Risk arbitrage, also called merger arbitrage, is a speculative trading strategy of providing liquidity to owners of a stock that is currently the target of an announced acquisition. Risk arbitrage belongs to a larger class of speculative trading strategies called event driven strategies that seek to identify and exploit relative mispricings of securities whose issuers are involved in mergers, divestures, restructurings or other corporate events. The strategies are generally leveraged and are often implemented to be market neutral. They are widely employed by certain hedge funds and proprietary traders.
Mergers can be cash deals, in which the acquiring company offers cash for the target company’s stock, or stock deals, in which the acquirer offers to exchange its own shares for those of the target company based on a specified ratio.
In a cash deal, risk arbitrage works as follows. The acquiring company offers to buy the target’s stock at a premium over the current market price. Upon that announcement, the target firm’s stock price generally rises to a level just below the offer price. It usually won’t rise to the offer price because of uncertainty about the merger actually taking place. Much can happen to derail a planned merger. The parties to the merger may decide, for one reason or another, not to proceed. Regulators might block the merger on antitrust grounds. Shareholders might feel the merger is not in their best interest and vote to block it. Unanticipated events, such as a market crash or war, might intervene and make the merger infeasible in the new economic or geopolitical environment. If the merger fails to go through, the target firm’s stock price will immediately fall, often to a level below where it was before the merger was announced. This possibility is called deal risk, and it poses a quandary for the target firm’s shareholders. Should they immediately sell their shares in the market and lock in the current price, or should they hold out, hoping the merger goes through, but risking a loss if it doesn’t? Many choose to sell, and it is risk arbitragers who are their buyers.
Risk arbitragers are experts in assessing deal risk. They hire lawyers to dissect deals and anticipate things that might go wrong. They look at the economic and geopolitical environment. They assess the mood of shareholders. They look at the spread between the offered price and current market price for the target firm’s stock. They assess how much of it is due to deal risk and how much of it is a liquidity spread reflecting pent up demand of shareholders wanting to sell. If they feel the liquidity spread is high enough, risk arbitragers will step in and buy the stock—they capture the spread in exchange for bearing the deal risk.
Risk arbitragers hedge their position by simultaneously shorting the acquiring firm’s stock. This provides a crude market neutral hedge, but it increases their exposure to deal risk. Usually, an acquiring firm’s stock price declines slightly prior to a merger. This is especially true if investors perceive the acquiring firm as overpaying for the acquisition. If the merger goes through, an arbitrager will profit from further decline in the acquirer’s stock price. If the merger fails, he will lose as the acquirer’s stock price rebounds.
With stock mergers, risk arbitrage works much as it does with cash mergers. Based on
- the target firm’s stock price,
- the acquiring firm’s stock price, and
- the ratio at which one is to be exchanged for the other,
risk arbitrageurs assess the deal. If they perceive an attractive liquidity spread, they buy the target firm’s stock and short the acquiring firm’s stock as a hedge. If the merger goes through, they receive the acquiring firm’s stock in exchange for the purchased shares and deliver that stock to close out their short position.
Other event driven strategies entail investing in divestitures or new stock issuances. Many involve investing in corporations that file for bankruptcy or are otherwise distressed. A unifying element in most of these strategies is that the arbitrager profits by providing liquidity—buying what others want to sell or selling what others want to buy. The strategies tend to make consistent profits, but they can suffer occasionally staggering losses. As with many market neutral strategies, event driven strategies have return distributions that tend to be negatively skewed and leptokurtic.