Merger Arbitrage Strategy 101

merger arbitrage investing strategy

Looking for investment ideas? Read on and learn how to generate high returns from an investment strategy called merger arbitrage that Warren Buffett has used in his early years to beat the market consistently. And if you’re looking to implement the strategy, don’t miss out on this essential step by step BONUS tutorial to identify and assess M&A arbitrage investment opportunities.

What is a merger?

In the corporate world, companies buy each other all the time to increase their scale, profits, or to fend off a competitive threat among others. While this happens in both the private and the public markets, merger arbitrage (also called risk arbitrage) takes place when a public company (listed on a public stock exchange) is acquired by another company (public or private). That the target is public matters because risk arbitrage is all about profiting from a subsequent price increase in the target’s stock up to the offer price.

Example of potential acquisition situation

Public Company A makes an offer to acquire the shares of Public Company B for $65/share. Before the announcement, the shares of Company B were trading at $50/share. Upon the news release, Company B’s shares immediately shoot up to $60/share.

The attentive reader will have noticed that the target’s stock price has not increased to the exact offer price. This introduces the concept of merger spread, which is the difference between the current price and the offer price, and represents the chance that the transaction falls through (and interest rates/opportunity cost, to some extent).

Indeed, the announcement of a merger and the closing of a merger are two distinct events! When a merger is announced, it only means that two companies have come to an agreement to combine and have signed a legally binding contract (the merger agreement) to this effect. However, similarly to when you sign the paperwork to buy a house and leave a deposit, the house is not actually yours until the transaction closes and legal ownership documents are established. Until that’s the case, you can back out if you’re willing to lose your deposit (and upset your realtor). The same is true for a corporate transaction, except that even if the two companies do not change their minds, a few other things could go wrong and get in the way of a transaction.

For one, that both the companies’ executives and Boards want to pursue the transaction does not mean that the shareholders do; and after all, they’re the ones owning the businesses, so any transaction can be blocked by them if it doesn’t get enough votes in support of it (usually 50% of the shares outstanding). In addition, mergers can also fall apart if they are blocked by regulators due to antitrust (competition) concerns, or if one of the companies gets pulled in another transaction by a third-party.

Merger Arbitrage

Merger arbitrage or other types of event-driven investing can be highly profitable to investors who spend the time to do their research (or to read this website). There are many deals happening in any given year, and the best way to generate steady returns is to invest only in the few that offer the best risk-reward profiles.

Let’s go back to our acquisition scenario. If an investor believed that the merger was going to close, he would buy the share of the target at its current level and receive the full cash consideration for his shares upon closing, therefore pocketing $5/share of spread. Sounds simple? That’s because it is, as long as you make sure to only bet on those transactions that are highly likely to close.


Types of merger

When the consideration is not cash. Companies looking to acquire another have two currencies at their disposal: cash (or cash financed with debt, which is the same) or stock. As a result, there are 3 possible kinds of deals: cash deals, all-stock deals, and yes, you guessed it, a mix of both.

Cash deals: an acquiring company offers to buy the target’s shares from its shareholders for a cash consideration. If the transaction is approved by shareholders and regulators, the transaction closes, the target’s shares are de-listed and its shareholders receive the full purchase price in their brokerage account in cash.

All-stock deals: an acquiring company offers to buy the target’s shares from its shareholders in exchange of its own stock (this is done via an exchange of shares according to the exchange ratio negotiated by the companies and present in the merger agreement). If the transaction is approved by shareholders and regulators, the transaction closes, the target’s shares are de-listed and its shareholders receive the corresponding shares of the acquirer (or combined entity) in their brokerage account.

Mix: an acquiring company offers to buy the target’s shares from its shareholders in exchange of its own stock AND a cash consideration. If the transaction is approved by shareholders and regulators, the transaction closes, the target’s shares are de-listed and its shareholders receive the corresponding shares of the acquirer (or combined entity) and the cash portion in their brokerage account.

Merger arbitrage spread: How different forms of consideration impact the investment strategy for risk arbitrageurs

Cash deal scenario: Public Company A makes an offer to acquire the shares of Public Company B for $65/share in cash. Before the announcement, the shares of Company B were trading at $50/share. Upon the news release, Company B’s shares immediately shoot up to $60/share.

Investors who believe the deal will close simply buy Company B’s shares at $60/share, and wait for the transaction to close to pocket the $5/share delta.

All-stock scenario: Public Company A makes an offer to acquire the shares of Public Company B, with shareholders receiving 0.50 share of Company A for each share of Company B they hold. Before the announcement, the shares of Company A were trading at $130/share (which values Company B at $65/share) and the shares of Company B were trading at $50/share. Upon the news release, Company B’s shares immediately shoot up to $60/share.
Investors who believe the deal will close can buy Company B’s shares at $60/share, and sell short 0.5 share of Company A for each share of Company B they’ve bought, pocketing $5 of merger spread per share of Company B – remember, when the investor short sells Company’s A shares (i.e. borrows shares of A he doesn’t own to sell them in the market), he receives the money for them upfront. Therefore, each share of Company B purchased is an outflow of $60, and the associated short sale of 0.5 share of Company A is an inflow of $65 ($130*0.5), hence netting the investor $5 in the process. When the transaction closes, the investor will receive 0.5 share of Company A for each Company B’s share he owns, which will be used to cancel out the short selling of Company’s A shares.

Hypothetical example for 10 shares of Company B bought and 5 shares of Company A sold short

Mix: Public Company A makes an offer to acquire the shares of Public Company B, with shareholders receiving 0.30 share of Company A and $26 for each share of Company B they hold. Before the announcement, the shares of Company A were trading at $130/share (which values Company B at $65/share) and the shares of Company B were trading at $50/share. Upon the news release, Company B’s shares immediately shoot up to $60/share.

Similarly to the previous example, investors who believe the transaction will close will need to short sell shares of Company A in the same proportion of the exchange ratio (0.30 share of Company A per share of Company B purchased). Because of the cash component, the investor won’t pocket the spread right away, but upon closing. The logic is a mix of the two previous examples.

Hypothetical example for 10 shares of Company B bought and 3 shares of Company A sold short

Arbitrage Opportunity

Risk arbitrage is a strategy that should be in most investors’ toolbox, even retail investors. In fact, retail investors have the opportunity to play in the most attractive opportunities, while large institutional investors are mostly limited to large transactions occurring in very liquid stocks. What’s more, merger arbitrage often yields high double digit percentage returns (annualized) and is weakly correlated with overall stock market performance (although there is a rather high correlation between economic growth, stock market performance and M&A activity). Therefore, don’t wait and start exploring this site to review the latest investment opportunities available for your portfolio. And remember that there is a free step by step BONUS tutorial available to identify and assess M&A arbitrage investment opportunities.