M&A Arbitrage
I have a question on M&A arbitrage. I understand the rationale behind it - long the target, short the acquirer. However, how do portfolio managers actually use this strategy? I assume they don't wait till news actually come out. How would they know which company is getting acquired, and putting in trades in time?
Any insight is greatly appreciated.
A deal is announced and the PM makes a trade based on his view of whether or not the deal will be actually consummated. If the deal falls through and doesn't get done or it does get executed, depending on the trade, the PM could make or lose money.
They make money off of it by only betting on sure things. Like Gordon Gekko.
There is a price discount based on the probability of the deal going through, that is where the money is made.
Generally speaking, the higher the spread between the bid price and market price, the lower probability of a deal being completed as determined by the market.
M&A arbitrage funds can either a) make a ballsy wager on a deal completing with a high spread (think CNOOC's recent purchase of Nexen) or b) enter the same trade on a low spread deal, but leverage your position to magnify your equity return.
There's also more complex ways of doing this through options and other derivatives which might actually reflect true arbitrage due to market inefficiencies.
Valuation analysis is done on an industry this can point out targets for m&a companies that have a chance of being acquired usually show similar characteristics.
This is not merger arb. This is takeout as an upside to your equity thesis or LBO as a floor to your valuation downside.
Traditional merger arb is high leverage low spreads. And thus the kind of game where one bad call can blow you up.
1) If they don't wait till the news comes out, its speculative arb. Since it's speculative, it's a best guess at a company that could be acquired for a variety of reasons; could be an industry in consolidation (slow growth, bigger players can only grow by acquiring slower players), or something more concrete such as exploration of strategic alternatives (which could include a sale of the company, selling part of the company, spin-offs etc.) , among other things. These are riskier and PMs are selective in when to get involved.
2) A deal is announced (logistically, news of a merger is released pre or post market, or trading is halted during the day for a few minutes for the news to be announced), and the stock almost instantaneously trades higher when it begins trading. At that point, based on what you think the closing date is, you can calculate an annualized spread, which should reflect the general level of risk involved in the deal, and you can calculate a probability of deal completion based on what you think the market anticipated downside is (not scientific, would be safe to take a 30 day VWAP of the period before deal announcement in most cases). Next, comes quantitative analysis (what's the company actually worth in a deal/no deal scenario, and fundamentally if you were going to value it as a sell side research analyst), and qualitative analysis (is the management team / board likely to sell? Is there perceived long term potential that is being limited with this bid, that would prohibit shareholders from approving the deal? are there anti-trust issues that could arise?) and a lot of phone calls with sell side analysts, management, and fellow shareholders. Then, is analysis of the merger agreement which tells you conditions on which the deal is predicated, such as regulatory and shareholder approval, termination/reverse termination fees, and events that could allow the buyer to walk away, among other things.
Arb is trading, and not investing, where you're likely trading from the moment the deal is announced in target/acquirers/competitors stock (could be any combination of long/short depending on your view) or options with limited information. You eventually go through the process described above and get a clearer picture but you are trading very shortly after deal announcement or a spec arb catalyst.
Great breakdown. There were so much bad information before this post. Just to add, while most of the time it's about collecting a spread and not being blown up, for some blatantly underpriced implied break probability, the risk arb manager can choose to chinese the deal.
Also, there could also be somewhat more speculative plays on further higher bids coming in, thus creating some option-like upside on the IRR.
Lastly, while traditionally risk arb is long the target for cash deal and long the target short acquirer for share deal, you could also make a play on the capital structure. For example, acquirer A, upon absorbing target B, could choose to call/refi the outstanding target B bond, thus affective the valuation. These are the most interesting ones in my opinion.
Another quick question. What about stock deals. I know people buy the target and short the acquirer, but how do you know when to get in/get out? Thanks a lot.
Thanks guys!
you have a lot of questions on this topic...this book is only like 80 pages, and covers pretty much everything you would want to know about various risk arb situations:
http://www.amazon.com/Risk-Arbitrage-Wiley-Investment-Classics/dp/04704…
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