What is Merger Arbitrage Strategy

What is Merger Arbitrage?

Merger arbitrage, also known as risk arbitrage, is an event-driven strategy mainly undertaken by hedge funds that attempts to capture a spread (difference) between two stock prices-

AND

- The price at which an acquiring company (acquirer) has announced it will pay for that target company upon a successful deal at a future date.

The spread between these two stock prices exists due to the uncertainty that the deal may not be successful.
The size of the spread will depend upon the risk of the deal closing as well as the expected time until the deal is successfully completed.
The key insight with this strategy is that the price of the target usually rises, and the price of the acquirer usually falls, when a bid is announced.
A typical approach may be to buy the target and short the acquirer, and profit from the price movements if the bid succeeds or the price is raised.

Examples of Merger Arbitrage Positions

ABC Ltd to buy XYZ Ltd for INR 50 per share in cash. The deal announced on Jan 1, 2020.
XYZ Ltd’s closing price on Jan 1 was INR 49
ABC Ltd’s closing price on Jan 1 was INR 49.5
Trading strategy– Buy XYZ on the close on Jan 1, 2020
Potential Profit-INR 1 per share

ABC Ltd to buy XYZ Ltd in an all-stock deal with an exchange ratio equal to 1. The deal announced on Jan 1, 2020.
XYZ Ltd’s closing price on Jan 1 was INR 49
ABC Ltd’s closing price on Jan 1 was INR 50
Trading strategy– Short 1 ABC share and buy 1 XYZ share at the close of Jan 1, 2020
Potential Profit-INR 1 per share

What are the fundamentals of Merger Arbitrage?

A merger arbitrage manager typically executes the following steps to establish and exit a transaction-

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What are the risk elements in implementing a merger arbitrage strategy?

Deal Risk – It includes all the factors that could prevent or delay the closing of the deal

Portfolio Risk – It includes factors that arise in the management of the merger arbitrage fund or portfolio.

Deal Risk:

Market Risk:

Large shifts in market conditions may make it difficult to secure financing for acquisition and may also lead a board of directors to revisit the potential synergies identified at the time of the deal.

Extreme volatility may also cause the spread between target share and acquirer share price to break down and arbitrage may not be possible.

Interest rates:

A rise in interest rates will increase the cost of debt financing, which may affect the financial viability of a merger or acquisition.

It is possible that the cost of debt is higher than the potential synergies and the acquirer is no longer interested in making the deal.

Target Firm’s financial situation:

Material changes to the financial or economic condition of the target firm may cause the acquiring firm to terminate its offer.

Significant changes to the target company’s strategy may also lead to the termination of the deal.

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Legal Issues:

There are various legal requirements that have to be followed for a successful merger or acquisition.
In India for example, companies have to follow the Competition Act, Companies Act, SEBI, FEMA, and Income Tax Act and also have to take various court permissions.

Agreement:

The terms and conditions of the merger agreement should be reviewed to ensure that there are limited opportunities for one/both parties to terminate the deal.
A high number of conditions can increase the risk of termination of the deal.

Portfolio Risk:

The use of leverage can both enhance gains and heighten losses.
Given the relatively tight spread that exists in many acquisition scenarios, higher levels of leverage will increase the risk of the positions.

Merger Arbitrage Returns

The above picture by Barclays represents month-wise net returns from 2016 to 2020 of “Merger Arbitrage Index”
We can see there has been a decline in the arbitrage spreads since 2016. The negative returns imply that the merger arbitrage strategy is not risk-free (hence the name risk arbitrage) due to the above-mentioned risks.
The decline in arbitrage spread coincides with the decline in the aggregate returns and alphas of merger arbitrage hedge funds.

Author: Keval Shah

About the Author: Keval Shah is a Chartered Accountant and FRM 2 Candidate. He is passionate about financial markets and loves to play Chess.