Trading Acquisitions Part 2 – M&A Arbitrage
What is M&A Arbitrage?
Mergers and Acquisitions (M&A) occur when one company buys another company. Whether the purchase is considered a merger or acquisition is related to the size of each company and the way in which the businesses will exist after the M&A activity. Mergers are usually two companies of around the same size, and acquisitions are usually accomplished when one larger company purchases a smaller company. M&A Arbitrage is a trading strategy that involves simultaneously buying and selling the stocks of the companies involved in the M&A in order to profit from the difference in the perceived risk of the deal and the actual price gap.
The Mechanics of M&A Arbitrage
M&A Arbitrage involves capitalizing on the risk and pricing differentials between the acquiring company and its target as part of a stock-for-stock acquisition deal. Target companies usually see a stock price increase after the acquisition announcement while acquiring companies usually see a drop in their stock price after the acquisition announcement. So, the arbitrage strategy involves evaluating the reasons for the acquisition and the probability that the deal will ultimately be successful. The target stock price typically increases to just below the acquisition offer price, and the amount of this difference reflects the market uncertainty about the deal closing.
This strategy is most effective when there is a fairly large price gap between the target’s market price and the offer price in the acquisition deal. The arbitrage trading strategy is created by buying shares of the target stock while simultaneously shorting shares of the acquiring company’s stock. The combination of these two activities also eliminates any outside market risk. When the deal is complete and the acquiring company exchanges its stock for the target’s stock, the arbitrage investor uses the newly converted target shares to cover the short position.
Why Do Investors Use M&A Arbitrage Strategies?
Done correctly, M&A arbitrage is a fairly simple way to earn an above-average rate of return with relatively low risk. By shorting the acquiring company’s stock and purchasing the target company’s stock, investors are also able to neutralize the effect of outside market volatility. The strategy is based on the belief that M&A activity induces temporary mispricing and inefficiency in the stock prices of the target and acquiring companies. M&A Arbitrage, however, is not without risk.
The biggest risk associated with the M&A Arbitrage strategy is that the deal will not close. A variety of factors could ultimately prevent an acquisition from being completed. Regulatory approval may be required for the M&A to close, and that may not come if the government believes the acquiring company will be in a position that discourages market competition. Alternatively, the company may not be able to obtain the approval of its shareholders. Finally, the deal could fall through simply because one of the companies could not satisfy the conditions of the merger or acquisition.
Although M&A Arbitrage trading strategies are fairly insulated from the impact of general market activity, large market swings could threaten the profitability of this strategy. A strong bull market could push up the stock prices of both companies making the target stock too expensive for the acquisition and create a loss on the short position in the acquiring company’s stock. A strong bear market could decrease the value of both companies and cause losses if the target stock falls precipitously more than the acquiring company.
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