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Trading strategy for M&A Arbitrage

 Mergers and Acquisition (M&A) arbitrage involves trading stock of those companies that are targeted for either Merger or Acquisition. Merger arbitrage is s stock-buying practice that seeks to capitalize on the price difference between the current market value of a security and its value following a successful takeover, merger, spinoff, or other form of corporate reorganization. The whole idea is that an M&A deal normally involves a price premium for the target company and this price gap creates a potential for arbitrage.

LONG ON ACQUIRER IN CASH DEAL AND SHORT IN STOCK DEAL

Cash deals signify that acquirer’s management is more optimistic about the synergies than the target’s management as the later loses control of the resulting firm in a pure cash deal while stock deals signify that target is highly optimistic about the merger and want to retain their equity stake in the resulting firm.

Now, based on the results of survey performed by McKinsey, Dealogic and Datastream, cash deals generate an average DVA* of 13.7%, compared with -3.3 percent for pure stock deals. This signals that market values acquirer’s optimism more than that of the target. 

Another reason for this trend is that historically, acquirer has been paying a higher premium for pure stock deals. The graph above shows that in pure cash deals, an average of 49 percent of acquirers overpay as compared with 69 percent for pure stock deals – a difference that has remained fairly constant over time.

The analysis signifies that post-announcement, there is a 51% probability of acquirer’s stock going up in a cash deal so go long on the acquirer and there is only 31% probability of acquirer’s stock going up in a stock deal so short it.

*POP defined as proportion of transactions where share price reaction, adjusted for market movements, from 2 days prior to 2 days after deal, was negative for acquirer.

*DVA is defined as combined (acquirer and target) change in market capitalization, adjusted for market movements, from 2 days prior to 2 days after announcement, as % of transaction value.


A risk arbitrager speculates value addition and buys stock of the target company before the merger takes place. Risk arbitrage is almost always profitable if the merger goes through, but the arbitrager almost always takes a loss if the merger fails. However, there is a big gamble whether the merger will actually take place. It would make lot of sense to short the potential acquirer at the same time as there is a higher probability of acquirer’s prices going down (69% in stock deal and 49% in cash deal), especially if it is a hostile takeover.


In the recent past, the returns from risk arbitrage are on the decline for a number of reasons – Corporate acquirers are bidding more cautiously, unwilling to make large bids that could seriously impact their balance sheet. This means that the difference between the offer price and target price is getting smaller. A risk arbitrager always need to make sure that the target price is less than the offer price and if not the target is not worth the investment. However, the target’s price could be higher than the offer if there is a chance that another acquirer would make a higher bid for the same target. In that case, it would be important to analyze the synergies between the higher bidder and target, and also assess the possibilities of the merger actually going through.


 



Disclosure: No position