In the world of business, there are plenty of terms like merger (an agreement that combines two existing companies into one) and arbitrage (the simultaneous purchase and sale of the same security, commodity, or foreign exchange from different markets) that are often bandied about. However, when these two words are combined into one phrase (merger arbitrage), the term has a meaning all to itself. Though not a household phrase, merger arbitrage is a standard term in the business world.
What Is Merger Arbitrage?
Merger arbitrage, also referred to as “risk arbitrage,” is a type of investment strategy that involves buying and selling (at the same time) the stock of the two companies that are merging. By taking advantage of the market inefficiencies that are common when two companies merge, it’s possible to make a profit from that investment. A successful merger arbitrage strategy banks on the possibility of the merger not closing on the expected date and hopefully reaping the profits when the merger (or acquisition) is finalized. The investors that use the merger arbitrage strategy are referred to as “arbitrageurs.”
How Merger Arbitrage Works
It’s standard practice in the world of mergers and acquisitions (M&As) for the acquiring company (buyer) to offer a premium for the target company’s (seller’s) stock — typically, these stocks are purchased at higher-than-market prices. When the word about the merger hits the street, that almost always increases the share price of the target’s securities.
In cases of the investor owning shares prior to the announcement, this profit can be reaped on the day of the announcement. However, when an investor buys in after the announcement, the gains realized depend on the arbitrage spread. The arbitrage spread is the difference between the acquisition price and the market price on the date of purchase. The larger the spread, the higher the gain. Obviously, this is a sophisticated investment strategy, where one must know the ins and outs of the marketplace to be successful.
Cash Mergers vs. Stock Mergers
A cash merger is exactly as it sounds — when the acquiring company A pays cash (almost always at a premium) for shares of the target company B. Similarly, a stock merger is when the acquirer offers shares of its own to the stockholders of the target company. Again, both scenarios are common in the business world. In both instances, the goal is to maximize returns by “going long” — meaning the stock is held by the investor until it reaches its target price.
Active Arbitrage vs. Passive Arbitrage
Another subtlety is the issue of active versus passive arbitrage. Active arbitrage is when an arbitrageur holds enough of the stock of the target company to influence the merger. In the case of passive arbitrage, it’s an investment made in a way that the merger arbitrage funds and shareholdings of the arbitrageur aren’t significant enough to sway the outcome of the transaction.
Predicting the Outcome
An important indicator of the probable success of the M&A arbitrage merger is the degree of hostility. The degree of hostility is a measure of how amenable the target company is to the M&A. The higher the resistance of the target company, the greater degree of hostility. So naturally, the higher the degree of hostility, the harder the M&A arbitrage process will be and the greater the chances for success will be diminished. However, a large investment of merger arbitrage funds by an arbitrageur will increase the odds of success, as these investors are financially committed to make the M&A a reality.
Document Security for Merger Arbitrage
Naturally, any type of merger or acquisition, whether or not it involves merger arbitrage, requires scores and scores of confidential documents that are necessary for the transaction. Because of this, utilizing a virtual data room (VDR) for the successful completion of the transaction is necessary. A VDR is a secure, online location where all participants can store and share the required documentation with the appropriate parties without risk.
CapLinked Fits for Merger Arbitrage Transactions
A VDR is a vital tool for dealing with merger arbitrage. Being able to streamline the process ”“ saving both time and money ”“ is paramount. A CapLinked VDR will ensure that the security integrity of the documents will be maintained during all phases of the transaction, and its ease of use will help simplify the merger arbitrage, making it less stressful for everybody. Being able to complete the transaction ”“ on time and within budget ”“ is a win-win for all parties involved.
CapLinked, an industry leader in the VDR space, provides online workspaces that are secure and yet simple to manage. The tools that CapLinked provides with its VDRs include high-level admin controls, document and version management, multiple layers of security and 24/7 customer support. Its
user-friendly interface and ability to work on virtually every type of computer or internet-connected device makes CapLinked the best choice for anyone dealing with any type of M&A. Sign up for a free trial today.
Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.
Investopedia – Merger Arbitrage
Investopedia – Trade Takeover Stocks With Merger Arbitrage
Special Situation Investments – Guide to Merger Arbitrage
Wall Street Mojo – Merger Arbitrage