What is Merger Arbitrage?

What is arbitrage?

In its simplest form, arbitrage is the purchase of a security in one market and sale of the same security in a different market. 

For example, Special Microbrew Co. makes a large array of microbrews.  Management decides to list the company in both New York and Paris.  At one point in time, Special trades at $5.00 per share in New York.  At that same point in time, Special trades at $5.01 in Paris.  An arbitrageur would purchase the shares in New York at $5.00 and sell them in Paris at $5.01, netting a $0.01 profit.

Obviously, a penny profit per share is not a large amount.  Arbitrageurs of this sort need large amounts of capital to make real money.  There are other forms of arbitrage.

What are the different types of arbitrage?

Different types of arbitrage including pure arbitrage, pairs trading, liquidation arbitrage and merger (or risk) arbitrage.  This post will focus on merger arbitrage.

What is merger arbitrage?

Merger arbitrage is the trading of companies involved in mergers and acquisitions.  For retail investors, it is the simplest form of arbitrage.  It essentially involves one company that another company decides to acquire, because the company could be undervalued.  The acquiring company announces the deal and the price of the company being acquired should increase to the intrinsic value. 

A simple example: Special Microbrew Co. is trading at $5.00 per share.  Big Brewery Co. decides it would like to expand in microbrew business and wants to acquire a microbrewery.  Big Brewery’s investment team looks at potential targets and decides Special is the appropriate target.  Big Brewery’s investment team and a selected team of banks decide what Special’s intrinsic value is, and decide Special’s value is $7.50 per share.  Big Brewery announces the deal that it will acquire Special for $7.50 per share in cash in three months.

Early traders, primarily hedge funds, try to take advantage of their first mover advantage and connection to instant information and bid up the price to $6.50 per share.  Currently, there is a $1.00 difference between the market price and target price, thus creating an opportunity for arbitrage.  A retail investor can purchase the shares of Special shares for $6.50 and receive $7.50 in cash in three months.  This would work to over a 15% return, or over 60% when annualized. 

Details of the deal

The example given above only explains the situation if there is a cash deal.  Different types of deal structures are:

• All cash deal
• All stock deal
• Combination of cash and stock

All cash deal

An all cash deal is where the buyer offers the investors in the company being acquired all cash for the shares.  The example above is the simplest form of an all cash deal.

All stock deal

An all stock deal is where the buyer offers the investors in the company being acquired some fraction of shares in the buyer’s company.  For example, in the above example, Special Microbrew is trading at $5.00 per share.  Big Brewery is trading at $75.00 per share.  Keeping consistent with the idea that Special is worth $7.50 per share, Big Brewery offers Special’s investors 0.10 shares of Big Brewery ($75.00/$7.50 = 0.10).

These deals are more complex than an all cash deal.  In an all stock deal, an investor is betting on the stock price of the acquirer.  In these events, the share price of the company being acquired often increases and the share price of the buyer often decreases.  Thus, investors frequently purchase (or are long) the company being acquired and be short the buyer.  Shorting the buyer protects against changes in the buyer’s stock price, which will ultimately impact the final price of the deal.

In the all stock example above, Big Brewery is trading at near $75.00 per share and will offer Special’s shareholders 0.10 shares.  For example, a retail investor has $650 to invest.  He would purchase 100 shares of Special and short 0.10 shares (100 * 0.10 = 10) of Big Brewery.  After the deal is announced, Big Brewery falls in price from $75.00 to $65.00.  Thus, Special’s investors only would receive $6.50 per share versus the $7.50 at the time of announcement.  By shorting Big Brewery, the retail investor is protected.  See below the comparison of the mechanics of the all cash deal and all stock deal.

	# of shares	Price	Total
All cash deal
Special at time of completion	100	$7.50	$750.00
Total received at closing			$750.00
All stock deal
Special at time of announcment	100	$6.50	$650.00
If investor shorts Big Brewery
Big Brewery at time of announcement	10	$75.00	$750.00
Big Brewery at time of completion	10	$65.00	$650.00
Profit for shorting Big Brewery			$100.00
Investor receives 0.10 shares of Big Brewery	10	$65.00	$650.00
Total received at closing			$750.00

Combination of stock and cash

A combination of stock and cash is the most complex.  It is where the buyer offers some stock and cash to the investors of the company being acquired.  Instead of offering 0.10 shares of Big Brewery, Big Brewery’s management could offer 0.05 shares ($75.00 * 0.05 = $3.75) and $3.75 in cash per share.  Thus, the investor is still receiving $7.50 per share.  In addition, as in the all stock deal above, an investor would have to short the buyer’s share by the appropriate amount.

What are the risks involved in merger arbitrage?

The primary risk in merger arbitrage is the deal not being completed causing prices of both the company being purchased and buyer to move in unknown directions.  Thus, there are risks for large losses.

For example, assume the purchase of Special by Big Brewery will be an all stock deal.  The arbitrageur is long Special and short Big Brewery.  Assume the deal falls through due to the rating agencies believing Special could pose a credit risk to Big Brewery.  Big Brewery’s credit rating is too important and management decides to withdraw the purchase.  In this case, the share price of Special could decrease from the $6.50 to $5.00 or where it was trading before the deal was announced.  The share price of Big Brewery could increase from $75.00 to $80.00 because investors were worried that Big Brewery has less credit risk.  Thus, there are large losses on both sides of the trade.

Another risk for merger arbitrage is the “realization of value” problem.  The “realization of value” problem, according to Benjamin Graham, is investors place a value on a security at sometime in the future.  If the security does not reach the estimated value at that time, the annualized return will continue to fall.  For example, in the Special example above, the deal will be completed in three months and net approximately a 60% gain.  If the deal takes six months instead, the annualized return falls to 30%.

Key reasons deals may fall through or be delayed include ability of the buyer to obtain financing, issues that surface during the due diligence phase, regulatory problems, or competing offers.

Why should an investor consider merger arbitrage?

With all the risks associated with merger arbitrage, why should an investor consider it?  Well, most investors would like to commit their capital to the long-term.  The market may create conditions where investors cannot allocate capital to enough attractive long-term commitments.

The market conditions that many find advantageous for merger arbitrage include when equity markets are going down.  Down equity markets typically include a rally in risk-free bonds (i.e. US Treasuries), thus increasing the price of Treasuries and reducing the yield.  In addition, management of companies may be concerned with the decreasing share price and could consider selling portions of the business or acquisition offers.

Warren Buffett sometimes engages in arbitrage situations.  According the book, “The Essays of Warren Buffett,” in his 1988 and 1989 letter to shareholders, he outlines the reasons for arbitrage:

Our insurance subsidiaries sometimes engage in arbitrage as an alternative to hold short-term cash equivalents.  We prefer, of course, to make long-term commitments, but we often have more cash than good ideas.  At such times, arbitrage sometimes promises much greater returns than Treasury Bills, and equally important, cools any temptation we may have to relax our standards of long-term investments…

(after discussing the RJR Nabisco arbitrage) considering Berkshire’s good results in 1988, you might expect us to pile into arbitrage during 1989.  Instead, we expect to be on the sidelines.

One pleasant reason is that our cash holdings are down – because our position in equities that we expect to hold for a very long time is substantially up.  As regular readers of this report know, our new commitments are not based on a judgment about short-term prospects for the stock market.  Rather, they reflect an opinion about long-term business prospects for specific companies…

Even if we had a lot of cash we probably would do little arbitrage in 1989.  Some extraordinary excesses have developed in the takeover field…

We have no idea how long the excesses will last…But we do know that the less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.  We have no desire to arbitrage transactions that reflect the unbridled – and, in our view, often unwarranted – optimism of both buyers and lenders…

 How is return in merger arbitrage situations calculated?

The most straightforward way to calculate the return in arbitrage situations is the formula provided by Benjamin Graham.  It is simply:

G = expected gain if deal is completed

L = expected loss if deal is not completed

C = expected chance deal is completed

Y = expected time when value will be realized

P = current price per share

Annual return = (CG – L(100%-C)) / YP

In the above example, the return would be expressed as the following:

G = $1.00, expected gain if deal is completed

L = $1.50, expected loss if deal is not completed

C = 95%, expected chance of success

Y = 0.25 year, expected time when value will be realized

P = $6.50, current share price

Annual return = ((95% * $1.00) - $1.50(100%-95%)) / (0.25 * $6.50)

Annual return = ($0.95 - $0.075) / ($1.625)

Annual return = 53.85%

Based on the risk characteristics of the trade, the investor could expect an annual rate of return of approximately 54% if the purchase of Special by Big Brewery is completed on schedule.

Conclusion

There is a reason merger arbitrage is called risk arbitrage – there is a large amount of inherent risk.  But, if done correctly, merger arbitrage can provide solid returns over the long-term.