors to profit. They can get the shares with the merger securities at a discount to their inherent value, then sell the shares and merger securities separately. When sold this way, the assets will fetch their true values, and the investors will profit. That is a form of merger arbitrage.

Criticism of Merger Securities

Merger securities can present a number of issues for small retail investors. In a worst-case scenario, a retail investor may be considered too small to merit any merger securities at all. That is more likely to be a problem if the investor owns only an odd lot or fractional shares in a company.

Holding shares through a mutual fund or an exchange traded fund (ETF) is a way to avoid the issues that merger securities can create for small investors.

If small investors actually get merger securities, they then have to deal with selling them. Many retail investors have little aptitude for or interest in trading options, let alone warrants. Bonds and preferred shares are generally easier to understand and sell. If the market value of the merger securities is relatively low, it may make sense for small investors to sell them and get it done.

On the other hand, investors who unexpectedly get valuable merger securities that they do not understand should seek help from a financial advisor. Advisors cost money, and individual investors are likely to end up paying more than the company distributing the merger securities would have to get good advice. That is another drawback of merger securities.