Merger Arbitrage Strategy and its risk

What is Merger Arbitrage?

 Merger arbitrage, also known as risk arbitrage, is a event-driven strategy mainly
undertaken by hedge funds that attempts to capture a spread (difference) between two
stock prices-

o The price at which a company (target) trades after a deal is announced

AND
o The price at which an acquiring company (acquirer) has announced it will pay
for that target company upon successful deal at a future date.

 The spread between these two stock prices exists due to the uncertainty that the deal
may not be successful.

 The size of the spread will depend upon the risk of the deal closing as well as the
expected time until the deal is successfully completed.

 The key insight with this strategy is that the price of the target usually rises, and the price
of the acquirer usually falls, when a bid is announced.

 A typical approach may be to buy the target and short the acquirer, and profit from the
price movements if the bid succeeds or the price is raised.

Examples of Merger Arbitrage Positions

1. Cash Deal

 ABC Ltd to buy XYZ Ltd for INR 50 per share in cash. Deal announced on Jan 1, 2020.

 XYZ Ltd’s closing price on Jan 1 was INR 49

 ABC Ltd’s closing price on Jan 1 was INR 49.5

 Trading strategy- Buy XYZ on the close on Jan 1, 2020

 Potential Profit-INR 1 per share

 2. Stock Deal

 ABC Ltd to buy XYZ Ltd in all-stock deal with an exchange ratio equal to 1. Deal
announced on Jan 1, 2020.

 XYZ Ltd’s closing price on Jan 1 was INR 49

 ABC Ltd’s closing price on Jan 1 was INR 50

 Trading strategy- Short 1 ABC share and buy 1 XYZ share at the close of Jan 1, 2020

 Potential Profit-INR 1 per share

What are the fundamentals of Merger Arbitrage?

A merger arbitrage manager typically executes the following steps to establish and exit a
transaction-

1) Transaction announcement

 The first step in a merger arbitrage trade usually follows the announcement of a merger or
acquisition.
 Usually, a manager takes position after the public announcement of a deal.

2) Identify and evaluate risks

 The profitability of a merger arbitrage trade is highly contingent on the completion of a

transaction.
 There are various types of risks (explained later) which may impact merger arbitrage strategy

3) Establish positions in target and acquirer

 For cash deals – the simplest arbitrage trade entails the purchase of the target firm’s stock,
which would be held until the deal is completed.
 For stock deals – the manager will typically buy the target firm’s stock and sell short the
stock of the acquiring firm. However, a manager who expects the bid to fail would, sell short
the target firm and buy the acquirer firm.
4) Tender shares and unwind short positions

 In a cash deal, the target firm’s stock is usually tendered by the deadline for cash
consideration.
 In a stock deal, the investor will receive shares of the acquirer as payment for their
holdings of the target stock upon the completion of the merger. These shares are
delivered against the short position to close out the trade.

What are the risk elements in implementing merger arbitrage strategy?