In a merger, one company takes over another one by paying a certain sum in cash, stock, or a mix of both. If a target company is publicly listed, there might be an opportunity for arbitrage. Usually, in order to incentivize management and shareholders of the target to take the deal, a buyer offers a premium (sometimes even multiples) to the pre-announcement price of the target’s shares. As a result, after the merger proposal is announced, the target’s shares jump up. However, often due to numerous uncertainties still outstanding, they usually settle somewhat below the offer price. This spread reflects the uncertainty and riskiness of transaction as perceived by the market. Eventually, if the deal goes through and closes successfully (or the risks are resolved), the spread gets eliminated and the share price of the target company reaches the offer price. If the deal fails, however, the share price of the target company is likely to fall to pre-announcement levels. In essence, and this is crucial, opportunities to profit from merger arbitrage arise from investor’s assessment that the market is overestimating/incorrectly pricing the risks of potential failure, and then betting on the successful closure of the merger (or from pure luck – by guessing correctly which mergers will close successfully).
Major risks include failure to satisfy the conditions (shareholder, regulatory approval, financing), withdrawal of the offer, and potential price amendments. Hedged positions also have to watch out for the borrow related risks – fee increase (lowers/eliminates the upside) or vanishing of the borrowing availability, which could result in a short squeeze.
Sometimes the target company may have more than one prospective buyer. The presence of other suitors (official or rumors only) shows the potential for a “standard” merger arbitrage to develop into a bidding-war. The longer and more intense the bidding-war process is, the more times buyers have to raise their bids to overcome the competitors. Sometimes, the final and winning offer ends up multifold above the initial price, thus, bidding-wars have the potential to significantly thicken the wallets of the target’s shareholders as well as merger arbitrageurs. Some valuation work may help to get a picture of the potential limit the bids can go up to, however, depending on the industry and business of the target company, precise estimations are not always possible.
The situation can get particularly compelling if you can spot the acquisition target in the very early stage of the merger process (rumors, preliminary talks) or even before that – when the potential acquisition is not yet reflected in the share price. The earlier you can locate the potential target, the better as when a preliminary bid is already announced or rumors on potential offer begin spreading, share price appreciates quickly and consumes part of the potential upside. Research for early-stage merger situations includes scanning for any rumors, checking for comments from the management, analyzing the potential buyers, and industry background (maybe the industry is already in the process of consolidation?). The valuation side is important here as you have to estimate the potential limits of the offer (what is the highest possible price here).
See more in our in-depth Guide to Merger Arbitrage HERE.