By Investment Master Class

‘Merger arbitrage’, a form of risk’ arbitrage,  is the term given to buying stocks involved in a takeover situation to capture the spread between the market price and the takeover price. The target stock usually trades at a discount to the takeover price to reflect the risk the takeover fails as well as the time value of money until the deal completes.

However, unlike ‘classic arbitrage’, there is a risk the deal won’t happen. If a deal breaks, the target stock price generally falls back towards it’s pre-deal level [the price can fall lower or retain some of the premium depending on the situation] leading to large losses. Thus the term ‘risk arbitrage’.

In a cash deal, the investor will buy the target’s shares at a discount to the takeover price which are exchanged for cash at deal completion. In a scrip deal, the investor will buy the target’s shares and short the acquirer’s shares, in the appropriate ratio, to lock in the ‘spread’. At completion the target’s shares will be exchanged for the acquirer’s shares which will be used to net off the short position.

“Say you get a $50 offer from a company that was trading at $35 and it immediately jumps to $49. Now most investors don’t want to stick around for the last dollar and risk losing $14 if the deal breaks. They made a good profit and want to take the property and go home.  On the other hand, the arbitrageur steps in, and for that extra dollar, takes the $14 risk of deal completion. Now a dollar may not sound like a lot. But a dollar over $50 is roughly a two percent return. And let’s say it’s a tender offer and will close in 60 days. That means you can do the deal six times a year so six times two is a 12 percent rate of return. That can be an attractive rate of return for a relatively short term investment” John Paulson

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The key attraction of merger arbitrage compared to investing in a company based on fundamentals is that you are less exposed to the broader influences of the stock market given the somewhat specific price and time outcome.

"The beauty of arbitrage is you can earn good returns that are non-correlated with the market"  John Paulson

investment master class john paulson merger arbitrage value investing

However, in stressed markets and/or economic environments, merger arbitrage returns tend to become more highly correlated with the broader market given financing can dry up, market-out and/or material adverse change clauses get triggered, and funds face redemptions.

Buffett has been actively involved in merger arbitrage in both the Buffett Partnership and then Berkshire Hathaway. Buffett only participated in deals once they had been announced, unlike many investors who look to participate in pre-announced deals, where a deal maybe rumoured [rumourtrage], a company may disclose they are considering corporate actions/strategic alternatives or there is speculated to be further corporate action given significant merger activity in a sector.

"The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumours or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities"  Warren Buffett 1988

Merger arbitrage is a specialised area requiring skills in valuation, portfolio/risk management, takeover laws/regulatory rules, industry dynamics, human psychology, tax rules etc.

"A legal education helps us in the analytical process. It instills discipline" Brian Stark

“One of the things you have to be good at in the risk arbitrage business is valuation: you need to be able to understand your downside” John Phelan

"To be successful requires very specialised skills unique to the arbitrageur. One must be an expert in evaluating the financing, legal, regulatory, accounting, market and business issues that may affect a deal's outcome. To properly evaluate these risks, the arbitrageur must have expertise in analysing merger agreements, financing agreements, strategic issues and financial statements, as well as federal, state and local regulatory issues." John Paulson

Given the merger 'spread' is normally quite slim, the profits from merger arbitrage tends to be small relative to the loss you incur if a deal fails. In the example above, an investor risked fourteen dollars to make one dollar. This asymmetry is why it is analogous to 'picking up nickels in front of a steamroller'.

“The strategy, while properly executed, can produce non-correlated, low-volatility returns, [however] any individual deal may carry substantial risk. This is because the upside in a transaction is very small compared to the potential downside. While the annualised return may be high, the absolute return is small, and the downside can be 10 times, 20 times or even 30 times the amount of potential gain” John Paulson

“When things go wrong in merger arbitrage, they can go very wrong – often in an asymmetric way.” Joel Greenblatt

"Premiums, ranging generally from 10 percent to even 50 percent - exceptionally even 100 percent - maybe offered for acquisition targets.  An arbitrageur, when he takes his long position, is thereby assuming a great part of this premium in the price he pays.  Should the deal be sabotaged for some reason, the downside price slide can be rather large.  So one must carefully calculate the downside risk" Guy Wyser-Pratte

To make money in merger arbitrage the investor needs the deal to complete. As a starting point it's worth considering a few basics. Prior to analysing a deal it's worth asking a few questions with regards to the jurisdiction of the deal. Roddy Campbell of Cross Asset Management poses the following three question: Is there 1) a level playing field? 2) a decent body of precedent of corporate law decisions? and 3) an ability to predict the behaviour of participants and comprehend their motives? If you answer NO on any of those, it's probably best to move on t0 the next opportunity.

It's worth establishing a checklist of key considerations to ensure items are not overlooked. Some considerations include:

Deal type - is the deal announced or rumoured? Announced deals carry significantly lower risk.
Type of Buyer - is the buyer a financial buyer [ie private equity] or a strategic buyer? Sensible strategic acquisitions by larger companies in the same industry tend to have a higher likelihood of success [in the absence of competition issues].
Nature of Target - was the company being shopped for sale? A company being shopped means the company is 'in play' and the board is open to a transaction.  Other buyers may emerge if the deal breaks. Conversely, the list of alternate buyers may already be exhausted. If the market was aware the company was being shopped the pre-deal price is likely to have some takeover premium in it which may disappear if the deal breaks.
Type of Bid - is the buyer paying cash or scrip, a combination of both, or some other form of payment? Is the deal a takeover, scheme of arrangement or other type of transaction?
Borrow - if the deal is a scrip deal, is there ample borrow? What are the borrow costs?
Hostile or Friendly - has the seller agreed to the terms of the deal or is it a hostile takeover? Friendly

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