Merger arbitrage is a sophisticated investment strategy that buys and sells stock of two merging companies at the same time.
Before looking at why merger arbitrage is a sound investment strategy for those who understand the market, the concept must first be defined.
‘Arbitrage’ can be defined as buying and selling a product or stock (or other asset) in different markets simultaneously. The idea is to capitalise on the spread between the asset’s buying price and selling price. In very simple terms, an example of arbitrage can be seen when people buy a product from a shop and then sell it through Amazon for more money.
If a seller buys a TV from a company for €100 and sells it through Amazon or another online retailer for €120, then there is arbitrage.
In this case one would make a €20 (20 per cent) profit. Within capital markets there are numerous types of arbitrage, including convertible bond arbitrage and currency arbitrage. One of the most tested and trusted involves merger arbitrage – where profits are made from announced mergers and acquisitions.
How does a merger arbitrage investment strategy work?
When an acquiring company wants to buy a target company, it usually has to pay a premium. The premium has to be over the target company’s share price, so that it’s a worthwhile deal for its board of directors. Merger arbitrage is an investment strategy that makes money from the difference between the target company’s current share price and the amount paid for its acquisition against the context of the announced merger.
Therefore, merger arbitrage can be described as an event-driven investment strategy, which makes profit from pricing inefficiencies that may happen after the announcement of the merger, acquisition, bankruptcy or other major corporate event.
If we take an example of a potential merger: when a company makes it public that they intend to acquire another, the stock of the target company will usually rise.
The stock of the target will trade in function of the transaction terms announced, and will trade at a discount (a spread) to the transaction consideration to be ultimately received (whether in cash and/or stock of the acquirer), depending on the risks of completion of the transaction or on the upside optionality in the form of a potential counterbid or the need to see improvement in the transaction terms (where the price will be above the terms of the transaction consideration).
This is where a merger arbitrageur will step in.
So, how is it profitable for the arbitrageur?
Firstly, it’s important to realise that corporate mergers are usually split into two categories – stock-for-stock mergers and cash mergers:
• Stock-for-stock merger – this is where the acquirer exchanges its own stock for stock of the company it wants to buy. During this kind of merger, a merger arbitrageur will buy the stock of the target company and short the stock of the acquiring company. When the merger is through and complete, the merger arbitrageur uses the converted stock (from target company into acquiring company) to cover the short position.
• Cash merger – where the acquiring company buys the target company’s shares for cash. Until the acquisition is complete, the target company’s stock will trade in function of the acquisition price. If you buy the target company’s stock below the offer terms before the acquisition closes, therefore, you can make a profit should the acquisition go through. Merger arbitrage formed as an investment strategy during the boom years of the 1980s, when returns were very high.
This was because it was a new strategy with no real competition. Some arbitrage firms made returns of more than 20 per cent per year. This made it more popular as a strategy and the field became much more competitive, lowering the available returns.
What are the risks of merger arbitrage investment?
The biggest risk is that the merger doesn’t go ahead at all, resulting in a share price drop of the target company.
A deal can fall apart for numerous reasons, including shareholders voting against it, a company performing badly, losing funding or regulators blocking the deal. The compensation is the merger spread previously mentioned and is payment to the arbitrageur for the option they provided to long-term shareholders – that is, to exit their stake quickly without having to wait for the deal to close.
These risks are why merger arbitrageurs must have high levels of knowledge, skill and understanding of myriad factors.
They must accurately analyse the potential of a merger and determine whether it is likely to actually happen and how it will play out. This is why large institutional investors such as hedge funds, investment banks and private equity firms are the primary user of merger arbitrage as an investment strategy.
Is merger arbitrage the right investment strategy for you?
A merger arbitrage investment strategy aims to collate a diversified portfolio of arbitrage trades. Each trade must offer the following:
• An annual return above the cost of capital.
• Market implied probability of success.
• An expectation of a return with little correlation to other trades.
The market will set the spread of each opportunity and overall, merger arbitrage continues to outperform other hedge fund strategies on a risk-adjusted scale because of its recurring and compounding income stream nature. There are other advantages of merger arbitrage compared with bonds, including that usually returns therefrom are taxed more favourably.
Merger arbitrage as an investment strategy can provide consistent, relatively low-risk attractive returns which are compounding over time. But a broken deal can cost the arbitrageur. Losses can be higher than the profit expected from a successful investment, so diversification is very important to minimise risk.
Historically, 94 per cent of mergers have completed. Stats show that 87 per cent closed with the initial deal terms in place, a further 6 per cent with higher terms and 1 per cent with lower. Around 6 per cent of announced mergers have failed to close.
So, while merger arbitrage is a good bet as part of a diversified portfolio due to its low-risk, low-correlation with other asset classes and absolute return, it also needs expertise and resources to run as a strategy.
Individual investors should work with professional merger arbitrage funds, which is why individual investors are best off allocating funds to a professional merger arbitrage fund, such as the Abrax Merger Arbitrage strategy managed by AUM Asset Management Limited.
Based in Malta, AUM has been founded in 2015 by Jean-François de Clermont-Tonnerre, is headed by Roberta Bonavia, and is one of the country’s biggest privately owned investment management companies.
Abrax has been trading in announced mergers and acquisitions since 2011 with an annualised return since inception of +8 per cent and consists of a traditional hedge fund and a UCITS structure.
This interview was first carried in the June/July edition of the Commercial Courier