Engaging in merger arbitrage—that is, entering a position after a definitive agreement has been signed between the target and the acquirer—is akin to selling options. The most an arbitrageur can make is the payment received when the merger closes. The downside is unlimited: in a worst-case scenario a complete loss of capital is possible if a merger collapses.
Thomas Kirchner, in this second edition of Merger Arbitrage: How to Profit from Global Event-Driven Arbitrage (Wiley, 2016), describes the ins and outs of mergers in easily understandable prose. He also addresses the risks and returns of the merger arbitrage strategy as well as its role in a diversified portfolio.
A couple of points about the risk:return profile of this strategy.
Quantifying the probability and severity of potential losses involves a lot of guesswork. In fact, the author writes, “even if quantitative methods are used to determine probabilities, it is difficult to say for sure how much credibility they have. Mergers are subject to a large number of variables that behave very differently under varying economic circumstances. Moreover, most arbitrage portfolios tend to have a limited number of positions, because only a limited number of companies merge at any one time. An overreliance on probabilities in such portfolios can be dangerous.” (p. 140)
The typical return on a merger arbitrage position is 2 to 4 percent achieved over, on average, four months. Annualized, the return would be 6 to 12 percent. Using the IQ Index and the S&P Merger Arbitrage Index as (admittedly flawed) proxies for the performance of this strategy as well as indices of hedge funds that specialize in merger arbitrage, we see that their “median return is comparable to that of the S&P 500 index, whereas volatility is more akin to that of bonds.” (p. 465)
Investors who are considering adding a merger arbitrage component to their portfolio should read this well-crafted book, as should students of finance. Cobbling together knowledge about mergers from the financial press simply leaves too many gaping holes.