After the notification of a merger or acquisition, the stock of the target company normally trades below the price offered by the acquiring company. Merger arbitrage refers to the investment strategy that attempts to profit from the arbitrage spread, which is the difference between the offer price and current price of the target’s stock.
If the merger or acquisition is successful, the arbitrageur books the arbitrage spread as profit due to the fact that the price of the target’s stock converges to the offered price—hence the arbitrage spreads closes to zero—as the consummation date approaches.
However, if the merger or acquisition fails, the arbitrageur suffers a loss, usually much bigger than the profits earned if the deal would have succeeded. Cash and stock transactions are the two primary types of mergers and acquisitions.
In a cash transaction, the acquiring company offers to pay a specific sum of money in exchange for the target company’s stock, whereas in a stock transaction, the acquirer offers its common stock.
In case of a cash offer the arbitrageur simply buys the target company’s stock, whereas in a stock transaction, the arbitrageur sells short the acquiring firm’s stock in addition to buying the target’s stock.
the primary source of profits in the first type of investment is the difference between the purchase price and the cash received and the secondary source of profits is the dividend paid by the target company.
In contrast, the long/short position has three sources of profit. The primary source of profits is the change in the arbitrage spread while the second source of profits is the dividend paid by the target company minus the dividend that must be paid on the acquirer’s stock.
The third source of profits is the interest paid by the arbitrageur’s broker on the profits generated from the short selling of the acquiring firm’s stock. Most stock transactions involve a fixed exchange ratio.
However, many stock transactions have built-in collars that are designed to protect the shareholders of either the acquiring or the target company or both companies. In a collar offer, the acquiring company sets up ranges for the exchange ratio based on the average stock price of the acquirer over a specific number of days prior to the transaction’s closing.
Typically, the exchange ratio is structured to rise as the acquirer’s stock price declines, falls as its price increases, and remains stable over a middle range. Besides collar offers, more complex deal structures involving preferred stocks, warrants, departures, and other securities or combinations of casthand stock transactions are common.
Therefore, the first step of a merger arbitrageur is to calculate the different components of the arbitrage spread. Besides the time value of money, the risk premium for the completion risk is the main reason for a positive arbitrage spread, as the idiosyncratic risk of deal completion cannot typically be hedged.
Figure above clearly shows the asymmetric payoff structure of merger arbitrage transactions, as the median arbitrage spread of failed deals widens dramatically on the termination announcement day whereas the median arbitrage spread decreases continuously as the deal resolution date gets closer. Therefore, predicting which announced merger or acquisition will be successful and which will fail is the most important task for merger arbitrageurs, as Branch and Yang show.