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Introduction to Merger Arbitrage

I. Introduction to Merger Arbitrage


A. Definition of Merger Arbitrage

Merger arbitrage is a process akin to picking up a few pennies and nickels along the way while panning the river for the big prize, gold. You are basically trying to pick up a few short-term and hopefully low risk dollars in your journey to your long-term investment goals. To explain merger arbitrage (also known as risk arbitrage), I am going to borrow from a blog entry I wrote on January 11, 2007 titled A Merger Arbitrage Opportunity, where I wrote,
“2006 proved to be a banner year for global mergers & acquisitions with $3.79 trillion worth of deals, which even surpassed the deals made during the height of the dot com boom in 2000. As you may have noticed, when a merger or acquisition is announced, the stock of the company getting acquired usually jumps up and closes the day at a price very close to the acquisition price but often a little lower. For example when private equity firm Genstar Capital announced the acquisition of International Aluminum Corp yesterday, the stock jumped up more than 4% to close the day at $52.08. This is almost a dollar less than the acquisition price of $53 per share in cash that Genstar is offering. Here are a few reasons why this occurs.
  1. Unless there is a possibility of a rival bid, the stock of the company getting acquired will stay stagnant and tie up capital until the acquisition is completed.
  2. The acquisition may not go through due to antitrust issues or breach of conditions mentioned in the deal.
  3. The deal may be an all stock or stock plus cash deal and there is a risk that the stock of the acquisitor may drop in value before the acquisition is complete.
  4. If it is a very large deal, there is a risk that the acquisitor may not be able to raise the required capital to complete the deal.
Investors can profit from mergers and acquisition in a variety of ways and one of them is described in detail in this excellent FocusInvestor article called Introduction To Risk Arbitrage: Rainy Day Returns? (PDF).

B. Historical Context and Evolution

In case you are wondering, risk arbitrage is not just for hedge fund managers but has been used by both Warren Buffett of Berkshire Hathaway (BRK.A) and his guru Benjamin Graham. Maurece Shiller began his career on Wall Street in 1922 and in 1959 wrote one of the earliest books on event-driven strategies called Investors’s Guide to Special Situations Strategies in the Stock Market. The book discusses the merger arbitrage strategy as do the 1987 book Special Situation Investing: Hedging, Arbitrage, and Liquidation by Brian Stark and Joel Greenblatt’s famous book You Can Be A Stock Market Genius. The strategy has been used by investors for several decades although its attractiveness ebbs and flows depending on interest rates and the regulatory environment as covered later in this article.

C. Objectives and Principles

Over a twelve year period from 2010 to 2021, 95% of all announced mergers and acquisitions ended up closing successfully.  This included the period coming out of the Great Recession of 2008-2009 as well as the COVID-19 related bear market of 2020.
The objective of the strategy is to capture the merger arbitrage spread on the successful M&A deals while minimizing the chances of getting stuck in a deal that either takes a very long time to complete or fails. 
 
The reasons for deal failure and their impact will be covered in the risks and challenges section of the article.

D. Key Terminology

  • The phrases merger arbitrage, risk arbitrage, merger arb and risk arb also refer to the same thing and as described above is a strategy to capture profits after a M&A transaction is announced but before it closes.
  • M&A, mergers and acquisitions and deals all refer to two companies that are combining in a merger of equals or a large company acquiring a smaller one. Some investors use the word merger and the word acquisition interchangeably.
  • Merger arbitrage spread or just spread refers to the profit opportunity that exists between the current market price and the deal price. For example if the stocks of a company being acquired is trading at $50 and the acquisition price is $55, then the spread is $5 and is often expressed as a percentage. In this case there is a 10% spread (or profit) to be made by investing at $50 and waiting for the deal to close and get paid $55.
  • Annualized returns are important to investors who participate in merger arbitrage because it allows them to compare the return of a specific arbitrage opportunity with other investments. If a deal offers a 10% spread and closes in six months, then the annualized return is double or 20%. Similarly if a deal offers a spread of 5% and closes in three months, the annualized return also works out to 20%.

II. Understanding Merger Arbitrage Strategy


A. Overview of Merger Arbitrage Strategy

The merger arbitrage strategy focuses on generating returns that are usually better than holding cash or low-risk bonds in a portfolio. The strategy complements a broadly diversified portfolio with a risk and return profile that is often better than fixed income investments.

B. How Merger Arbitrage Works

For the details of an actual merger arbitrage opportunity, I have described a deal I participated in and wrote about on March 2, 2009, which incidentally proved to be near the bottom of the “great recession” bear market. Merger Arbitrage and the Pfizer – Wyeth Deal: On Monday January 26, 2009, Pfizer (PFE) made a definitive announcement to acquire Wyeth in a deal estimated at nearly $68 billion or $50.19/share at the time of announcement. Since Dow Jones had already reported on the deal the previous Friday, the stock appreciated from Thursday’s close of $38.83 to $43.74 on Friday, January 23, 2009. Hence I am going to use $38.83 as a pre-deal price. Pfizer is offering $33 in cash plus 0.985 of a Pfizer share in exchange for each share of Wyeth. With the 0.985 share of Pfizer working out to $17.19 at the time of announcement, the cash component of the deal worked out to $44.7 billion. Pfizer ended 2008 with nearly $24 billion in cash and short-term investments on its balance sheet and has decided to raise $22.5 billion in debt for the deal from a consortium of banks. Since this is a friendly acquisition, the key risk appears to be Pfizer’s ability to raise this debt. The deal is expected to close by the end of the third quarter of 2009 or in the fourth quarter. Based on the Feb 27, 2009 close of $12.31 for Pfizer, the 0.985 share component works out to $12.12. Combining that with $33 in cash, the deal is worth $45.12 to Wyeth shareholders right now. Wyeth shares closed at $40.82 last Friday, representing a discount of $4.30 or 9.5% to the value of the deal. Some of the analysis I have come across for this deal, tends to ignore the impact of Wyeth’s dividend on the overall return. Wyeth pays a $0.30 dividend per share each quarter. The first quarter dividend will be paid on March 2nd for shareholders on record Feb 13, 2009 and hence I have not included it while computing the total payment in the table below. The table below looks at actual returns and annualized returns for the arbitrage opportunity for two scenarios. The first scenario assumes the acquisition will close by the end of the third quarter, translating into a 7-month holding period (0.58 years). The second scenario assumes an end of fourth quarter close or a 10-month holding period.
Acquisition Timeline Total Payment Actual Return Annualized Return
Closes End of Q3 $45.72 12% 20.58%
Closes End of Q4 $46.02 12.74% 15.29%
Total Payment = $33 cash + 0.985 of a Pfizer share ($12.12) + Wyeth dividends
In an environment where cash is yielding just 2 to 3%, a 12% actual return appears to be an attractive bet. Please keep in mind that the above returns are not taking into account the probability of success or failure of the deal. If you want to arrive at the estimated annualized returns based on the probability of success or failure of this deal, you can use the formula discussed in the Introduction To Risk Arbitrage article mentioned above, Expected return = (GC*C – L(100%-C))/YP G: Expected gain in dollars in the event of success L: Expected loss in dollars in the event of failure C: Expected probability of success in percentage Y: Holding period in years P: Price of stock at the time of purchase Assuming the first scenario where the deal closes by the end of Q3, a 70% chance of success that the deal will go through and Wyeth falling $2 to return to the pre-deal announcement price if the deal does not succeed, the expected return works out to, Expected return = (($4.9 * 0.70) – ($2 * 0.30))/(0.58*$40.82) = 11.95% Pfizer generated $18.24 in operating cash flow in 2008 and paid out $8.5 billion in dividends. Starting in the second quarter of 2009, Pfizer plans to cut its 32 cent quarterly dividend in half, potentially conserving as much as $3 billion in cash for the company pre-dilution. With Wyeth generating $5.27 billion in operating cash flow in 2008 and the credit markets thawing, I believe the probability of Pfizer raising the capital required to complete this deal is quite high. Even with a 70% probability of success, the expected annualized return of 11.95% is decent given current market conditions.

C. Key Components of Merger Arbitrage

  1. Identifying Target Companies: As someone who is new to the strategy it is sometimes tempting to capture the largest spreads by buying the stocks of companies trading at a large discount to their deal price. However the large spread also represents the market’s assessment of how much risk there is of the deal failing. We track all U.S. listed merger arbitrage opportunities in our Merger Arbitrage Tool that allows you to identify and understand both deals with large spreads and ones that are less risky with smaller spreads.
  2. Analyzing Deal Terms and Conditions: It is absolutely essential to understand the deal type (all cash, all stock, etc.), if the target company that will be acquired has a “go shop” period for a few days to pitch itself to other suitors, whether the acquiring company has the required financing to pay for this merger, the kinds of regulatory approvals the deal would require, how much of a premium is being paid to convince shareholders to vote for the deal and how large the termination fee is in case the deal fails.
  3. Assessing Risk Factors: The spread on a deal is an early indicator of the level of risk a deal faces. If the spread is large, the market expects the deal to face challenges that could mean a very long time to close or eventual failure. The quality of the acquiring company is important because an inexperienced acquirer might not be able to navigate the regulatory challenges effectively or raise the financing needed to close the deal. The industry the company operates in is also important as it could mean that regulators besides antitrust regulators might have to approve the deal.

D. Risk-Reward Profile of Merger Arbitrage

Merger arbitrage is no free lunch and the strategy comes with its own unique risks. There is a reason it is also know as risk arbitrage. The larger the spread and greater the potential profit, the larger the risk as well. One way to think about merger arbitrage spreads is the way you would think about investing in bonds. The safest bonds have low risk of default and you are very likely to get back all the money you lent to the company or government when the bond matures in a few months of a few years. You interest rate on the bond will also be low. In contrast if you choose to lend money to companies or governments that are on less sure footing, you will get a higher interest rate but there is also a higher risk that the bond issuer might default and you might not get your money back, let alone the high interest that lured you into the bond.

III. Factors Driving Mergers and Acquisitions (M&A) Activity

A. Market Forces

  1. Economic Conditions: Low interest rates spur M&A activity because companies can borrow money cheaply to acquire other companies to spur their future growth. A strong GDP might not always translate to low interest rates but it could provide a psychological boost to companies to take more risks by being more active on the M&A front.
  2. Industry Trends: Companies and industries often go through cycles and you see consolidation though M&A activity both during the top of the cycle. When the cycle is at its peak, companies are flush with cash and if can’t reinvest in their business, they choose to put the extra cash to work through mergers and acquisitions. At the bottom of the cycle, the weak companies have gone bankrupt or are close to failing and this spurs deal activity where the surviving strong companies swoop in to purchase their weaker competitors are bargain prices.
  3. Competitive Dynamics: Large companies, especially in the technology industry, often attempt to acquire their smaller competitors to either enhance their product offerings or eliminate a competitor. A highly fragmented industry with a large number of small competitors could spur M&A activity where a few large companies attempt to consolidate the industry.

B. Regulatory Environment

  1. Antitrust Laws and Regulations: Consolidation within an industry can be good for companies as they gain larger market share and can start to charge higher prices. It is however not very good for consumers who now have limited choices and are forced to pay those higher prices. Most countries have an antitrust regulators that reviews deals and determines if letting the deal close will create an anti-competitive environment. In the United States, it is either the Federal Trade Commission (FTC) or the Department of Justice (DOJ) that chooses to take a close look at deals.
  2. Government Policies and Interventions: Deals that are smaller than a certain size ($119.5 million for certain types of deals in 2024) do not have to complete a form called the HSR filing with the antitrust regulators in the United States. All other companies have to complete the HSR filing and this starts a 30 day clock for the regulators to review the deal. If the clock expires without the regulators challenging the deal or requesting more information, the parties can proceed with the transaction. Deals in specific industries such as banking, airlines and media will have different industry specific regulators such as the The Office of the Comptroller of the Currency’s (OCC), the Department of Transportation (DOT) and the Federal Communications Commission (FCC) that will need to approve the deal.
  3. Foreign Regulators: If the company being acquired has operations in other countries then regulators in those countries might take a look at the deal and in some instances attempt to stop it. Microsoft’s acquisition of the video gaming giant Activision Blizzard required approval in 60 countries.
 

IV. Types of Merger and Acquisition Deals


A. Cash Deals

In an all cash deal, the acquiring company pays the target company’s shareholders in cash when the deal closes. For example when Microsoft closed its acquisition of gaming company Activision Blizzard in late 2023, shareholders of Activision Blizzard received $95 per share in cash after the deal closed.

B. All Stock Deals

In an all stock deal, the shareholders of the target company will receive stock of the acquiring company when the deal closes. For example, when Salesforce acquired the data visualization company Tableau Software in 2019, it was an all stock deal worth $15.7 billion. When the deal closed, for every share of Tableau, shareholders received 1.103 shares of Salesforce. All stock deals can be tax efficient as the shareholders of the target company may not have to pay taxes and it can also be advantageous to the acquiring company because they don’t have to raise money to close the deal.

C. Cash-and-Stock Deals

In some instances, the deal could be structured in such a way that part of the merger consideration is paid in cash and part of it as stock of the acquiring company. For example when the pharmaceutical giant AbbVie decided to acquire Allergan in a massive $63 billion deal in 2019, shareholders received 0.8660 AbbVie shares and $120.30 in cash for each Allergan Share that they held.

D. Special Conditions

The value of some deals can vary based on several factors including the price of the acquiring company stock, the assets held by the target company at closing, the perceived value of real estate that will be sold after closing or the potential profits received in the future if the target company’s pipeline of drugs receive FDA approval several years in the future. To handle some of these conditions, the deal might include something called a collar or a contingent value right (CVR). A collar is used where instead of receiving a fixed number of shares of the acquiring company, the target company shareholders might either receive more or less shares of the acquiring company stock depending on the price of the acquiring company stock at closing. A contingent value right (CVR) – also called an earnout in private market transactions – includes potential future payments long after the deal closes, based on certain conditions being met (such the FDA approval of a drug). Deals that include collars or CVRs are often classified as special conditions deals.