How to Make Money from Merger Arbitrage

When a public company is acquired there is a potential to make money on the difference between the offered price and the current market price. If the company trades for $10/share and a suitor offers its shareholders $15/share, obviously someone is going to make money on the difference.

The basic risks involved are:

• Whether the takeover will be completed as planned or delayed or even canceled


• If it's a stock-only deal (where shareholders of the company being acquired are offered shares of a company that is taking over), then there is a risk that the merger will not as successful as expected and new company's stock decreases

There are typically three possible options that can be presented to the shareholders of a target company (a company being taken over): stock-only, stock-and-cash, and cash-only. Usually cash-only is the best option since its more straightforward and you only need to be concerned with valuating the target company.

The ideal deal is when the merger is cash-only, there is a very high likelihood of the successful takeover, and the whole deal is expected to complete very quickly. The sooner the deal closes the quicker you can take your profits and look for other arbitrage options on the market. The problem with such an "ideal deal," though, is that it is very difficult to buy shares of the target company before they're bid up to the takeover price. If the company trades at $10/share and offer price is $15/share, the share will most likely reach the offer price of $15/share on the announcement date. Unless you're sitting in front of a terminal all day long and monitor merger activity, you will miss out on a buying opportunity that day.

So, the most likely scenario is when a merger takes 4-8 months to complete and there are persistent rumors about different ways that a deal could fall through. After several months many investors grow wary and start selling the stock lower than the offer price. If you're patient and your research tells you that the deal will certainly happen, you can start buying during that slight price dip - the prices aren't likely to fall by much unless the deal is really shaky, but even if you make 7-15% over the course of 2-4 months, those returns will add up to a sizable annual rate of return for you if you can find deal after deal after deal throughout the year. To quote ArbitrageView:

"One of the best ways to reduce the risk in merger arbitrage is to participate in multiple deals simultaneously. Diversifying across several deals without being overweight in any particular one will ensure that if one of the deals fails it will have only limited impact on the portfolio as a whole."

So, here is how I would approach a merger arbitrage investing process:

• Find a list of mergers currently underway


• Choose highest-yielding arbitrage opportunities and focus on them first


• Research the target company:


• Determine its fair value


• Evaluate whether this company will be a good long-term investment at the current price if the merger falls through


• Research merger terms:


• Evaluate the risks involved


• Quantify the likelihood of the merger deal falling through


• Finally, carefully consider all the risks and yields involved and made a decision whether to participate in the arbitrage of this deal or not
  

You can use Benjamin Graham's risk arbitrage formula to determine what your reward would be once you account for risk involved in the deal. Here is how it works:

Annual Return= (C*G-L(100%-C)) / (Y*P)

or

Annual Return = (0.70*0.15-0.20(1-0.70)) / (0.5*1) = 0.09 = 9%

Where:
• C is the expected chance of success (%) or 70% in the example
• P is the current price of the security or 1 in the example
• L is the expected loss in the event of a failure (usually original price) or 20% in the example
• Y is the expected holding time in years (usually the time until the merger takes place) or 0.5 (6 months) in the example
• G is the expected gain in the event of a success (usually takeover price) or 15% in the example

Additional resources:

Arbitrage opportunities in pending merger deals in the U.S. market:

• ArbitrageView: click here
• MergerInvesting: click here
• The Online Investor: click here
  

Articles about merger/risk arbitrage:

• Investopedia: Trading the Odds with Arbitrage
• Risk Glossary: Event Driven Trading Strategy
• Morningstar: The Basics of a Buyout
• American Venture Magazine: Merger Arbitrage
  

Other web sites focused on mergers/acquisitions and arbitrage strategies:

• Mergers & Acquisitions DealBook (by New York Times): click here
• Deal Journal (blog by Wall Street Journal): click here
• FocusInvestor.com (Tons of information on Buffett-style investing and arbitrage): click here