What is Merger Arbitrage
Public companies, unlike privately held companies, are listed on the financial markets of their respective nation, and often on more than one exchange. Organisations usually use the avenue of taking a company public in order to raise more capital in order to expand and grow the business or ensure that it stays afloat. Other benefits of taking a company public include being able to use stock prices as a barometer of the organisations performance as well as opening up more avenues for securing loans (aka more capital).
However, taking a company public also exposes it to the vagaries of the financial markets and its regulators, in that the management will not be able to take actions in isolation and that the company will have to adhere to various policies set by the financial regulator. Further, and most importantly it also opens up the company to be taken over (i.e. purchased by another company). This can often be heart wrenching if the management and board consists of founder owners or people who have invested significant time into the company.
The rationales to target and acquire or merge with another company are many. At a very basic level it could be divided into 1) Strategic Buyers 2) Financial Buyers 3) Raiders / Activists.
Usually, such corporate actions (see below) are usually preceded by announcements in the financial news. Under normal circumstances, the target company’s stock price rises (or falls) to the offer price set (usually part of the announcements). Thus, merger arbitrage is the quick purchase of the stock of a target company and selling the shares on increase of its price. Before we get into the details, let’s revisit the brass tacks for a moment.
Let’s start with looking at the basic terminologies which are used and which I shall also be using throughout the course of this article
- Arbitrage – The ability to earn or generate profits with zero or almost minimal risk.
- Buyer / Acquirer – The company which makes an offer to another company so that it can purchase it
- Target – The organization which is the target of the buyer’s purchase bid
- Merger – The situation where two companies merge together to form a single company.
- Acquisition – A process by which a business (company) purchases another company. The purchase may be settled by Cash, Shares, or Assets
- Friendly / Hostile Takeover – A situation where the target does not want to be acquired by the buyer company is a hostile takeover. A friendly
- Tender Offer – An occasion where the buyer makes an offer directly to the shareholders of the target company rather than the board & management in order to increase its shareholding. A self-tender offer would be an offer by a company to its own shareholders for repurchasing of its shares
- Cash Offer – An acquisition or merger where the buyer pays the target company with cash
- Shares Offer – Same as cash offer except that the target is offered a ratio of the buyer’s stock in exchange
- Short – To bet against a stock, or more simply betting that a stock’s price will reduce
Where to Begin – Process Overview
News Sources & Announcements
Assuming that we are individual investors who don’t have the luxury of following the markets 24×7 unlike the big boys and girls (read institutional investors) of finance, the first place to begin with will be looking out and staying up to date with financial news.
Thus, if one has a brokerage account which allows investing only in the USA, it would make more sense to look out for news which concern companies which are listed on either the NYSE or the NASDAQ as it will only be on these deals that we will be able to seek and act on an arbitrage opportunity. So as mentioned above, one could look at various news sources. The ones which I frequent are the WSJ, Yahoo Finance, MSN Finance, and Thomson One. Other sources include CB Insights and Factset.
Verification and Analysis
Once the news has been identified the next step would be to verify the news with other news sources and websites. The news sources I mentioned above are highly trustworthy sites and are likely to be very accurate in their reporting.
After verification, we will undertake a quick analysis of the stock of the target company and calculate the potential returns which we could earn by acting on the arbitrage opportunity. In order to undertake the analysis, do look out for the terms of the deal in news announcements.
It is during this stage that we will decide upon a price at which we will look to sell the stock.
Purchase & Selling the Shares
Post-analysis, it is prudent to purchase the stocks of the company / target in question. It is advisable to invest at least $1,000 or at the very minimum a sum of $500. A lower amount will eat away at your profits because of commission fees and taxes thereby reducing your net earnings.
As one gains experience with arbitrage, he/she can devise personal techniques to undertake analysis or strategies for exploiting the arbitrage opportunity.
Let us now walk through two simple examples of merger arbitrage. For the purpose of this article, let’s look at a factional all cash and an all share transaction, followed by a live case.