Basics
Mergers
In aPredictors of merger success
Baker and Savasoglu contend that the best single predictor of merger success is hostility: only 38% of hostile deals were successfully consummated, while so-called friendly deals boasted a success rate of 82%. Cornelli and Li contend that arbitrageurs are actually the most important element in determining the success of a merger. Since arbitrageurs have made significant financial bets that the merger will go through, it is expected that they will push for consummation. For this very reason, the probability that the merger will consummate increases as arbitrageur control increases. In their study, Cornelli and Li found that the arbitrage industry would hold as much as 30%-40% of a target's stock during the merger process. This represents a significant portion of the shares required to vote yes to deal consummation in most mergers. Thus, takeovers in which arbitrageurs bought shares had an actual success rate higher than the average probability of success implied by market prices. As a result, they can generate substantial positive returns on their portfolio positions.Active vs. passive risk arbitrage
The arbitrageur can generate returns either actively or passively. Active arbitrageurs purchase enough stock in the target to control the outcome of the merger. These activist investors initiate sales processes or hold back support from ongoing mergers in attempts to solicit a higher bid. On the other end of the spectrum, passive arbitrageurs do not influence the outcome of the merger. One set of passive arbitrageurs invests in deals that the market expects to succeed and increases holdings if the probability of success improves. The other set of passive arbitrageurs is more involved, but passive nonetheless: these arbitrageurs are more selective with their investments, meticulously testing assumptions on the risk-reward profile of individual deals. This set of arbitrageurs will invest in deals in which they conclude that the probability of success is greater than what the spread implies. Passive arbitrageurs have more freedom in very liquid stocks: the more liquid the target stock, the better risk arbitrageurs can hide their trade. In this case, using the assumption that a higher arbitrageur presence increases the probability of consummation, the share price will not fully reflect the increased probability of success and the risk arbitrageur can buy shares and make a profit. The arbitrageur must decide whether an active role or a passive role in the merger is the more attractive option in a given situation.Risk-return profile
The risk-return profile in risk arbitrage is relatively asymmetric. There is typically a far greater downside if the deal breaks than there is upside if the deal is completed.Deal-level risks
Risk "arbitrage" is not risk-free. Its profits materialize if the spread, which exists as a result of the risk that the merger will not be consummated at its original terms, eventually narrows. Risk arises from the possibility of deals failing to go through or not being consummated within the timeframe originally indicated. The risk arbitrageur must be aware of the risks that threaten both the original terms and the ultimate consummation of the deal. These risks include price cuts, deal extension risk and deal termination. A price cut would lower the offer value of the target's shares, and the arbitrageur could end up with a net loss even if the merger is consummated. An unexpected extension to the deal completion timeframe lowers the expected annualized return which in turn causes a decline in the stock to compensate assuming the probability of the deal completing remains constant. However, the majority of mergers and acquisitions are not revised. Therefore, the arbitrageur need only concern himself with the question of whether the deal will be consummated according to its original terms or terminated. Deal termination can occur for many reasons. These reasons may include either party's inability to satisfy conditions of the merger, a failure to obtain the requisite shareholder approval, failure to receiveMarket risk
Several authors find that the returns to risk arbitrage are somewhat uncorrelated to the returns of the stock market in typical market environments. However, risk arbitrage is not necessarily insensitive to the performance of the stock market in all market conditions. When the stock market experiences a decrease of 4% or more, theReturns
In the long run, risk arbitrage appears to generate positive returns. Baker and Savasoglu replicated a diversified risk arbitrage portfolio containing 1,901 mergers between 1981 and 1996; the portfolio generated excess annualized returns of 9.6%. Maheswaran and Yeoh examined the risk-adjusted profitability of merger arbitrage in Australia using a sample of 193 bids from January 1991 to April 2000; the portfolio returned 0.84% to 1.20% per month. Mitchell and Pulvino used a sample of 4,750 offers between 1963 and 1998 to characterize the risk and return in risk arbitrage; the portfolio generated annualized returns of 6.2%. The arbitrageur can face significant losses when a deal does not go through. Individual deal spreads can widen to more than fifty percent in broken deals. The HFRI Merger Arbitrage Index posted a maximum one-month loss of -6.5% but a maximum one-month gain of only 2.9% from 1990 to 2005. Merger arbitrage is significantly constrained by transaction costs. Arbitrageurs could generate abnormally high returns using this strategy, but the frequency and high cost of trades negate much of the profits.Example
Suppose Company A is trading at $40 a share. Then Company X announces a plan to buy Company A, in which case holders of Company A's stock get $80 in cash. Then Company A's stock jumps to $70. It does not go to $80 since there is some chance the deal will not go through. In this case, the arbitrageur can purchase shares of Company A's stock for $70. He will gain $10 if the deal is completed and lose $30 if the deal is terminated (assuming the stock returns to its original $40 in a break, which may not occur). According to the market, the probability that the deal is consummated at its original terms is 75% and the probability that the deal will be terminated is 25%. The arbitrageur has three choices: # Purchase Company A's stock at $70. They would do this if he believes the probability that the deal will close is higher than or in-line with the odds offered by the market. # Short sell Company A's stock at $70. They would do this if he believes the probability that the deal will be terminated is higher than the odds offered by the market. If the arbitrageur believes the probability the deal will be occur is greater than 50% (that is, they believe the acquisition will still occur) but less than the probability assigned by the market (say, 60% in this example), they must also assume that the market will assign a probability of deal occurrence closer to their belief at some point before the close of the acquisition. # Do not get involved in the deal at this point in time.References
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