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Merger Arbitrage

Hedge Funds

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Merger arbitrage strategies revolve around the world of confirmed or rumored mergers and acquisitions (commonly called M&A). Hedge funds specializing in this strategy look at many factors of M&A which determine success. Managers can either wait for firms to announce mergers or acquisitions, or attempt to anticipate mergers and create positions in advance. The success of merger arbitrage strategies is based on the buyer’s ability to complete the purchase, and partially based on the underlying quality of the company being purchased. Hedge fund managers must think carefully before pulling the trigger on M&A arbitrage strategies, since a constant risk exists that mergers or acquisitions will fail. They must also ensure that firms are committed to the deal, since rumors and lies are commonly planted in the market to earn profits for their originators.

Merger and acquisition arbitrage usually consists of purchasing the shares of the firm being acquired, and shorting or selling shares of the acquiring firm. The expectation is that post-merger values will meet somewhere in the middle, at a point which creates a profit for the hedge fund itself. There is almost always a more powerful firm acquiring a less powerful firm. Imbalances between firms in power, quality, and survivability exist even in mergers.

Merger Arbitrage: Cash Deal or Share Swap

Mergers or acquisitions can be executed in multiple ways. The two ways to build a friendly M&A deal is a cash payment or a share swap. The execution of a deal will alter how an arbitrage strategy is constructed.

A cash deal derives profit from the spread between the desired firm’s market price and its proposed purchase price. The buying organization offers the desired firm’s shareholders a premium on top of common share market prices. This premium will be negotiated upward by the desired firm’s shareholders, while the proposers attempt to hold it steady or decrease it. The share prices of the desired firm will rise towards the price most likely to be the final closing price. If the deal decreases in likeliness to succeed, shares slide towards their natural market value.

A swap merger or acquisition exchanges a buying firm’s shares for a purchased firm’s shares. Purchasing firms offer a share exchange ratio instead of a fixed exchange price. The value of shares in the exchange is rarely perfectly even, creating arbitrage opportunities. The market reacts to share swaps by purchasing the shares likely to rise as a result of the exchange, and selling or short selling the shares likely to decrease in value. The ratio of shares exchanged is often a fixed ratio, which limits the willingness of shareowners to complete the deal if prices move too far. If prices of either company’s shares move so widely that the deal is not worth completing, the deal will be rejected by one of the two firm’s shareholders, resulting in arbitrage losses. Share swap deals are far more complicated and usually have wider spreads than cash deals.

Merger Arbitrage Risks

The risks of merger and acquisition arbitrage is failure or restructuring of a deal in a way that creates no substantial profit. The spread created by arbitrage deals expands and contracts based on evidence the deal will conclude profitably or fail. An increasing failure risk grows the spread, creating losses for people who initiated their arbitrage at a narrower spread. A decreasing failure risk lowers the spread, creating profit for those who initiated their arbitrage at a wider spread. Maximum losses come at complete failure of a deal. Most managers invest in a wide array of potential mergers and acquisitions, diversifying away the risk of a single deal’s failure substantially harming their fund. If some deals collapse, other deals will carry those losses.

Merger Arbitrage: Leveraged Buyouts

Hedge funds may pay careful attention to leveraged buyouts. A leveraged buyout occurs when an outside group borrows large amounts of money to buy a firm or company. This shouldn’t be confused with managed buyouts, where internal management teams borrow money to buy their firm from shareholders. Both buyout categories establish collateral from the target firm’s assets, but a leveraged buyout has another firm’s shares in the mix. A managed buyout is an internal takeover, and does not involve a third party firm.

Merger Arbitrage: Deal Failures

Mergers, acquisitions, or leveraged buyouts can fail at any point in the transaction. Shareholders of any firm involved in a merger or acquisition can reject the deal outright. Shareholders may also seek other offers or accept a deal from another source. If financial difficulties emerged which were not disclosed, auditors will reveal these issues and shareholders may reject or adjust the proposed deal. Government regulators, anti-trust officials, or legal authorities can also shut down proposed deals. Regulators compare potential deals to existing laws to determine if regulations will be broken, while anti-trust authorities review them for monopoly possibilities. Hedge funds participating in merger and acquisition arbitrage must remain aware of these risks.

Hedge funds must qualify mergers and acquisitions before structuring arbitrage strategies. Losses are based on the amount of deals which fail after positions are initiated. Deal failures are very avoidable. Deals are likely to succeed if they benefit shareholders, remain the highest market offers, and don’t attract regulatory intervention. Management must be pleased with the deal, and not attempting a fight or a counter-offer. The purchasing corporation’s financial or tactical return anticipated from the deal should provide higher return at that level of risk than other available choices. If rewards are better elsewhere, there is no reason to place money into a deal for a long period of time.

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