What is Merger Arbitrage?
Merger arbitrage involves buying shares of acquisition targets at a discount to the deal price, profiting when the deal closes.
The Spread
After announcement, target stock trades below deal price. This spread reflects:
- Time value of money until close
- Risk the deal fails
- Regulatory and financing uncertainty
Cash vs Stock Deals
- Cash deals - Target converges to cash offer price
- Stock deals - Ratio of target to acquirer price matters; may require hedging
Risk Factors
- Regulatory rejection - Antitrust concerns
- Shareholder approval - Votes may fail
- Financing conditions - Acquirer may lose funding
- Material adverse change - Deal terms allow walking away
Evaluating Merger Arb Opportunities
- Annualized spread return
- Regulatory pathway (Hart-Scott-Rodino)
- Strategic vs financial buyer
- Break-up fee (downside protection)
Risks of Failed Deals
When deals fail, targets often fall 20-50%. Position sizing is critical.