Occasionally, we hear about two different companies with separate ownerships coming together to form one company. An example of such union is Elance and O’desk, two formerly separate online freelancing companies, that came together to form ‘Upwork’.

Merger arbitrage comes about when two companies begin or announce negotiations for a potential merger.

What is Merger Arbitrage?

Merger arbitrage refers to a simultaneous process of buying stocks, upon the notice of a potential merger, and selling them to make profit. Merger arbitrage is usually associated or referred to as a form of hedge fund strategy.

People or companies who engage in merger arbitration are known as arbitrageurs. They estimate the level of potential risk involved in the investment or merger and decide on whether or not to buy and sell the stocks.

Merger arbitrage is a subtopic under event-driven investment which is a topic that is concerned with taking advantage of market inefficiencies that exist before the creation of a merger. But whiles portfolio managers are more interested in the profitability of the company, merger arbitrageurs are more concerned about whether or not the deal will be approved and how long the deal will take until it closes.

When a company discloses its intent to acquire a target firm, the target firm’s stock price rises whereas the acquiring firm’s stock price falls. Since there’s a possibility that the deal will or will not be finalized, the target company’s risen stock price is offered at a discount until the deal is finalized. The arbitrageur then buys at this discounted price knowing that if the deal is agreed, he will make a profit by selling the stock at the non-discounted price and if it does not, he will make a loss.

For instance, the stock price of a target company rises from $50 to $80 but is offered at a discount of $10. The arbitrageur buys at $70. If the deal is finalized, he will make a $10 profit but if is not approved, he will sell at the initial $50 and make a loss of $20.

There are two main forms of merger acquisitions; cash merger and stock merger.

In the case of a cash merger, an acquiring firm makes a proposal to buy the shares of a target firm at a given price in cash. The target company’s stock will trade at a price below the purchase price until the merger or acquisition is completed. During this period, the arbitrage company buys the stock of the target firm at this discounted price and when the acquirer finally buys the shares, the discrepancy between the prices becomes the arbitrageur’s profit.

In a stock merger the acquiring firm decides to purchase the target firm by exchanging its own stock for the target company’s stock. When such proposal is made, the arbitrageur engages in an act known as “setting and spread”. This term refers to the act where the arbitrageur short sells the acquirer and buys the target company’s stock. Upon completion of the merger the stock of the target company, based on the agreed upon ratio, is then converted into the acquiring company’s stock. The arbitrageur then gets the stock delivered into his short position and completes the arbitrage.

Risks involved

Such short position trading comes along with its own associated risks. The main risk involved is the possibility of negotiations breaking down. Some of the reasons that account for a negotiation breakdown include the acquirer’s failure to meet the demands of the target, failed attempt by the target to obtain shareholder approval, inability to obtain regulatory clearances, or any rough turn of events which may kill the acquiring firm’s desire to go through with the transaction.

Another peculiar issue of concern is with regards to stock mergers. In cases where the exchange ratio is not fixed/constant but dependent on the price of the acquirer, other complications may occur.