I first came across the term merger arbitrage while reading Dhando Investor. A basic definition is the idea of taking advantage of the price difference between an investment.
e.g. if gold is selling for US$980 on the Australian market and being sold for $1010 in the US market, an arbitrageur would purchase gold from the Australian market and sell it immediately on the US market with close to zero risk. We will look at how it relates to stocks.
A detailed explanation is provided on Wikipedia about the different types of arbitrage. A nice little summary from the page is…
Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. – Wikipedia
Why Merger Arbitrage?
In a down market, we all hate to see our money shrink. According to behavioral finance, losing money hurts twice as much as gaining the same amount of money. Merger arbitrage not only saves your portfolio is bad times, it also saves you from big financial and behavioral losses.
But how does a well analyzed arbitrage will save your portfolio?
The basic idea is that it provides a short term gain with very low risk.
I only tend to engage in a play when the deal between two merging companies is close to finalized This lets me invest my money for a short period of time (usually 3-5 weeks).
How to Analyze a Merger Arbitrage
First you need to find a source to get ideas from.
I tend to get my information from reading books, magazines, listening to finance stations on the radio and blogs but the best description and rundown of how to get started, what to watch for, when to start considering putting money down etc came from FWallStreet. I highly recommend you take a look.
There are 4 posts that make up the arbitrage/workout series.
I personally only engage in merger arbitrage where it has been confirmed (via newspapers, press release etc) a company will be buying out another company. My investing nature is completely against “speculative buyouts”.
Homework BEFORE Jumping In
The truth is, merger arbitrage is not easy. It is time consuming (at first) and not risk free (although it can be very low risk).
These are some general steps of how a merger usually plays out and what you must look for.
1. Due diligence by both parties;
2. Agree on a price, terms, and contingencies (financing, regulator approval);
3. Get preliminary shareholder sentiment (or controlling shareholder approval);
4. Secure financing arrangements (if needed);
5. Obtain regulator (SEC, FCC, any and all) approval;
6. Get final shareholder approval at a meeting called for that purpose;
7. Complete the deal.
A more practical version of this that you can use as a checklist is;
- Make sure both parties have done their due diligence
- Check management of both parties are trustworthy
- Financing and regulator approval is complete
- Get preliminary shareholder sentiment or controlling shareholder approval
- Obtain regulator (SEC, FCC, any and all) approval
- Get final shareholder approval at a meeting called for that purpose
- Check to see that insiders are continually vesting or buying shares
- Verify upside and downside risk is asymmetric by assigning potential upside to downside returns
The above steps can all be found from news, SEC filings and proxy statements. Remember to improve your workflow by taking advantage of the SEC RSS to make it quick and easy to check.
In most mergers, once the deal gets past number 5 or 6, the deal is very close to completion and close to risk free at this point.
However, by this time, the price difference or spread has usually closed and the profit will probably be a very small percentage. Maybe 1-2%.
BUT, there are many many mergers that Wall Street forgets about. It is these that provide quite a substantial annualized gain.
Risk in Merging Arbitrage
- A deal could fall out just as suddenly as it was announced.
- Last minute financing could be the problem
- The deadline may not be met
- Required approvals may not be obtained
- and more
That is why, to reduce as must risk as possible, doing your homework on the 7 steps above as well as keeping up to date with current situations is vital for a successful investment.
Risk also comes from being involved in too many at the same time.
Most practitioners buy into a great many deals perhaps 50 or more per year. With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks. – Warren Buffett
The key is to look for the ones where the odds are in your favor.