Shorting a Merger in all stock deal
Hi all, just a few questions
Stock for stock deal, that you think won't close - how would one short this. Obviously in a normal stock-for stock merger arb, you would buy the target and buy puts of the acquirer - but what if you were bearish on the deal closing?
If one was bearish on both the target and acquirer (macro thesis about the space in general), would just shorting the target be fine? If Macro thesis plays out but deal closes you win, if macro doesn't work out, but deal doesn't close you win, and obviously you win if both work out. Am I understanding this correctly?
Also where would one (Incoming IB analyst with no access to Bloomberg terminal) find information on puts outstanding, to try to calculate merger arb on this deal.
Merger arb 101:
In an all stock deal, investors usually long the target and short the acquirer at the merger exchange ratio. This allows you to lock in the spread between the target and acquirer which is a function of whether the deal closes or not. If it closes, you make that spread in the above trade construct and that is your only risk.
If you think the deal is going to fail, then you short the target and long the acquirer again in the exchange ratio. If it breaks, you make money and if it closes you lose the spread.
If you have a view on the ”macro”, you can vary the amount of acquirer stock you short or long respectively. So if you think the deal is going to break AND you think the sector is terrible, then yes you can just short the target. If the sector derates, the acquirer stock will trade down and the target stock will follow suit because the target is trading at a discount to the acquirer. The target stock will also trade down because the downside on a break is lower than before the deal was announced due to the sector derating.
To your question if you’re just short the target: if macro thesis works but deal completes, you could lose money if the spread is wide today. The target would likely trade up on a deal closing so you would need to make sure the macro derating is stronger than how much the target trades up on a closed deal.
if you think deal has higher risk than market is pricing, short T/buy A. if you think deal goes thru but that it's a dumb deal and will leave A exposed, prob would just short A. you need to separate deal risk from business / macro risk. yes, they can be intertwined, but focus on what bet want to make first. generally should not mesh multiple theses. once that's sorted, then consider how to structure / express the view
Theoretically, if the probability of stock A acquiring stock B is 100% then the spread should trade around the risk free rate. Calculate the market's probability of a deal going through by analyzing the risk premia of the trade (e.g. risk free rate - current spread = market implied probability of the deal). A no deal case would be the spread pre-announcement (so that spread is what you set as neutral probability, e.g. the general probability of a deal happening with either of the companies).
Between now and the close date, the spread will vary, indicating richness or cheapness.
Time increases the probability of an implied outcome. Every day, as we move forward in time, the probability of the outcome should increase (unless new info shifts the probability). E.g. you start today with 85% probability and between now and the close date, you would assume the spread narrows by 15%/days between.
Information will shift probabilities. As an analyst, you need to decompose the "market implied" into a distribution of probabilities x scenarios. E.g. market spread (risk premia) is 3%, implying a 75% probability of success. But you decompose that into scenarios A (100% success), scenario B (renegotiation), scenario C (bid war), scenario D (fail), Scenario E (reg issues). Your initial, informationally driven, weights might be something like 50%, 15%, 10%, 15%, 10%. Given your probabilities x scenarios, your rolled up probability of success is ~60% which should drive a premia of 4.5%. Compared to where the market is (3%), you may think the spread is trading richly, and may fade it if you have identified an upcoming catalyst (e.g. there is a court hearing by a competitor on regulatory risk next week, you can speculate if you think there may be new information from that event).
Simply going long the target and short the acquirer is the "beta" of the trade. That's never a trade idea (unless you're a LO and all you do is buy the risk arb factor).
Can't the acquirer go up in value after the acquisition ? Maybe they paid 10 dollars for it but its worth 15 dollars?
Yes but risk arb is about extracting a risk premia from the market, not a delta move on the underlying legs.
Plenty of merger arb players just buy the “risk arb factor” under the guise they have some differentiation and make a lot of money. Nothing wrong if your value add is avoiding deals breaking even if you’re buying deals at “fair” levels in my opinion. Doesn’t sound sexy but who cares if deal closes.
What lol
Merger arb is so 2022. Outdated strategy
Why do you say that? 2023 was an excellent year for merger arb.
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