Risk arbitrage is a trading strategy which is generally employed to benefit from the price differential between two companies involved in an M&A deal. Also called “Merger Arbitrage,” the strategy is employed to bet on price efficiencies arising from the successful completion of a merger and acquisition agreement. This strategy employed on this event-driven arbitrage trade will vary depending on the type of M&A or the takeover deal that is being discussed. In a takeover deal, there are typically three possibilities
- Cash Merger- The acquirer offers to buy the target company’s shares for cash.
- Stock Merger- The acquirer offers the acquiring company’s shares to the promoters and shareholders of the target company in a certain ratio.
- Cash and Stock Merger- A mix of 1 and 2.
Let’s take a look at the first two possibilities,
In a cash merger, the acquiring company agrees to buy a target company for a certain cash price. In a majority of M&A deals, the acquiring firm generally offers to buy the shares of the company being acquired at a premium to the current market price.
For instance, if company A agrees to buy shares of company B at a premium of 10 percent to its current market price, of say $100, the share prices of the target company will typically spike since the value of the company increases although the valuation may not really change. The extent to which the share prices of the target company jump will depend on the likelihood of the deal going through and the bids placed by other competitors.
In a cash merger, the risk arbitrager would buy shares of the target company while they’re still below the offer price and sell them at a premium on completion of the deal.
In stock mergers, the acquirer offers to buy the target company’s stock by offering its shares in return, at a specific ratio. Generally, before the acquisition talks begin, the share prices of the two companies can be seen trading at a particular spread. Once the M&A deal progresses, the shares of the company to be acquired will rise while the share prices of the acquiring company will drop by a value which is more or less equal to the equity paid to acquire the target company. In other words, the spread in the share prices between the two companies narrow, since once the deal is closed, there will only be one listed company: The acquirer. On completion of the deal, the stock of the acquired company will be converted into the stock of the acquirer based on the pre-determined exchange ratio in the merger agreement.
In a stock merger, the risk arbitrage strategy involves buying the shares of the company being acquired and simultaneously going short in the shares of the acquiring firm to profit from the diminishing gap in the share prices of the acquirer and the target company correspondingly. Once the companies are merged, the long positions held in the target company will be closed out against the short positions in the acquirer.
Although termed risk arbitrage, the strategy is not completely risk-free since there is a threat of a breakdown in the merger agreement. Besides, there is the possibility of price negotiations during ongoing discussions or the deal being extended indefinitely, or changes to the original terms, all of which could impact affecting potential revenues and the share prices of either one or both the companies involved in the M&A arrangement.
The risk-return profile of a risk arbitrage trade is asymmetric, where the potential downside risk is much higher if the deal does not go through compared to the limited gains in the event of the completion of the merger.