The Advantages of Investing in Merger Arbitrage
In general, merger arbitrage managers seek to make their investment strategies as market-neutral as possible, leaving the bulk of the portfolio’s exposure to whether or not specific corporate events actually occur. As a result, merger arbitrage strategies can generate positive returns in most market environments. In addition:
- Returns have historically had low correlation with the stock and bond market.
- Over time, returns have historically been less volatile than equity markets.
- Given the absolute return nature of the strategy and the focus on limiting downside risk, over the long term compounded rates of return have recently been higher than those afforded by traditional investing.
How Do Merger Arbitrage Managers Evaluate Deals?
Merger arbitrage is a complex strategy requiring a combination of knowledge, experience and skill.
When considering a deal, arbitrageurs must:
- Analyze public information regarding the companies in the transaction and the markets in which they compete
- Estimate the probabilities of a government antitrust investigation and enforcement action and the likely outcome of such an action
- Monitor litigation by government and private parties and analyze the likelihood of antitrust and other regulatory approvals
- Mitigate various potential deal risks such as: acquirer termination, deal delay, material adverse changes to either party, shareholder disapproval, tax obligations and financing concerns
- In hostile transactions, analyze target company anti-takeover defenses
Types of Mergers
There are three principal categories of mergers: cash mergers, stock-for-stock mergers and mixed stock and cash mergers. In cash mergers, the shareholders of the target company receive a cash consideration for their shares. Until the acquisition is complete, the stock of the target company typically trades below the acquisition price. Therefore, a merger arbitrage manager can buy the stock of the target company before the acquisition, and then make a profit if and when the acquisition is completed.
Merger Arbitrage Risks
Merger arbitrage is a complex strategy. The management of unwanted risk requires a combination of knowledge, experience and skill. After considering both the potential return relative to the risk associated with the transaction, the arbitrageur will look to invest in those deals with the highest level of return with the lowest risk.